The Catholic University of America
Apr 27 2010

Some Comments on Financial Reform

Posted by Ernest Zampelli at 3:05 PM
- Categories: Economy

In the wake of the recent financial crisis, calls for meaningful financial reform echo everywhere and rightly so.  The question is “What should constitute the pillars of such reform?”.  Some argue that we need to return to the days of Glass-Steagall, the 1933 act that separated commercial banking from investment banking.  Others contend that the largest banks, those deemed “too big to fail”, be broken up and that new limits on bank size be imposed.  I’m very much skeptical about the need for the first and somewhat unsure about the necessity and sufficiency of the second.

The Gramm-Leach-Bliley Act (GLBA) passed in 1999 repealed provisions of Glass-Steagall and parts of the Bank Holding Act of 1952, basically opening the door for “universal” banks, financial institutions that may offer a full range of financial services from banking to insurance to security underwriting and brokerage.  Its passage was not merely a consequence of intense lobbying by the financial sector.  As James Barth, R. Dan Brumbaugh Jr., and James Wilcox point out in a 2000 paper in the Journal of Economic Perspectives,  considerable empirical evidence had been amassed in the academic literature regarding the efficacy of universal banking versus the specialized banking during the Glass-Steagall period.   In particular, research in the 1980’s and 90’s tended to dispel arguments that universal banks are more risky than specialized banks and that they threatened the stability of the financial system.  Indeed, most evidence suggested that the greater asset diversification of universal banks actually helped to stabilize the system during periods of financial crisis.

My sense is that enactment of GLBA, per se, was not the source of the crisis and that there is little need to return to a Glass-Steagall world.  That being said, the universal banking system cannot be treated in a laissez-faire manner, especially when it comes to the use of exotic financial instruments with which mortgages are securitized.  Mortgage securitization yields substantial benefits by shifting risk to investors that are most able to absorb that risk.  “Plain vanilla” mortgage backed securities (MBS) are capable of doing that.  Plain vanilla refers to the fact that the security is simply a portfolio of mortgages put together by the bank and sold, usually to large institutional investors, e.g., pension funds, whose time horizons usually match well with the maturity of the security.  A more exotic security, the now infamous Collateralized Debt Obligation (CDO) would be a portfolio of MBS’s of different qualities, making this less transparent and more complicated, with little apparent benefit.  I’d like to see banks be prohibited from issuing CDO’s and be made to retain an equity stake in all MBS’s that they sell.  This should reduce the incentive to make mortgage loans for which the risk of default is high.  Higher minimum capital requirements need to be imposed to limit the scope of additional loans.

Additionally, oversight of both individual banks and the system as a whole must be strengthened.  Regulators, including the Federal Reserve, did not discharge their responsibilities properly.  The risk management strategies of universal banks must be closely monitored to assess an individual bank’s exposure to systemic risk.  In addition, because of the high degree of connectivity among institutions, there needs to be a holistic approach to closely monitoring the entire financial system.  This, in turn, means that prudent regulation be extended to all major participants including non-bank financial firms like AIG, Goldman-Sachs, etc.  Unless such firms are subject to close regulatory oversight, the safety of the financial system will be compromised.  Finally, regarding the bank size issue, I tend to agree with Paul Krugman.  Allowing banks to fail, small or large, is probably not wise—witness the Great Depression.  Fundamentally, it’s not bank size but what banks are allowed to do that matters.


Scott Montgomery

Scott Montgomery wrote on 04/28/10 11:34 AM

The only thing I would suggest that goes along with what Ernie has said is that regulating these securities is going to freeze up all assets that are currently used as investments, which would also casue a "Great Depression". This is because the effects of all of these derivatives is more widespread than we know and it involves all types of investments from venture capital and so on. I believe that you would have to freeze half of all assets in the U.S. including individuals with 401k's to see the effect of every derivtive transaction and that is just not possible. The way to do it is to take each individual investment strategy and determine what the desired results are to be and set ground rules for each of them. This will take a long time but it is the only solution to the problem.
Steve McKenna

Steve McKenna wrote on 05/02/10 8:40 PM

I agree, Ernie. Banks need to be forced out of the CDO market--with no skin in the game, they just rack up fees and have been too easily enticed to increase the risk of the equity traunches at the behest of hedge funds who were invested in and standing to profit hugely from credit default swaps. Another big piece of reform that has to happen, I think, is a change in the way the rating agencies do business. The conflict of interest in rating the securities of clients for those clients, instead of for investors, is a big problem, no?

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