Dodd’s Financial “Reform” Bill Is Nothing but a Placebo for a Very Sick Economy

hat tip: Washington’s blog
Monday, March 29, 2010

On March 3rd, Richard Fisher – President of the Federal Reserve Bank of Dallas – told the Council on Foreign Relations:

A truly effective restructuring of our regulatory regime will have to neutralize what I consider to be the greatest threat to our financial system’s stability—the so-called too-big-to-fail, or TBTF, banks. In the past two decades, the biggest banks have grown significantly bigger. In 1990, the 10 largest U.S. banks had almost 25 percent of the industry’s assets. Their share grew to 44 percent in 2000 and almost 60 percent in 2009.

The existing rules and oversight are not up to the acute regulatory challenge imposed by the biggest banks. First, they are sprawling and complex—so vast that their own management teams may not fully understand their own risk exposures. If that is so, it would be futile to expect that their regulators and creditors could untangle all the threads, especially under rapidly changing market conditions. Second, big banks may believe they can act recklessly without fear of paying the ultimate penalty. They and many of their creditors assume the Fed and other government agencies will cushion the fall and assume the damages, even if their troubles stem from negligence or trickery. They have only to look to recent experience to confirm that assumption.

Some argue that bigness is not bad, per se. Many ask how the U.S. can keep its competitive edge on the global stage if we cede LFI territory to other nations—an argument I consider hollow given the experience of the Japanese and others who came to regret seeking the distinction of having the world’s biggest financial institutions. I know this much: Big banks interact with the economy and financial markets in a multitude of ways, creating connections that transcend the limits of industry and geography. Because of their deep and wide connections to other banks and financial institutions, a few really big banks can send tidal waves of troubles through the financial system if they falter, leading to a downward spiral of bad loans and contracting credit that destroys many jobs and many businesses.

March 30th, 2010 | Posted in Web-Only Content | Read More »

Broken Incentives: “People See What They’re Incentivized to See. If You Pay Someone Not to See the Truth, They Won’t See the Truth.”

hat tip: Washington’s Blog
Monday, March 15, 2010

Upton Sinclair said:

It is difficult to get a man to understand something, when his salary depends upon his not understanding it.

Bestselling financial writer Michael Lewis is now saying the same thing. In an interview with 60 Minutes, Lewis said:

Wall Street is able to delude itself because it’s paid to delude itself. That’s one of the lessons of this story. People see what they’re incentivized to see. If you pay someone not to see the truth, they won’t see the truth.

As Lewis makes clear, the broken incentive system causes the heads of the Wall Street giants to act in ways which are not only destructive to the economy as a whole and to American jobs, but to the long-term health of their own companies.

If the broken incentive system were fixed, Wall Street big shots could suddenly be able to “see” the destructive effects of fraudulent and risky behavior. That would take politicians getting out of bed with Wall Street for a couple of minutes, which is unlikely, given how warm and cozy it is Unfortunately, that’s probably not politically feasible.

Of course, executive compensation should be linked to performance, in the sense of creating sustainable wealth for shareholders and the economy as a whole. But if the companies and politicians are too spineless to do that, at least ill-gotten gains could be taken away after the fact when executives are found to have committed fraud or driven their companies into the ground.For example, as I wrote last April:

[William K. Black - the senior regulator during the S&L crisis, and an Associate Professor of Economics and Law at the University of Missouri ] provided the historical background to the PCA [The Prompt Corrective Action Law (PCA)] in a little-noticed essay last month:

… PCA also recognized that failing bankers had perverse incentives to “live large” and cause larger losses to the FDIC and taxpayers. PCA’s answer was to mandate that the regulators stop these abuses by, for example, strictly limiting executive compensation and forbidding payments on subordinated debt.

March 19th, 2010 | Posted in Web-Only Content | Read More »