Goldman Sachs' Revolving Door: Regulatory Capture

In July 2012, Andrew Williams, a former spokesman for U.S. Treasury Secretary Timothy Geithner, announced plans to head over to Goldman Sachs at the end of that month.[1] Williams was the second of the Secretary’s spokesmen to head to theWall Street bank. Such moves may reflect a standing policy at the bank to have a revolving door. The previous U.S. Treasury Secretary, Henry Paulson, had been the CEO at Goldman. This suggests that the revolving door was to include populating high offices in government, presumably not out of a sense of civic duty, but, rather, to see that Goldman's interests would be protected and even promoted through public policy. Hence President Obama was said to have had a Wall Street government with respect to positions bearing on Wall Street. I submit that deconstructing such a revolving door would be very difficult. 

From the standpoint of a government official being hired by Goldman, the prospect of becoming wealthy is a large incentive to make the jump. Such an official would typically have scruples about using his contacts in government to pull strings for the bank. Mired in scandal following the financial crisis of 2008, Goldman’s leadership no doubt understood the value in hiring good PR men. Such hires could even put a good face on the cozy relationship between the bank and people still in government.

The “revolving door” dynamic is also difficult to break up because it contributes toward the capture of regulators by the regulated. This is known as regulatory capture. The regulated companies supply information that regulators need in order to devise regulations; the companies can use this reliance to their advantage even just in providing tainted, self-serving data. Moreover, the revolving door can make it easier for the managements of the regulated companies to get even high government officials to put political pressure on the regulatory agencies to go soft on regulating. In the case of Goldman Sachs, it is reasonable to expect that Henry Paulson would have bent to the bank's request for lax regulatory oversight from the SEC, which of course had no idea how many subprime-mortgage-derivative bonds Wall Street had been producing and selling up to the financial crisis of 2008. 

 

The SEC can be soft on Wall Street and point to insufficient staffing as the reason, while the reality is far more sordid in terms of the relationship between the regulators and the powerful regulated. 

Legislated restrictions on former government financial officials going to Wall Street banks could of course be circumvented, given the incentives described above, though prohibiting employment (or financial enrichment, such as by consulting) in the industries related to an official's area for many years seems possible. Even if Goldman Sachs could not hire away Treasury or SEC offiicals, the bank could still count on ex-Goldman folks who occupy key offices in the U.S. Government. 

Generally speaking, the financial and related political power of such huge aggregations of wealth such as a Wall Street bank has (and is) naturally overpower weak governments, by which I mean governments that depend on or do not have the will to resist the allure of money (or threats) from entities subject to the government. A government whose elected officials must rely on large sums of donated money just to get reelected is ripe for succumbing to corporate offers with strings attached. A strong government is insulated, whether by law, will, or power generally from such strings. A government that has many points of access (of influence) is likely to be weak in not only rebuffing pressure to reduce taxes and spend more, but also standing up to large corporations. A government in a pro-business society is likely to be weak with respect to the power of business, other things equal. Even more significant than these variables, however, is the tenuous basis of representative democracy amid Wall Street bewindowed towers. 

1. Bonnie Kavoussi, “Andrew Williams, Ex-Treasury Spokesman,Headed to Goldman Sachs,” The Huffington Post, July 12, 2012. 

Members of Congress Secretly Lobbied the Fed

As of late September 2012, more than one hundred members of Congress had lobbied the Federal Reserve and other regulatory agencies on the Volcker Rule, the part of the Dodd-Frank Financial Reform Act of 2010 that prohibits banks from operating like casinos (e.g., trading with proprietary funds, rather than those of customers).[1] The rule stems from the importance of banks in our financial system. In September 2008, the world nearly witnessed the collapse of that system when banks stopped trusting each other (e.g., via commercial paper market) because of the risks that some of the big ones had been taking with mortgage-backed derivative securities and the related insurance swap securities. Awash in healthy-seeming fees, the banks purchased risky subprime mortgages and bundled them into bond-like securities that could be sold to investors.
Congress passed the Dodd-Frank Act, so it makes sense, and indeed is positive from the standpoint of accountability, that lawmakers remain involve as the relevant regulators (who are not elected) translate the broad legislative language into specific rules for banks. However, the newspaper’s report points to a less-than-salubrious practice wherein members of Congress contact regulatory agencies in private and before even the period for public comment. This raises the possibility that Wall Street was using its connections in Congress to weaken the public safeguards in the bill—essentially putting a narrow private interest in front of the public interest that the bill was designed to protect.

The access purchased comes not only from having information that the regulatory agencies need; banks (and American corporations in general) could contribute unlimited amounts of money from the corporate treasury (rather than from contributions from executives and employees) to “social welfare” non-profit organizations that can spend money on political ads in support of friendly candidates (and against their opponents) without having to divulge the identities of the donors. So Wall Street banks can furtively promote U.S. Senate candidates who support the repeal of the Dodd-Frank Act without any of us knowing it. In fact, the “social welfare” (54c) groups can in turn contribute directly to a candidate’s campaign without divulging the names of the donors. Not even the IRS, which has been concerned about whether the donors pay the required gift tax, bothers the “social welfare” organizations for donor lists after complaints from several U.S. Senators. Nor has the SEC pushed corporations to divulge to their respective stockholders how the political donations have been spent. I suspect that senatorial influence lies behind this inaction too.
It is not as though there were some uncertainty regarding the need for disclosure in a democracy. Even though eight of the nine U.S. Supreme Court justices in Citizens United stress in their opinions the necessity of disclosure, corporations, no doubt well-connected in the halls of power in Washington from the donations already given, have a way to evade the transparency. Political and corporate democracy are both undercut as banks and business corporations can spend unlimited amounts (out of their respective profits) to help “pro-business” candidates for public office. Rather than being speech itself (and thus subject to free-speech constitutional protection), money is power that can be used to skew or otherwise limit the contours of public debate. After the election, the continued influence of the money is also stealth, such as when members of Congress lobby the Federal Reserve to weaken regulation meant to safeguard our financial system from a repeat of the near-collapse in 2008. For deregulation to be urged so soon after a near-depression gives us an indication of how dangerous “money as invisible speech” is to the public good, even if such influence is in the corporate interest.
As creatures of the state, corporations should not have a share in governance, for that function subverts the causal relationship between Creator and creature. That is to say, a corporate management (or board) presuming to influence members of Congress can be likened to the self-idolatry of a creature supposing itself to be God. Interestingly, as going concerns, corporations are immortal, legally speaking. As for us mere mortals, Rousseau reminds us that we are born free but live in chains—only we are under the delusion that we are still free because the confining elements are subterranean qua the furtive influence of great concentrations of private wealth. I suppose one question is whether finite bundles of subjectivity can somehow become aware of that which has been designed to be outside of our awareness, and, if so, whether a society can so move to protect its good in a viable republic.

1. Ben Protess, “Behind the Scenes, a Lawmaker Pushes to Curb the Volcker Rule,” The New York Times, September 21, 2012.

Is the U.S. Congress Too Beholden to the Financial Industry?

That financial deregulation had any traction at all following the financial crisis of 2008 in the U.S. is stunning, for the implication is that Wall Street money has tremendous influence in the U.S. Governent even after Wall Street banks have screwed up (even in triggering a financial crisis!). 

According to Gary Gensler, head of the Commodity Futures Trading Commission in 2012, Congress stood with the big banks in the struggle to shield Americans from the risks and excesses of Wall Street even after the financial crisis of 2008. He pointed in particular to a proposal from the U.S. House’s Appropriations Committee to cut his agency’s funding by 12 percent.[1] The CFTC had been given expanded powers by the Dodd-Frank Act in 2010. Doubtless the proposed budget-cut had something to do with that. It is astonishing that such a proposal would come in the wake of a financial crisis caused in large part by Wall Street bankers taking too many risks. That the agency was then tasked with regulating the problematic $700 trillion market on derivatives—a task that dwarfed the agency’s regulatory power over futures—suggests that the decision to cut the agency's budget after the financial crisis was especially agrevious, being based, I submit, in Wall Street's denial over its harmful role in triggering the financial crisis in which subprime-mortgage-based bond derivatives collapsed in value even as banks including Goldman Sachs were trying to unload the "crap" as good values. 

CFTC Chairman Gary Gensler staring down the big banks

That an industry with a vested interest in rolling back financial regulations could have any influence at all over elected representatives reflects the general ignorance or naivity concerning conflicts of interest. In a COI, a private interest predominates even if the good of the whole is being estolled. A bank-rolled member of Congress can used the espoused public-interest rationale advanced by the banking industry as cover to hide the cosy relationship. For example, a bank's public affairs department could put out the word that increased financial regulation, even after a financial crisis, is really socialism. The bank-rolled members of Congress could then use the socialism scare-tactic on their respective constituents while quietly accepting the large campaign-contributions from the banks. Meanwhile, the American people feel secure that such representatives are protecting them from a threat rather than enabling one.

1. Alexader Eichler, “CFTC Head Gary Gensler: Congress ‘Sides With Wall Street’,” The Huffington Post, June 8, 2012. 

For more on the conflicts of interest in the financial sector (and others), see: Skip Worden, Institutional Conflicts of Interest, available at Amazon.

The U.S. Department of Justice: Big Banks May Legitimately Be above the Law

The Financial Times reported in 2013 that lawmakers in the U.S. Congress were claiming that the Department of Justice had been “too soft on big banks and their executives by failing to bring criminal cases related to the financial crisis.”[1] In the five years following the financial crisis of 2008, no Wall Street executive was criminally charged with fraud. The U.S. Justice Department chose not to go after the bankers for their lack of due diligence regarding their purchases of sub-prime mortgages from mortgage originators. This in spite of the fact that at Citibank, for example, a manager in the bank’s due diligence department estimated that 50% to 80% of the approved mortgages did not meet the bank’s credit policy, and yet Robert Rubin, the CEO at the time, did not act on the manager’s email. This suggests that a criminal complaint could have been lodged against the bank itself, but then what would be the implications for the financial system should Citibank had gone under after being found criminally guilty? Does it even hold that a guilty verdict would mean bankruptcy? Simply stated, a company can be so large that its failure due to a guilty verdict could harm innocent third parties, including stockholders, employees, suppliers, and even the general public if the bankruptcy triggers a systemic collapse of the financial system. Such concerns are called collateral consequences. 

After the collapse of Lehman Brothers in September 2008, systemic risk became a particularly salient concern for criminal prosecutors at the U.S. Department of Justice. Swayed by a desire to minimize the potential disproportionate harm to innocent parties from a verdict-triggered major bankruptcy, the prosecutors believed they were obligated to consider collateral consequences even if that meant that the really big banks would be immune from criminal prosecution. To such banks, this could be used as a competitive advantage because keeping within the constraints of law in making money would not apply. I contend, therefore, that the U.S. Government should not have taken collateral consequences into consideration. 

 Mythili Raman testifying before Congress. mainjustice.com

Mythili Raman, Acting Assistant Attorney General in the Criminal Division, argued that collateral factors as a group should be considered. Testifying before Congress on May 22, 2013, she cited “the disproportionate impact on innocent third parties, including the public at large,” as being entirely appropriate for prosecutors to consider.[2] Her reference to the general public means that systemic risk was among the legitimate factors in her view, and yet she also said, “the size of a corporation will never be a factor in and of itself and that no institution is too big to prosecute.”[3] Crucially, her position was that one particular consequence should never be the only factor. “A single collateral consequence cannot be the reason.” However, she added that “collateral consequences are issues that we must and do consider.”[4] Because banks too big to fail tend to have more than one significant collateral consequence (e.g., many stockholders and employees, as well as systemic risk), such banks may be too big to jail.

In testimony before Congress in March 2013, U.S. Attorney General Eric Holder had admitted that the lawyers in his department were wary of the “negative impact” on the economy from prosecuting a large financial institution. “(I)t is a function of the fact that some of these institutions have become too large.” Differing from Raman, he thought the size of large banks “has an inhibiting influence – impact on our ability to bring resolutions that I think would be more appropriate. . . . (a)nd I think that is something that we – you all – need to consider.”[5] I want to unpack this rather robust admission, for it is significant.

Firstly, the Attorney General was hinting at what Sen. Kaufman had observed while in office. Namely, it should not have been the F.B.I.’s concern whether the Wall Street banks continued as viable concerns. In other words, systemic risk or even collateral consequences more generally had no business being considered by prosecutors whose job it was to enforce the law. Including systemic risk among the collateral consequences thus further compromised the rule of law. As Sen. Charles Grassley put it, “It was stunning to hear the nation’s top prosecutor acknowledge that, from the justice department’s perspective, the big banks are too big to jail. This is worrisome for the fair application of justice in our country.”[6]

Secondly, the Attorney General was suggesting that Congress should reduce the size of the biggest banks—those with over $1 trillion in assets. This would have removed the specter of banks being too big to jail. Also, by implication, Holder had concluded that the Dodd-Frank Act would not be sufficient to solve the "too big to fail" problem. That law was premised in part on the theoretically beautiful but practically insufficient assumption that imposing disproportionate capital reserve requirements on the biggest banks would not only be enough to keep them sound even in a financial crisis, but would also prompt the banks' boards to reduce the size of their banks. Besides of cost-advantages in being so large, and getting even larger as the five biggest banks have since done, the psychology of empire-building, which had gripped Lehman's Dick Fuld so, can easily dismiss the disproportionate costs of retaining or enlarging size. 

Regarding the implications for the U.S. Department of Justice should the biggest banks have taken the bait and voluntarily reduced their respective sizes, it is clear that if no systemic risk (i.e., of being too big to fail without taking the whole financial system down) were to exist, then third-party collateral damage would not be disproportionate so the banks (and bankers) could be prosecuted. Accordingly, the Huffington Post observed at the time that lawmakers “may be encouraged to apply even more public pressure on efforts to crack down on big banks.” [7] Lawmakers having received campaign contributions from those banks, however, would hardly do so. In fact, those members of Congress would even defend the large sizes of the biggest banks. 

Exceptions admittedly existed. Rep. Sherman, the chair of the full committee, noted while Raman was testifying that the fact that the Department of Justice considered collateral consequences rather than simply enforced the law was enough justification to break up the big banks. Putting aside the issue of size for the conduct of banking (e.g., whether a gigantic sized bank is necessary to make huge loans or would a syndicate of banks do as good of a job and spread the risk), having powerful people and organizations de facto above the law is something that just cannot be permitted in a republic. So on this basis alone, the rationale goes, society had an overwhelming interest in braking up the largest U.S. banks. 

Unfortunately, being too big to fail has carried (and still carries) with it tremendous political power—muscle that could have been used all too easily to resist legislative proposals (or even public debate) oriented to seriously downsizing the mammoth banks. This has the real problem since economic power became so concentrated in large corporations and banks: can a republic resist the power of its most powerful for the good even of the economy, and the public societal good more generally? Were the big banks pulling the strings that led to Raman’s assertion that collateral consequences “must and should” be considered in deciding whether to prosecute? Whether Raman realized it or not at the time, the implication that the rule of law applied impartially should be compromised by the magnitude of the predicted collateral consequences from a corporate conviction is, euphemistically speaking, troubling.

See “The Untouchables,” Frontline, January 22, 2013 and Essays on the Financial Crisis: Systemic Greed and Arrogant Stupidity, available at Amazon.

1. Shahien Nasiripour and Kara Schannell, “Holder Says Some Banks Are ‘Too Large’,” The Financial Times, March 7, 2013.
2 Congressional Hearing, “Who Is Too Big to Fail: Are Large Financial Institutions Immune from Federal Prosecution?” Financial Services Committee, Oversight and Investigations Sub-Committee, U.S. House of Representatives, May 22, 2013. See also the letter to sub-committee members; Shahien Nasiripour, “Too-Big-To-Jail Dogs Obama’s Justice Department As Government Documents Raise Questions,” The Huffington Post, May 22, 2013.
3. Ibid.
4. Ibid.
5. Nasiripour and Schannell,  “Holder Says Some Banks Are ‘Too Large’,”
6. Ibid.
7. Ibid.

Morgan Stanley: Systemic Mistrust or Bad Financials after the Financial Crisis?

"Morgan Stanley by any measure is a safe and solid investment bank. Except for one: The amount of trust people have in the whole financial and political system. It's just about zero,” according to Jesse Eisinger of The New York Times in October 2011. Even as there is undoubtedly an element of hyperbole in his conclusion—for zero trust in the financial system and governments would occasion far greater problems than the world faced at the time of Eisinger’s report—his broader point that bankers would be held accountable one way or the other for not having learned their lesson on derivatives (and risk more generally) is valid. The subtext is that even though banks like Morgan Stanley were in actuality in solid financial shape, they deserved the negative repercussions from the systemic skepticism that the banks themselves brought about by virtually ignoring risk analysis in preference to a run of profits and (not coincidentally) bonuses.

Eisinger points out that, at least as of October 2011, Morgan Stanley “has almost $60 billion in common equity, compared with $36 billion before September 2008, and its ratios are stronger. Its trading book - which is volatile and where any bank can take sudden, large losses - is smaller than it was. Morgan Stanley has more long-term debt and higher deposits, both of which stabilize its finances. The bank has more cash available in case there's a crunch and a smaller amount of Level III assets, which don't have an independently verifiable value and so must be estimated by the bank. Hedge funds have parked a smaller amount of assets at Morgan Stanley. That's good because in the financial crisis, they pulled them from the bank.” But because all of this could be easily wiped out by a run on the bank occasioned or fueled by a wider mistrust of the financial sector, Eisinger brings up the topic of derivatives as a way of showing that the bankers did not in fact learn their lesson (i.e., all the improved stats may be for naught). Accordingly, the bankers deserved the systemic mistrust even at the expense of any effort having resulted in added financial strength.  

According to the reporter, Morgan Stanley had a face value of $56 trillion in derivatives in October 2011. He notes that JP Morgan Chase had more: a face value of $79 trillion. This is the GNP of some countries. Even though the bankers insisted at the time that they had adequately hedged their long positions, the hedges themselves could fail, especially if the derivatives are positively correlated, as in September 2008 when AIG was completely overwhelmed due to the housing-based derivatives caving in virtually all at once.

In other words, those of us capable of learning lessons know that we should not trust hedges in so far as systemic risk is concerned; the system itself can be overwhelmed by the sheer momentum of a really big wave. So we are back to the issue of trust in the entire financial system, which is and ought to be a drag on even stellar financials until the broader lesson is learned. Unfortunately, that lesson may not be in the immediate financial interest of particular banks due to externalities occasioned by moral hazard (e.g., the possibility of being rescued while another bank, such as Lehman, fails).

Even though governments can step in to protect the broader system (unless captured by the regulated), legislators and regulators cannot force bankers to learn their lesson. A mentality to safeguard even one’s own bank as a going concern cannot be imposed; it must be felt and valued from the inside. All too often, bankers are engaged in “managing” regulations as impediments to be minimized rather than stepping back to ask why the regulations exist in the first place. They might exist for the banks’ own good. If so, the banking lobby trying to water down the Volcker Rule might have been working at odds with those institutions that the lobby ostensibly represents. Be careful what you wish for, Wall Street bankers. You might just get it, especially if you have the gold and therefore can make the rules. It would be ironic if the protesters rather than yourselves had your back, even as you ridicule the masses marching below your towering be-windowed edifices of greed.

Source:

Jesse Eisinger, “Between the Lines, Wall St. Banks Face a Deficit of Trust,” The New York Times, October 12, 2011. 

Decreasing Bank Size by Increasing Capital-Reserve Requirements: Plutocracy in Action?

Although the Dodd-Frank Financial Reform Act was passed in 2010 with some reforms, such as liquidity standards, stress tests, a consumer-protection bureau, and resolution plans, the emphasis on additional capital requirements (i.e., the SIFI surcharges) could be considered as weak because they may not be sufficient should another financial crisis trigger a shutdown in the commercial paperr market (i.e., banks lending to each other). A study by the Federal Reserve Bank of Boston found that even the additional capital requirements in Dodd-Frank would not have been enough for eight of the 26 banks with the largest capital loss during the financial crisis of 2008. As overvalued assets, such as subprime mortgage-backed derivatives, plummet in value, banks can burn through their capital reserves very quickly. A frenzy of short-sellers can quicken the downward cycle even more. This raises the question of whether additional capital resources would quickly be "burnt through" rather than being able to stand for long as a bulwark. The financial crisis showed the cascading effect that can quickly run through a banking sector as fear even between banks widens as one damaged bank impacts another, and another. 
With the $6.2 billion trading loss at JPMorgan Chase in the hindsight, Sen. Sherrod Brown (D-Ohio) and Sen. David Vitter (R-La) in the U.S. Senate proposed a bill that would require banks with more than $400 billion in assets to hold at least 15 percent of those assets in hard capital. The two senators meant this requirement to encourage the multi-trillion-dollar banks to split up into smaller banks. Although it had been argued that gigantic banks are necessary given the size of the loans wanted by the largest corporations, banks had of course been able to form syndicates to finance such mammoth deals. 
The Senate had recently voted 99-0 on a nonbinding resolution to end taxpayer subsidies to too-big-to-fail banks, so the U.S. Senate had Wall Street’s attention. Considering that the U.S. House of Representatives was working on legislation to deregulate derivatives, the chances that the U.S. Government would stand up to Wall Street even to the too-big-to-fail systemic risk were slim to nil. Indeed, the U.S. Department of Justice’s criminal division had been going easy in prosecuting the big banks for fraud out of fear that a conviction would cause a bank collapse (or because President Obama had received very large donations from Wall Street banks including notably Goldman Sachs).
The two senators’ strategy of going about breaking up the biggest banks indirectly by increasing their reserve requirements disproportionately didn't work, at least as of 2019. Advantages of size, including the human desire to empire-build (witness Dick Fuld at Lehman Brothers), could have been expected to outweigh the economic preference for a lower, more proportionate, reserve requirement. With anti-trust laws having been used to break up giants such as Standard Oil and ATT, the thought of breaking up the banks too big to fail even in the wake of the financial crisis was strangely viewed as radical and thus at odds with American incrementalism. The question was simply whether systemic risk should be added to monopoly (i.e., restraint of trade) as an additional rationale for breaking up huge concentrations of private property. This question could have been made explicit, rather than trying to manipulate the big banks to lose some weight.  
The approach of using disproportionately reserves can be critiqued on at least two grounds. First, should one or more of those banks decide to go with the 15% requirement rather than break up into smaller firms, even the additional capital might not be enough to protect a bank during a financial crisis. The study discussed above suggested as much. Second, even if the additional requirements would turn out to be sufficient in a crisis, the approach would obviate a decision by the government on whether systemic risk justifies a cap on how large banks can get. 
I suspect that the U.S. Congress and president backed off in really reforming Wall Street because of its money in campaign finance. In short, the big banks in Wall Street didn't want to shrink. In a system of political economy wherein the economy is regulated by government, rather than vice versa, backing off just because large concentrations of wealth (and thus power--even political) don't like the plans is unacceptable. Moreover, it is a sign of encroaching plutocracy wherein the regulated dictate behind closed doors to the regulators and politicians. Meanwhile, the public, including the economy itself, remains vulnerable. 

See Essays on the Financial Crisis: Systemic Greed and Arrogant Stupidity, available at Amazon.

Sources:

Eric Rosengren, “Bank Capital: Lessons from the U.S. Financial Crisis,” Federal Reserve Bank of Boston, February 25, 2013.
Zach Carter and Ryan Grim, “’Break Up the Banks’ Bill Gains Steam in Senate As Wall Street Lobbyists Cry Foul,” The Huffington Post, April 8, 2013.

Addressing Systemic Risk: Beyond the Dodd-Frank Act of 2010

After the U.S. financial crisis in September 2008, the former chairman of the Federal Reserve, Alan Greenspan, admitted to a Congressional committee that his free-market notion that a market will automatically self-correct itself had a major flaw. He had come to this realization because the financial market for mortgage-backed bonds had failed to correct in terms of price for the dramatic increase in risk. Instead, that market, and that of overnight commercial paper, had seized up rather than simply adjust price to the decreased demand. Fear had paralyzed what had hitherto been thought to be a self-correcting market. The failures of Bear Stearns and Lehman Brothers introduced us to the concept of systemic risk, wherein the failure of a bank (or company) causes a market to collapse. Such a bank is thus too big to fail. If actualized, such risk interferes with even the basic operation of a market, not to mention its self-correcting feature. One question is whether banks that are too big to fail should merely be more adequately regulated or broken up, as the U.S. Supreme Court broke up Standard Oil in 1911.

Alan Greenspan, former chairman of the U.S. Federal Reserve Bank

In March 2013, Alan Greenspan said in a TV interview that banks like JPMorgan that are too big to fail should be allowed to fail. “[What] we ought to do is to allow banks to fail, go through the standard Chapter 11 type of process of liquidation, and allow the markets to adjust accordingly,” said the 87-year-old Greenspan. “That has worked for a very long time.” Had he forgotten his own Congressional testimony in which he had admitted that markets may not “adjust accordingly” to irrational exuberance and systemic risk? Decades of the central banker’s experience had not prepared him for the “financial cliff” that the financial system nearly went over in the fall of 2008. Apparently for Greenspan at least, old habits (of thinking) die hard.

Greenspan said that the Dodd-Frank Act of 2010, which was oriented to saving the banks from their own risky excesses and providing such banks with an orderly liquidation process should they declare bankruptcy, had been a failure. He said the “too big to fail” problem was getting worse, not better. Banks such as JPMorgan had been “gaming” the new regulations, attracted by the high profits gained from risky trades outlawed by the Volcker Rule. That FDIC deposits were used at JPMorgan to make the trades suggests that the taxpayers have been underwriting the continued high risk, at least in part. In other words, free-market capitalism does not completely account for the risk that banks willfully assume even though it can cause the financial sector to suddenly seize up as a big bank goes under.

Greenspan’s answer to the failure of Dodd-Frank involves a return to his faith in the free market, as if the freezing of commercial paper had not occurred in September 2008 after Lehman failed. A year after that crisis, the former central banker had urged the break-up of the big banks too big to fail. “If they’re too big to fail, they’re too big,” Bloomberg News reports Greenspan said in October of 2009. “In 1911 we broke up Standard Oil -- so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.” One might add that the sheer existence of a bank with over $1 trillion in assets is too big for not only the financial markets, but also the republic as well. Even after the banks’ culpability had been made transparent in the financial crisis, Wall Street still had considerable lobbying pull over Congress—enough to get lawmakers to scrap Sen. Dick Durbin’s amendment that would have allowed judges merely to adjust mortgages that are in foreclosure. The allure of large contributions is simply too overpowering to a candidate or elected official for such concentrations of private wealth to be compatible with representative democracy. One or the other must inevitably give way. Relying on chapter 11 bankruptcy and market re-adjustment does not even begin to touch such ramifications.

In short, Dodd-Frank can be viewed as a piece of legislation that did not go far enough. This is perhaps no coincidence, given the power of the banks in Congress. Furthermore, as the $6.2 billion trading loss at JPMorgan demonstrates, bankers are able to evade and obstruct whatever incremental strengthening of financial regulation that lawmakers and regulators are able to enact over the objections of the bankers. The Volcker Rule, which bars the risky proprietary trading of banks, is no match for the wizzes on Wall Street. Systemic risk demands public policy beyond some additional regulation, or even a return to New Deal regulation. Going back to the Glass-Steagall Act of 1933, which had separated investment from commercial banking, would be insufficient, as banks had been gaming that law for decades before it was repealed in 1998 by Bill Clinton and Sen. Phil Gramm. Systemic risk and risks to democracy warrant public policy that changes the economic map, rather than merely giving the existing players some additional instructions or letting them fail and hoping the market will not collapse as a result. Addressing systemic risk warrants a systemic rather than an incremental or laissez-faire approach. I suspect that in addition to the obvious vested powerful interests, an aversion to substantive change and an associated preference for incrementalism account societally for much of the aversion to breaking up the big banks, as they had become ensconced in the system as part of the status quo.

Caroline Fairchild, “Greenspan Says Too Big To Fail Problem ‘Is Getting Worse, Not Better’,” The Huffington Post, March 15, 2013.

For more essays on that financial crisis, see Essays on the Financial Crisis: Systemic Greed and Arrogant Stupidity, available at Amazon.

Was Goldman Sachs Really Politically Impotent amid Public Scrutiny in the Wake of the Financial Crisis?

If the American financial houses on Wall Street are among the most powerful forces in American politics-- powers, as it were, behind the throne--does it make sense that the strongest bank would be politically impotent?  In other words, can a public blemish nullify the power of all that capital?

According to The New York Times, Goldman Sachs employs perhaps the country’s most well-connected stable of Washington lobbyists, and it spent $2.8 million [in 2009] to bend the ear of federal officials and lawmakers. Goldman executives and its political action committee gavve more than $24 million to federal candidates in the first decade of the twenty-first century, including nearly $1 million to Obama’s 2008 presidential campaign. Even so, the pounding in the media that Goldman Sachs took in April, 2010 left it sidelined — at least in public — as Congress moved toward a decision that could reshape the very industry it rules.  In particular, the SEC filing of charges and eleven hours of grueling testimony before Sen. Levin’s Investigations Committee left the bank a lobbyist persona non grata, if only for a day.  However, even then, the reality behind the scenes was doubtlessly very different.  Even as politicians publicly vilified the bank, they were picking up lucrative campaign contributions sourced in the bank, even if through intermediaries; any large scale electorate is notoriously bad at tracing links.  To be sure, The New York Times was reporting that Goldman Sachs was trying to find a way to influence the debate, even if it could not play as visible a role as it otherwise could have.

Goldman Sachs managers declined to comment the day after the hearing before Carl Levin's committee at the U.S. Senate. The question that the bankers were refusing to answer was on the impact that the bank's legal and public relations troubles were having on its Washington lobbying operations. Even so, one person briefed on its plans spoke on condition of anonymity because of the firm’s continuing legal and political troubles. He or she said it was still trying to push its agenda. The New York Times reported that according to industry officials, the bank had been “largely relying on trade groups, like the Securities Industry and Financial Markets Association. However, this could have been a smoke screen. The real deals could have been made behind closed doors, even by industry standards.  According to the paper, “More often, the firm — whose lobbyists and outside lawyers include such Washington luminaries as Richard A. Gephardt, the former House majority leader, and Ken Duberstein, the former Reagan administration official — has relied largely on intermediaries because politicians are worried about being associated with it, government and industry officials said.”  Members of Congress were worried about public association, but willing to be influenced through intermediaries. Therefore, even though Sen. Blanche Lincoln, who was in a tight race at the time, canceled a fund-raiser at the bank’s New York offices after the SEC filed its lawsuit, I would not be surprised that she accepted contributions by an intermediary.

Most voters are too far away from Washington to get the real scoop, and journalists who want to continue with their career are not apt to dig too deep. We are left with the surface, and can only guess as to the subterranean dynamics.  It seems to me that traces of the underground rumblings can be discerned in lines such as “at least in public.”  We are left wondering how deep the wells of gold run.  Perhaps only the goldman knows.  The actuality can be far different than appearances.  If possible, a study on the real influence of Wall Street in Washington would be very helpful. For this reason, it is apt to be a difficult task with many self-interested obstacles.  In any case, we ought not be so incredulous as to rest on the public appearances. Even as Lloyd Blankfein was testifying, senators turned increasingly friendly to him–with the exception of Carl Levin and perhaps John McCain.  The Democratic side in particular almost made excuses for the CEO, saying that any number of firms should be there with him. Those senators had given their soundbites to be picked up at home; it was time to make sure they were not cutting off one of the ruddy fat hands that feeds them. This expression comes from Nietzsche’s description of businessmen and their propensity to overreach. 

To be sure, Nietzsche is no advocate of modern morality; he viewed it as a defense of weakness.  Weakness cannot be other than weakness, he writes. So too, strength, he writes, cannot be other than strong.  So I contend that we ought to take reports of the political impotence of Goldman Sachs with a rather large grain of salt (or gold, in this case).  He or she who has the gold makes the rules. There is no natural law stating that this process must be transparent.  My question is: can we, the American public, get to it, or does the well of gold run too deep for our patience and perseverance?


See also "Essays on the Financial Crisis," available at Amazon. 

Source: http://www.nytimes.com/2010/04/29/business/29lobby.html

Can the Federal Reserve Handle Banks Too Big To Fail?

The biggest banks operating in the U.S. reaped an estimated $13 billion of income by taking advantage of the Federal Reserve’s below-market rate of .001% on $7.7 trillion in emergency loans in the wake of the credit freeze in September 2008. Rather than using the additional funds to increase lending, the banks fortified reserves and paid bonuses out to executives. Had member of Congress had been able to anticipate all this, it is possible that they would have prescribed stronger medicine, perhaps even including breaking up the banks with over $1 trillion in assets.
As Shakespeare has Marcellius say in Hamlet in reference to moral and political corruption, “something is rotten in Denmark.” Another line could be added from Macbeth. “Out, out damn spot!” Bloomberg News reported that “the Fed and its secret financing helped America’s biggest banks get bigger and go on to pay employees as much as they did at the height of the housing bubble.”
Total assets held by the six biggest U.S. banks increased 39 percent to $9.5 trillion on Sept. 30, 2011, from $6.8 trillion on the same day in 2006, according to Fed data reported by Bloomberg. Employees at the six biggest banks made twice the average for all U.S. workers in 2010, based on Bureau of Labor Statistics hourly compensation cost data. “The banks spent $146.3 billion on compensation in 2010, or an average of $126,342 per worker. That’s up almost 20 percent from five years earlier compared with less than 15 percent for the average worker. Average pay at the banks in 2010 was about the same as in 2007, before the bailouts.”
When members of Congress were voting on the $700 billion TARP, they were being kept in the dark on the Fed’s loans. The general public was out of the loop as well. Ted Kaufman, a former U.S. senator from Delaware, said that if Congress had been aware of the extent of the Fed rescue, the knowledge “could have changed the whole approach to reform legislation,” He claims he “would have been able to line up more support for breaking up the biggest banks. More than three years after the financial crisis, Sen. Sherrod Brown of Ohio observed, “There are lawmakers in both parties who would change their votes now [i.e., in December, 2011].” Byron L. Dorgan, a former senator from North Dakota, says the knowledge might have helped pass legislation to reinstate the Glass-Steagall Act, which for most of the last century separated customer deposits from the riskier practices of investment banking. Had people known about the hundreds of billions in loans to the biggest financial institutions, they would have demanded Congress take much more courageous actions to stop the practices that caused this near financial collapse.”
The government’s response to the crisis has not significantly reduced systemic risk, even with the higher reserves requirements for the biggest banks. According to Bloomberg, “Kaufman says some banks are so big that their failure could trigger a chain reaction in the financial system.” For so few banks to hold so many assets is “un-American,” says Richard W. Fisher, president of the Federal Reserve Bank of Dallas. “All of these gargantuan institutions are too big to regulate,” he continued. “I’m in favor of breaking them up and slimming them down.” Oliver William, an economist, concluded that the “banks that were too big got even bigger, and the problems that we had to begin with are magnified in the process.” A conflict of interest may be part of the underlying cause.
It could be that the bankers at the Federal Reserve Bank have been overly friendly to the bankers getting the funds. This conflict of interest could expose the Fed to losing lent funds should one or more of the troubled banks become insolvent and with insufficient collateral. Therefore, in an attempt to make the Fed accountable in regard to its emergency lending,  Congress included in its Dodd-Frank legislation (2010) requirements stipulating that the Fed develop and submit guidelines regarding selection criteria to be applied to banks seeking emergency loans and requirements by which bank collateral is to be reckoned as sufficient.
The publication of selection criteria would reduce the risk of moral hazard. The cost of borrowing for so-called too-big-to-fail banks is lower than that of smaller firms because lenders believe the government won’t let them go under. The perceived safety net creates what economists call moral hazard—the belief that bankers will take greater risks because they’ll enjoy any profits while shifting losses to taxpayers.” Jeremy Stein, a Fed governor, has spoken of moral hazard, according to the New York Times, as “the belief that government support can subsidize banks and make them less careful about the dangers inherent in their businesses.” Depending how strict the selection criteria are, “the banks might then realize that the Fed will not be a pushover in times of market stress.” At least as of April 2013, the Fed had not followed through on the mandate in Dodd-Frank that the Fed promulgate rules.
The Fed might have good reason to stave off rules that could restrict the Fed’s flexibility in a crisis. “The Fed might be thinking, ‘We don’t want to make a lot of rules that might hinder us from acting in an emergency situation that we can’t anticipate,’” Michael Bradfield, a former general counsel at the Fed, remarked. “I think the Fed should have reasonably broad discretion to deal with systemic issues,” he continued, “(b)ut then the question is, What’s systemic and what’s really needed, and what conditions ought to accompany that lending?” Demanding too much in collateral, for example, might mean that some very big banks that are hemorrhaging capital might not qualify for an emergency loan and go under as a result. If those banks are too big to fail, the entire financial system could follow suit.
Unfortunately, discretion at the Federal Reserve could enable the “insider” conflict of interest to be exploited. Such exploitation is likely from the banking lobby as well as from the Federal Reserve. Bloomberg reports that “(l)obbying expenditures by the six banks that would have been affected by the legislation rose to $29.4 million in 2010 compared with $22.1 million in 2006, the last full year before credit markets seized up—a gain of 33 percent, according to OpenSecrets.org, a research group that tracks money in U.S. politics. Lobbying by the American Bankers Association, a trade organization, increased at about the same rate.
In a rare glimpse of how the banking lobby operates, there is evidence that the lobbying firm Clark Lytle Geduldig & Cranford sent a memo to the American Bankers Association expressing worry that the Occupy movement and the Tea Party movement might find common ground and become a potentially potent threat by joining forces. Tellingly, the memo’s writers reveal how even potential threats to big business are relegated: “If we can show they have the same cynical motivation as a political opponent it will undermine their credibility in a profound way.” Using the media outlets, the “messengers” of powers vested in the status quo can quickly discredit others, as if from a popular wave of mass opinion. Meanwhile, the matter of the very existence of the banks too big to fail continued to float below the radar—the media dutifully transmitting the transparent issue of tents and evictions in various cities. In other words, even the occupiers—the anarchists outside the system!—allowed themselves to be played. Perhaps we are all being played.

Sources:

Bob Ivry, Bradley Keoun, and Phil Kuntz, “Secret Fed Loans Gave Banks $13 Billion Undisclosed to Congress,” Bloomberg Markets Magazine, November 27, 2011.

Peter Eavis, “Fed Still Owes Congress a Blueprint on Its Emergency Lending,” The New York Times, April 23, 2013.

Skip Worden, Essays on the Financial Crisis, available at Amazon.

Market or Government: Which Should Reduce Systemic Risk in the Banking Industry?

If the five largest banks—JP Morgan, Bank of America, Citigroup, Goldman Sachs, and Morgan Stanley—are too big to fail and yet substandard operationally on account of their respective complexities (e.g., investment banking added to commercial banking), might it be that the market-based decisions of investors will relegate the giants, which by the way had price-to-book value ratios of between .37 to .77 in May 2012, thereby solving the problem of systemic risk?

Smaller banks may be favored by investors because such banks do not “suffer a conglomerate discount,” according to the Wall Street Journal. “They also don’t have big investment-banking or trading arms.” These “arms” are relatively volatile and opaque businesses, and they may be more susceptible to the E.U. debt crisis due to the trades in derivatives. Finally, being less complex means being easier to value, and this can give investors added confidence, particularly as risk management has not exactly been done well at the largest U.S. bank by assets (i.e., JP Morgan)—though Goldman did well in hedging against the bear housing market (and its derivatives).

Therefore, investors could swing the balance away from the biggest banks, though such a shift would take time—barring a herd-like mentality. Regardless of their numbers, the biggest banks can run on the sheer solidity of a well-known name. The shock at the $2 billion loss demonstrates just how much reputational capital had been in the name, “JP Morgan Chase.” Indeed, Jamie Dimon, chairman and CEO of that bank when the huge loss took place, has argued nonetheless that being big allows the bank to compete globally, make large investments in technology and provide broad services to multinational companies. Even though his self-serving pitch omits the problem of risk (e.g., losing $2 billion trying to reduce risk), discounting the inefficiencies and risks that go with greater complexity can take a while, at least in terms of the market as a whole, because the big guys are not exactly going to lay down and give it up to the smaller guys without some pushback. Indeed, the big guys have considerable market and political power that can translate into hidden advantages written into regulations.

Even if the object is merely apparent, given the power of the big banks, it makes sense then that the U.S. Government sought to help at least “level the field” between the large and small by instituting capital surcharges for systemically important (i.e., large) banks. “We are creating incentives right now for institutions to get simpler, less complex and less volatile, and the market is going to be pushing people in that direction,” says William Isaac, FDIC chair during the 1980s thrift crisis and now head of Fifth Third. The question before us here is how much the market’s push can be relied on to get us to a place where systemic risk can be tolerated.

Even with a level playing-field, will investors favor smaller banks with higher price-to-book values sufficiently to cause the biggest banks to lose some lift and float closer to the ground? Even with the capital surcharges, is the playing-field level? Finally, is “level” enough for investors to favor smaller banks, which represent less systemic risk?

In the 1980s, the market-based approach to regulation, such as in the arrangement in which pollution permits could be bought and sold, sought to fuse public policy objectives with the efficiency of the market. I remember well having been steeped in that ideology in business school. Any objection to the approach in class quickly got a sarcastic, “Ok, Ted”—short for Ted Kennedy (or “you socialist!”). As an MBA student, I volunteered to assist a professor on a paper singing the praises of the efficiencies possible in self-regulation applied to securities dealers (NASD). In retrospect, I view my approach and that of the broader ideology as incredibly naïve, even if the efficiency aspect was well-intentioned. A solution allowing for efficiency “automatically” had a certain intellectual beauty to it, which I suspect some advocates experienced as akin to an unexpected good orgasm at a French whorehouse.

Rather than police bad boys, an industry will naturally seek the lowest common denominator if the government allows the industry to be regulated by self-regulation. The industry itself can then benefit by everyone cutting corners. In other words, short-term profit outweighs the long-term reputational capital to the industry itself from policing bad apples rather than joining them. Government is uniquely situated with regard to the common weal, or public good, to guard and protect it from short-sighted encroachments by aggrandizing players and even entire industries.

Therefore, it would be a mistake to think that systemic risk could be reduced by the biggest banks regulating themselves and their industry. It would be a case of wolves guarding the hen house. The question thus boils down to whether government regulation (uncaptured by the regulatees) or the market mechanism should be relied on to reduce systemic risk, or whether some combination of the two (i.e., government regulation "encouraging" the market) is optimal. If regulations unimpaired by bank lobbying are even possible in the U.S., it might be that the market has the final word anyway. The question then would be whether the market naturally seeks to reduce systemic risk, or is such risk an externality to the market and thus within the reach only of government.

Source:

David Reilly, “Bank Investors Bail onToo-Big-To-Fail,” The Wall Street Journal, May 16, 2012. 

The U.S. Federal Reserve as a Regulator of Banks: An Institutional Conflict of Interest

According to the Wall Street Journal, the Federal Reserve “has operated almost entirely behind closed doors as it rewrites the rule book governing the U.S. financial system.” The paper notes that this has been in sharp contrast to the trend at the Fed toward greater transparency in its interest-rate policies and emergency-lending programs. The complaint of a dearth of public meetings misses, however, not only the scripted nature of such displays, but also the more fundamental question of whether a central bank buffered from political pressure should play such a salient role as regulator. At the very least, the democratic deficit and a lack of accountability may be exacerbated by the Fed’s greater role as a regulator of banks—particularly after the major investment banks become commercial banks, and thus subject to the Fed’s regulations.

“While many Americans may not realize it,” the Journal continues, “the Fed has taken on a much larger regulatory role than at any time in history. Since the Dodd-Frank financial overhaul became law in July 2010, the Fed has held 47 separate votes on financial regulations.” This was as of February 22, 2012. In the process, the Fed was “reshaping the U.S. financial industry by directing banks on how much capital they must hold, what kind of trading they can engage in and what kind of fees they can charge retailers on debit-card transactions.” Unlike other regulatory agencies, not even the Fed governor’s votes were made public. Considering the contact that Fed officials had with their regulated banks on these issues and the Fed’s ties to banking itself, the lack of public meetings (only two on the 47 votes) suggests an opportunity for a conflict of interest to operate below the radar in the interest of the banks while the public holds the risk.

On the Volker Rule, which was to be the part of the Dodd-Frank law that prohibits banks from proprietary trading using their own funds because doing so is too risky for a bank too big to fail, Fed officials met with bankers at JP Morgan Chase sixteen times, Bank of America ten times, Goldman Sachs nine, and Barclays and Morgan Stanley seven each. On the Dodd-Frank provision on regulating derivatives—something a dissenting Fed governor claimed has exemptions that are too wide—Fed officials met with JP Morgan Chase fourteen times, Deutsche Bank and Goldman Sachs twelve each, and Bank of America, Barclays, Morgan Stanley and Wells Fargo eleven each. Even just in relying on these banks for information and feedback, the Fed risks getting biased input on which to make judgments.

Morgan Stanley may have insisted that the regulation of commodity derivatives would put farmers who rely on the futures market at risk. Moreover, the bankers could have insisted that an exemption would not be abused, or they could coordinate their own pressure with a farming lobby and U.S. senators from farm states. The bankers’ intent was obviously to minimize the cost to them in the regulations that are put in place. The public interest, or risk to the public, was beside the point.

The banks played a similar role in the late 1990s as they lobbied the White House and Sen. Phil Gramm to keep derivatives unregulated. That unseen monster winded up biting us in the ass in 2008. Therefore, putting the public interest at risk is not just part of some theory; giving the regulated too much influence in the writing of regulations involves a conflict of interest that can literally result in the collapse of the global financial system. A public-level perspective, rather than that of a firm or industry, must be primary among regulators or the system itself is put at risk.

Pointing to the lack of public meetings in the Fed’s approach as a regulator, Sheila Bair, former chair of the FDIC, stated, “People have a right to know and hear the discussion and hear the presentations and the reasoning for these rules. All of the other agencies which are governed by boards or commissions propose and approve these rules in public meetings.” Fed officials point out that open meetings tend to be scripted and even perfunctory. As if to state good intentions are sufficient, Fed chair Bernanke said in a 2010 speech, “As an agent of the government, a central bank must be accountable in the pursuit of its mandated goals, responsive to the public and its elected representatives and transparent in its policies.” However, a central bank is closer to its banks in many ways that it is to the public or its elected representatives. In fact, a central banks is supposed to be buffered from political influence. While this makes sense in terms of monetary policy, regulating is a separate function and a democratic deficit there is problematic.

I think the public meeting issue is a red herring. The real problem lies in a central bank going beyond monetary policy and acting as a bank for the banks to also be a regulatory agency. That the Fed’s regulatory process differs from those of the “real” agencies suggests that the Fed officials do not even seen the Fed as such an agency. As Bernanke said, “a central bank is . . .” This is the Fed’s identity. It is distinct from a regulatory agency. Accordingly, Congress should establish a separate regulatory agency to cover the banks, leaving the Fed officials to concentrate on their core functions in operating a central bank. It is not as if Bernanke “got it right” leading up to September 2008. Even in 2007, he did not think the declining housing market would cause much of a problem. He had no idea that the swap and derivative markets were about to implode. This is not a good basis on which take on additional responsibilities, particularly writing new banking regulations. In other words, it is not like much would be lost were banking regulation written and enforced by a regulatory agency rather than the Fed. In addition, such an agency would not be so closely tied to the banks as the Fed is, as hinted at by its myriad of meetings with them. Such an agency would not be explicitly distanced from political pressure as the Fed is.

There is nothing wrong with elected lawmakers and executive branch officials making sure that the laws they have passed and are enforcing, respectively, are being operationalized and enforced by regulators who keep the public interest foremost in mind. As a central bank, the Fed is neither under the U.S. President in the executive branch nor under Congress. Meanwhile, Fed officials are very close to the banks they regulate. The problem of accountability that is in the Fed’s independence from the two branches added to the conflict of interest of the Fed being so close to the banks it regulates sets the public up for the sort of thing we saw in September 2008. That crisis did not come out of nowhere, and the reasons for it go beyond the housing market. At the very least, relying so much on an “agency” (and chair!) that failed to anticipate September 2008 and then geared a bailout to the banks rather than to the millions of foreclosed borrowers (hint: conflict of interest!) to write and enforce additional banking regulations on an industry that does not want them is beyond stupid; it is suicide. Meanwhile, the issue was presented as one of public meetings, which were scripted anyway and did not prevent the Fed from meeting with its bankers.

Source:

Victoria McGrane and Jon Hilsenrath, “Fed Writes Sweeping Rules From Behind Closed Doors,” The Wall Street Journal, February 22, 2012.

Related books: 

Essays on the Financial Crisis

Institutional Conflicts of Interest