Macroeconomic Updates

This week the Obama Administration will formally lay out its so-called “reform” of financial market regulation.  Early reports tell us the “reforms” will be little more than what is already being discussed in Congress:

• an attempt to hold loan originators to be more accountable by requiring them to hold 5% of the credit risk of the loans they secure
• give the Federal Reserve additional responsibility of being a “systemic risk” regulator
• create a new regulator over consumer financial products and minor reforms to bond rating agencies

Reports in the business press tell us that the Administration has caved into pressure from the banking lobby and thus abandoned any attempt to undertake far reaching financial market reforms.  Reports in the popular press tell us the Administration also gave into political pressure from those in Washington who would loose power if financial markets were truly reformed.

Instead of preparing our financial markets for the world of the 21^st century, Congress and the Administration will slap yet another patch on the system that has not been restructured in over 70 years. Thus, it seems, little will change. Yet another patchwork solution will be put forward, instead of an attempt to truly reform our financial markets.

What a shame.

What would true reform of the financial markets look like?  It would start with a realization that the world has changed since the 1930s.  While commercial banks are very important to the functioning of our system, these banks can (and should) come in a variety of forms.  In addition, there are now many important non-bank financial institutions that need to be considered.

One way to think about this new landscape is in terms of deposit insurance and the amount of federal oversight and regulation that is truly needed.  Imagine a world where financial entities would be classified into a five-star risk/return/regulation framework.  It might look something like this:

Five Star Institutions:  Extremely Safe - Low Returns.  These institutions would have 100% deposit insurance, be required to fully disclose their financial statements in real time every day, face bank examinations monthly and pay shareholder very low returns.  Many of them might opt for a non-profit status.

Four Star Institutions:  Relative Safe - Relative Low Returns. These institutions would have deposit insurance on the first $50,000 of deposits with the ability to purchase private deposit insurance if desired, fully disclose financial statements every six months, face bank examinations yearly and pay shareholders low returns.

Three Star Institutions:  Moderately Safe - Moderate Returns.  These institutions would have deposit insurance on the first $5,000 of deposits with the ability to purchase more private deposit insurance, fully disclose financial statements every year, face examinations every two years and pay shareholders moderate returns.  These institutions could invest deposits in equities as well as debt instruments, much like mutual funds.

Two Star Institutions: Risky - Potential Significant Returns.  .  These institutions would have deposit insurance on the first $5,000 of deposits only by paying a fee to the FDIC, fully disclose financial statements every year, face examinations every two years and pay shareholders higher returns.  These institutions could invest deposits in a wide range of financial instruments.  Many of the accounts the offer would be illiquid.

One Star Institutions: High Risk - Potential High Returns.  These institutions would offer no deposits insurance, would agree to standardization in the reporting of returns, face bi-annual audits, subject to systemic risk regulation.  These institutions would undertake private equity (especially venture capital) investments and some hedge funds investments along with other asset purchases.  Most of the accounts they offer would be illiquid.

This type of system would offer the banking public (both savers and borrowers) a variety of choices. Underlying the system would be a level of safety and security, notice even one star institutions are subject to regulation, but competition would determine which entities succeed and which fail.

Think of this system as analogous to our restaurants.  We have a variety of restaurants that do different things:  fast food restaurants with their quick cheap food served on plastic trays all the way to high end restaurants with gourmet food and fine linen table cloths.  Are they all the same?  No.  Are we told what restaurant we must eat?  No, we choose.  When we choose we know there is a basic level of safety/regulation-someone we trust has inspected the kitchen and made sure it is clean-but we choose.

Even if a restaurant is closed by the health inspector, does that cause us to stop eating out all together?  No.

If we collectively choose not to go to a certain restaurant that restaurant does goes out of business.

And so it should be with our financial market regulation and financial market structure:  allow people to choose, force them to pay for what they want, but the regulators should also offer a level of safety to the system and close down those that are unsafe.

This would be true financial market reform.

This would be “change we could believe in.”  This is what the Obama Administration should be doing.

All the best,
MBrandl