James Pethokoukis

Politics and policy from inside Washington

Banks: No friends left in Washington. Except Barney Frank. Kind of

Jun 17, 2010 18:54 UTC

U.S. financial reform keeps getting tougher on big banks — so they need to take friends wherever they can find them. Right now, that means Massachusetts Democrat Barney Frank, the liberal chairman of the House Financial Services Committee.

Not that Wall Street can afford to be choosy right now. Much to the industry’s dismay, sweeping regulatory legislation became more draconian as it moved from the House to the Senate. America’s continuing economic woes kept the spotlight on Wall Street’s role in the financial crisis, as did the Securities and Exchange Commission’s lawsuit against Goldman Sachs.

Senate Republicans, potential allies, were of no help. By not offering legislative amendments at a key stage of the Senate debate, they created a playing field for moderate Democrats to battle liberal Democrats. Even worse, the Obama administration, a moderating force behind the scenes despite some populist presidential rhetoric, has also been on the sidelines of late. Just as negotiators from the two chambers began hashing out a deal, the Gulf oil spill began monopolizing White House attention.

There was a moment when there was a real chance, for instance, that banks would have to dump their highly profitable derivatives desks. But Frank quickly jumped out and said the notorious Senate provision went “too far.” It now seems likely that banks will be able to keep those units as long as they are separately capitalized. In addition, Frank has been more sympathetic towards the financial sector’s positions over changes to deposit insurance, rules regulating credit raters and how the president of the New York Federal Reserve bank gets appointed.  Frank realizes that an overly strict bill risks alienating the few Republican senators who might actually vote for it.

Not that Frank is doing the banks’ bidding. He supports a stricter version of the Volcker Rule than passed the Senate, one that could ban most proprietary trading and investment in private equity and hedge funds. America’s most unpopular industry should consider it a trade-off – for banks keeping their swaps desks – from one of the few friends it has left.

Watching the watchmen

Jun 17, 2010 18:38 UTC

A good piece on financial regulatory reform over at VoxEu:

Furthermore, the bill does not address the risk of political capture. The same politicians calling now for stricter lending standards called for extended home ownership only a few years ago. The future roles of Fannie Mae and Freddie Mac are notably absent from this Bill, and neither is the issue of mortgage subsidisation being addressed. And there seems to be rather more political oversight than less. While accountability of regulators is important, the line between accountability and capture is a thin one.

Will the new framework help prevent the next crisis or at least reduce its probability significantly? The answer is a firm no, not because the reform steps are damaging or wrong, but simply because they only provide the framework, within which the different actors and most importantly regulators, central bankers, and politicians will act. As shown clearly on this site by Ross Levine (2010), it was the violation or intentional ignoring of rules that led to the build-up of the bubble and the subsequent bust, not the lack of regulatory power or proprietary trading.

Me: Thus all the concern about regulatory discretion …

The danger of small banks

May 24, 2010 17:59 UTC

Binyamin Appelbaum of the NYT tries to simply things for me:  ”Broadly speaking, there were two ways for the federal government to respond to the financial crisis. The Obama administration chose more regulation.”

And that is bad news because regulators and their political overlords like bailouts with taxpayer money rather than market discipline. But shrinking the banks, while superficially appealing, is no magic bullet — as this Italian study argues:  ”A world with only small and domestic banks is no safer. The key benefit of multinational banks – being able to mobilise funds across countries – could still be extremely useful for maintaining stability in times of distress.”

Wall Street scores a win on financial reform … for now

May 21, 2010 14:43 UTC

A sigh of relief is due on Wall Street. The procedural finale for the U.S. Senate’s debate on financial reform came just in time for the big banks. The bill just kept getting tougher as the talk dragged on. But it could have been worse. While banks’ future activities and profitability may get pinched, their core business model appears intact. In the end, Wall Street got nicked, not nuked. Some observations:

1) Wall Street should thank the White House. Had President Barack Obama prioritized bank reform over healthcare at the height of the crisis, the biggest players might have been broken up, hard caps placed on balance sheets, and banking and investing operations separated. More recently, the Securities and Exchange Commission’s lawsuit against Goldman Sachs in April helped re-energize advocates for such changes.

2) Nothing radical here. While the Senate and House bills still need to be blended, it’s safe to say the most radical ideas have fallen by the wayside. A “systemic risk council” of federal regulators will recommend new capital and leverage rules to the Federal Reserve, which will be the most influential bank regulator. The Federal Deposit Insurance Corporation will have the power to wind down any failing large, systemically interconnected institution.

In addition, large, complex financial firms will have to submit plans for their rapid and orderly shutdown should they go under. And for the first time the derivatives that are currently traded privately will mostly be forced to go through clearing houses and in some cases trade on exchanges. Bank lobbyists have defended their corner: it’s not the regulatory reign of terror their clients’ most vociferous critics wanted. But it’s hardly a “light touch” regime, either, and it does involve real changes. Caveat: This assumes the Blanche Lincoln provision on derivatives is softened or stripped in the conference committee.

3) Too Big To Fail is still a problem. As long as regulators and politicians have vast amounts of discretion, a financial crisis will make bailouts an irresistible temptation. The way around this is either breaking up the banks or creating hard, market-based triggers for either regulatory action or a resolution process. Neither is in the bill.

4) Wall Street’s has an enduring PR problem. Yes, big banks are unpopular. But it has gotten so bad that they may not be able to so easily counter their image issues with campaign cash. Getting Wall Street money now has a stigma attached to it like oil and tobacco money. Candidates like Meg Whitman in California and John Kasich are getting hammered for their Wall Street ties. The industry’s continued unpopularity will no doubt spawn further attempts to tax, regulate and restrict the sector.

5) Bernanke trimphant. The Federal Reserve has to be pretty satisfied. It did not lose its role as regulator; in fact, it’s been strengthened. And the central banks was also able to fend off attempts to make it more transparent.  The downside:  The GOP (see Rand Paul)  has soured on the Fed in a big way, particularly at the grassroots. Further economic woes will lead to more calls to change its form and function.

Are US regulators blowing it … again

May 7, 2010 19:10 UTC

Karen Shaw Petrou at Federal Financial Analytics asks a good question:

Last Friday, we outlined the systemic-risk implications of the growing EU crisis. In the days that followed, LIBOR spreads tightened, funding dried up and our fears only rose. So, we were a bit surprised to hear a senior U.S. bank regulator tell a radio audience Thursday morning not to bother their heads about any prospects that the European crisis could wash ashore. That was, of course, followed in a few hours by a classic systemic-risk crisis on the exchanges. Was the U.S. regulator keeping the game-face on so as not to scare the children? Or, more worryingly, are U.S. regulators still unprepared for another bout of systemic risk, whistling in the dark much as they did when they told us that subprime-mortgage risk couldn’t spill over?


A computer glitch, a fat finger is that the best analysis we can do? Though I doubt we can trace the transactions if they went through “dark pools” yesterday’s situation looks a lot like a program trading variation with sell and cancel orders to create massive liquidity then intiating buys on a variation of the following example of a gaming strategy:

Savvy traders can use information about your order to manipulate prices in their favor. Some of the most common gaming scenarios include:

Gaming by manipulating the stock price. This scenario is explained with the following sequence of actions:
Figure 3. Gaming with Fishing
How gaming happens: 1) The Information Leak (Fishing)- By selling a few small lots, a gamer determines that a passive buyer has placed a standing order in a stock 2) The Exploratory Maneuver – The gamer buys the stock rapidly in the displayed market and succeeds in moving the stock up. 3) The Hit – After moving the stock, the gamer sends a large sell order to the dark pool and sells at substantially higher prices than the price he started buying at in the displayed market. 4) The Reversion – In less then two minutes it is all over. Prices revert as the gamer stops supporting the market.

Dark pools are lucrative, and can be anonymous trades.
U.S. regulators are observers and will have a difficult time regulating what the “insiders” already know and have succesfully kept quiet. It feels like I sat down at the high stakes table in Vegas, not investing with firms that are concerned with my volatility objectives or financial goals.
See the following for a simple description of “dark pools”.
http://www.itg.com/news_events/papers/IT GResearch_Toxic_Dark_Pool_070208.pdf

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4 ways Congress caused the financial crisis

May 5, 2010 15:08 UTC

That bankers disdain their new Washington overlords is no surprise. To many of them, Congress is plagued by “unnerving ignorance” and a refusal to admit its own role in the financial crisis. At least that is how a controversial JPMorgan report puts it. Impolitic perhaps, but not inaccurate.

It’s one thing to discuss such grumbles in the executive suite. It’s another to explicitly lay them out in a widely disseminated research report, accompanied by data and a full-color chart for emphasis — in the midst of the delicate financial reform debate in the U.S. Senate, to boot. But that’s what JPMorgan’s James Glassman did in a May 3 economic note.

In last week’s Senate committee interrogation of Goldman Sachs executives, senators displayed “confusion about our market economy,” according to Glassman, along with plenty of unearned self-righteousness. He snarkily noted that the economic implosion of rust-belt Michigan, home of Carl Levin, the committee chairman, had nothing to do with esoteric derivatives.

It’s not news that many senators appear to have only a tenuous grasp of the financial industry. But Glassman’s larger point is more relevant. It’s not just that Congress doesn’t understand what Goldman, as a market-maker, does — it’s also that elected officials may not recognize that the financial crisis was rooted in Washington as well as Wall Street.

A similar point is made in new study by Ross Levine of Brown University, “An Autopsy of the U.S. Financial System.” Bankers may have rushed to create fancy new securities, but it was legislators who enabled risky behavior by housing giants Fannie Mae and Freddie Mac — and failed to instill watchdogs like the Federal Reserve and the Securities and Exchange Commission with the backbone needed to rein in risky activities. In detail, Levine makes these points that illustrate the role of Congress:

1) Credit Ratings Agencies. While the crisis does not have a single cause, the behavior of the credit rating agencies is a defining characteristic. It is impossible to imagine the current crisis without the activities of the NRSROs. And, it is difficult to imagine the behavior of the NRSROs without the regulations that permitted, protected, and encouraged their activities. … Rather the evidence is most consistent with the view that regulatory policies and Congressional laws protected and encouraged the behavior of NRSROs.

2) Credit Default Swaps. I am suggesting that the evolution of the CDS market, the fragility of the banks, and the Fed’s capital rules illustrate a key feature of the financial crisis that is frequently ignored. The problems with CDSs and bank capital were not a surprise in 2008; there was ample warning that things were going awry. Senior government policymakers created policies that encouraged excessive risk taking by bankers and adhered to those policies over many years even as they learned about the ramifications of their policies.

3) The SEC and Investment Banks. Consider three interrelated SEC decisions regarding the regulation of investment banks. First, the SEC in 2004 exempted the five largest investment banks from the net capital rule, which was a 1975 rule for computing minimum capital standards at broker- dealers. Second, in a related, coordinated 2004 policy change, the SEC enacted a rule that induced the five investment banks to become “consolidated supervised entities” (CSEs): The SEC would oversee the entire financial firm. Specifically, the SEC now had responsibility for supervising the holding company, broker-dealer affiliates, and all other affiliates on a consolidated basis. Third, the SEC neutered its ability to conduct consolidated supervision of major investment banks. … The combination of these three policies contributed to the onset, magnitude, and breadth of the financial crisis. The SEC’s decisions created enormous latitude and incentives for investment banks to increase risk, and they did.

4) Fannie and Freddie. Deterioration in the financial condition of the GSEs was not a surprise. … But, Congress did not respond and allowed increasingly fragile GSEs to endanger the entire financial system. It is difficult to discern why. Some did not want to jeopardize the increased provision of affordable housing. Many received generous financial support from the GSEs in return for their protection. For the purposes of this paper, the critical issue is that policymakers did not respond as the GSEs became systemically fragile. Again, I am not arguing that the timing, extent, and full nature of the housing bubble were perfectly known. I am arguing that policymakers created incentives for massive risk-taking by the GSEs and then did not respond to information that this risk-taking threatened the financial system.

Of course, even senators who do understand finance may choose to indulge in ignorant-seeming grandstanding for political and electoral reasons. JPMorgan, in turn, has distanced itself from Glassman’s views, presumably to smooth any ruffled political feathers. Even if the bank’s management secretly agrees with its economist, it’s about as likely to say so as members of Congress are to admit their enormous shortcomings.


The list of causes is incomplete. It really began with Jimmy Carter (naturally, did that idiot do *anything* right) when he pushed through the original Community Development Act to get “help” for people who “can’t qualify for mortgages.” Then Bill Clinton and his willing accomplices in Congress made it MUCH WORSE, by strengthening the act, then he sicced Janet Reno on banks that were abiding by sound banking principles to force them to make loans TO UNQUALIFIED PEOPLE, by threatening them with “redlining” lawsuits. Along comes Gramm, Leach, Briley (removing the Glass Steagall act) and the real sharks of Wall Street (investment banks) were turned loose. The government was pushing this on all fronts, and the investment bankers did what comes naturally, they invented a way to handle all the bad debt without any risk to themselves (CDS.) When the Bush administration began to push to tighten the rules, we got Maxine Waters, Barnie Frank, Chris Dodd and many others of our rather stupid congress critters lining up to defend Freddie Mac and Ginnie Mae by saying really dishonest and stupid things like “they are sound.” I really don’t know why some reporter won’t try to unravel this apparent mystery (it’s really not) and report the real facts, along with the culprits in Congress. It’s disgusting, and typical of what has happened with the advent of career politicians who are much more interested in their own power and position, than actually doing something for the people they are supposed to represent.

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The Fantastic Four … Fed presidents against the Dodd bill

Apr 26, 2010 17:14 UTC

ffAgain, it isn’t just Republicans making the charge that the Dodd bill does not end Too Big To Fail. So are a quartet of regional Fed bank presidents:

1) Thomas Hoenig of the KC Fed (in a chat with the Huffington Post):

As for Dodd’s treatment of Too Big To Fail, Hoenig said the bill puts too much power in the hands of regulators. “What I worry about [is] if you have a large institution, and it got into very serious trouble and you only have a weekend to take care of it, the procedures under the Dodd bill would make that very difficult,” Hoenig said. “Let’s say you were coming into Monday morning and you didn’t have the ability to get to the judges in time to get this thing approved, and you had to get to another day. What you would tend to do is lend to that institution — if it were not a commercial bank, you would even use the [Fed's] so-called 13-3 authority… and you would lend to it,” he said in a reference to the legal authority that the Fed claimed gave it the power to lend taxpayer money to AIG. “So you would still have it as an operating bank, you would not have taken control of it, not put it in receivership yet, and yet you would be bailing it out. That’s what we have to avoid.
“There’s still this desire to leave discretion in the hands of the Secretary of the Treasury, and while I understand that desire — because you never know what the circumstance is going to be — the problem is in those circumstances you always take the path of least resistance because of the nature of the crisis.

“You don’t want to be the person responsible for the meltdown, so you take the exception and you move it through.

“But if you had a good firm rule of law, and the markets knew… there were no exceptions… you would be in the long run much better off. It does affect behavior,” he said.

2) Richard Fisher of the Dallas Fed (in a speech):

The dangers posed by TBTF banks are too great. To be sure, having a clearly articulated “resolution regime” would represent steps forward, though I fear they might provide false comfort in that a special resolution treatment for large firms might be viewed favorably by creditors, continuing the government-sponsored advantage bestowed upon them. Given the danger these institutions pose to spreading debilitating viruses throughout the financial world, my preference is for a more prophylactic approach: an international accord to break up these institutions into ones of more manageable size—more manageable for both the executives of these institutions and their regulatory supervisors.

3) Jeffrey Lacker of the Richmond Fed (in a CNBC interview with Steve Liesman):

Lacker: The issue of our time has to do with the government safety net for financial firms. And it’s grown tremendously, and containing that, establishing clear boundaries of that, is the number one priority. As I read the Dodd bill and the mechanism it sets up for the resolution authority, it doesn’t strike me that it’s likely to help us there. And in fact, it seems to me like a major danger is that there’s going to be more instability in financial markets instead of less.

Liesman: The Dodd bill allows for a three-bankruptcy judge panel to declare insolvency. It allows losses to go to unsecured creditors; it allows management to be replaced and shareholders to be wiped out. How much clearer could the government be in this bill that there will be real losses to investors?

Lacker: It allows those things, but it does not require them. Moreover, it provides tremendous discretion for the Treasury and FDIC to use that fund to buy assets from the failed firm, to guarantee liabilities of the failed firm, to buy liabilities of the failed firm. They can support creditors in the failed firm. They have a tremendous amount of discretion. And if they have the discretion, they are likely to be forced to use it in a crisis.

4) Charles Plosser of the Philly Fed:

In order to end TBTF, we must have a way that credibly convinces large financial firms and the markets that firms on the verge of failure will, in fact, be allowed to fail. If the resolution mechanism is either too vague or allows for too much discretion by regulators or Congress to rescue firms through subsidies or bailouts, then troubled firms will surely argue that the risks of failure are so severe and systemic that they must be bailed out. This is what we saw in the recent crisis. A credible commitment by government not to intervene or bail out firms must be the centerpiece of the resolution mechanism.

I believe the best approach to making such a credible commitment and thus ending TBTF is amending the bankruptcy code for nonbank financial firms and bank holding companies, rather than expanding the bank resolution process under the FDIC Improvement Act (FDICIA). While the Senate bill has tightened up the proposal with a stronger bias toward liquidating a troubled firm, the bill would still give a great deal of discretion to policymakers to avoid the discipline of a bankruptcy court. I recognize that the current bankruptcy code does not adequately address the inherent challenges in liquidating large financial institutions without risks to the market, but I believe a modified bankruptcy process would eliminate discretion and strengthen market discipline, by permitting creditors as well as regulators to place the firm into bankruptcy when it is unable to meet its financial obligations.

The state of play for financial reform

Apr 26, 2010 13:53 UTC

A few observations, comments and highlights:

1) Three things can happen today, as I see it: a) Chris Dodd and Richard Shelby reach a deal; b) Dems pick off a few Rs, get cloture, and the debate on the bill proceeds; or c) no deal, Rs stay unified and negotiations continue. Of those “c’ is the likely option — and that will eventually lead to a bill that may be getting tougher by moment. On Good Morning America today, Shelby seemed supportive of tougher derivatives language. And although it will not be in the bill, Kent Conrad’s comments that a bank tax is coming is reflective of the growing anti-Wall Street mood on Capitol Hill.

2) An interesting piece in The American by economist Phil Swagel, formerly of the Paulson Treasury Department, on whether the Dodd bill is a “bailout bill.” Read the whole thing, but in this bit he uses Lehman Brothers as an example:

In the fall of 2008, the Lehman Brothers bankruptcy was followed by severe negative effects as short-term credit markets shut down. This is sometimes taken as evidence that bankruptcy is not a tenable outcome for a large financial firm. This is wrong. The disruptions that followed Lehman’s collapse were greatly magnified by the idiosyncratic problem that a large money-market mutual fund broke the buck as a result of losses on Lehman debt. This sparked a panicked flight out of money-market mutual funds, which led commercial paper markets to seize up and in turn begat TARP. This situation would have been prevented only by guaranteeing Lehman debt—that is, by a bailout that the administration says would not be allowed to occur under its financial regulatory reform proposals. This means that either the administration intends to allow bailouts or that its approach would not in fact solve the problem of Lehman’s collapse—it cannot be both ways. In fact, the Dodd bill allows two forms of a bailout, since the government can put cash directly into a failing firm or guarantee its debt. The Dodd proposal is a bailout bill, plain and simple.

3) Here is Charles Plosser, head of the Philly Fed, on Dodd and TBTF:

I believe the best approach to making such a credible commitment and thus ending TBTF is amending the bankruptcy code for nonbank financial firms and bank holding companies, rather than expanding the bank resolution process under the FDIC Improvement Act (FDICIA). While the Senate bill has tightened up the proposal with a stronger bias toward liquidating a troubled firm, the bill would still give a great deal of discretion to policymakers to avoid the discipline of a bankruptcy court.

The Senate bill’s proposal to restrict the Federal Reserve’s supervisory authority to about 35 of the largest financial firms with $50 billion or more in assets further undermines the effort to end TBTF. The markets will likely interpret this provision as signaling that these firms are unique and will continue to be treated as TBTF. Many would assume that the language in the resolution section that emphasizes bankruptcy would not apply to these firms. This provision would, de facto, make the Federal Reserve supervisor of the firms deemed TBTF.

In addition, restricting the Federal Reserve’s supervisory authority to these large firms would focus the Federal Reserve’s attention more toward Wall Street and less on Main Street.


Dodd needs a job on Wall Street upon retirement, so he can’t be too aggressive

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Passing financial reform is no miracle

Apr 22, 2010 14:08 UTC

Jonathan Chait over at TNR is strangely amazed that financial reform may happen:

What’s happening with financial reform right now is unlike anything that’s happened since I’ve been following American politics. Look at the fundamentals of the issue. This is a matter where a massive industry — one that accounts for close to half of all corporate profits — is adamantly opposed to new regulation. The merits of the issue are so mind-numbingly complex that even economists and policy wonks sound distinctly fuzzy on the details. Throw in a Republican Party that had pursued, with evident political success, a policy of total obstruction. I’d tell you this was a formula either for defeat or a toothless reform.

And yet a substantial reform now appears close to inevitable. It’s not a toothless reform — a set of derivative regulations more hawkish than anybody could have dreamed possible a couple weeks ago just passed through the Agriculture Committee. It’s one of those strange moments when the normal laws of politics have been suspended.

Me:  I am more amazed that given the magnitude of the financial crisis and the level of public rage, the banks weren’t broken up and turned into quasi-public utilities. But Wall Street can thank the White House for that. After passing the stimulus, it decided to focus on healthcare. Time passed, passions ebbed, and the lobbying effort cranked up. But the aftermath of the crisis (+Goldman) always made it likely that reform would pass.


Hi, Bro
I want you to put an eye on thai protesters because they will be a big crack down. The red shirt changing their color nw that mean the sign of losing.

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Liberals hit Senate financial reform bill

Apr 20, 2010 17:24 UTC

As HuffPo puts it:

A coalition of former regulators, left-leaning economists and Democratic insiders have slammed the Senate’s version of regulatory reform in a letter to the parties’ two leaders, warning that the current bill won’t prevent a future financial crisis.

One of the signers is liberal think-tank economist Dean Baker. I e-mailed him and asked about the letter’s claim that the Dodd reform bill does not “eliminate a perpetual system of government sponsored corporate bailouts financed by the government or private industry.”

His speedy response:

To my view, the biggest failing is that it does not end TBTF banks. As a practical matter, I really doubt that any regulator is going to stand up to Goldman, Citi or any of the other big banks and tell them they can’t do something that is making them lots of money, but poses serious risks to the system. It would have helped if we had fired Bernanke, so that regulators understood that there was downside risk from failing to do their job and crack down on the big banks when necessary. But if Bernanke can get reappointed, even after allowing the worst economic disaster in 70 years, there is little hope that future regulators will take large personal risks to confront major banks when there is no downside to ignoring their practices.


Hey people. Just pull their business license. Everyone has to be accountable including big business, including banks, drug companies, oil companies, and manufacturers. It is not a right to operate a business in the US. Wake up America

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