Wednesday, June 17, 2009

George Soros and Robert Reich: How To Reform The Financial System

Two very smart financial minds, legendary currency trader George Soros and former Secretary of Labor Robert Reich, share how they would reform the financial system. The people in charge of this momentous task would be wise to listen to what Soros and Reich propose. See the following post by Economist Mark A. Thoma from The Economist's View.

First, Robert Reich:
The Three Essentials of Financial Reform, by Robert Reich: As the White House unveils its long-awaited proposals to prevent another Wall Street meltdown in the future, keep a lookout for three essentials. Without them the Street will revert to its old ways as soon as the coast clears. ...

1. Stop bankers from making huge, risky bets with other peoples’ money. At the least, require they back their bets with a large percentage of their own capital, and bar them from raising money off their balance sheets through derivative trades. Also require they take their pay in stock options or warrants that can’t be cashed in for at least three years, so they’ll take a longer-term view. Best of all would be a requirement that investment banks return to being partnerships and the capital on their books be their own, not yours or your pension fund’s. When investment banks were partnerships, every partner took an active interest in what every other partner and trader was doing. The real mischief started once they started selling shares to the public.

2. Prevent any bank from becoming too big to fail. Separate commercial from investment banking... Combining the basic utility with the casino only made bankers far richer and subjected you and me to risks we didn’t bargain for. If separating commercial from investment banking isn’t enough to bring all banks down to reasonable size, use antitrust laws to break them up.

3. Root out three major conflicts of interest. (1) Credit-rating agencies should no longer be paid by the companies whose issues are being rated; they should be paid by those who use their ratings. (2) Institutional investors like pension funds and mutual funds should not be getting investment advice from the same banks that profit off their investments... (3) the regional Feds that are responsible for much bank oversight should no longer be headed by presidents appointed by the region’s bankers; non-bankers should have the major say, and the regional presidents should have to be confirmed by the Senate.

..[T]he big bankers will fight every one of these with all guns blazing, and their lobbyists in full force. ... Bottom line: Genuine financial reform will be almost as difficult to achieve as real universal health care. Immense private interests are amassed against the public interest in both cases because staggering amounts of money are at stake. ...
Second, George Soros:
The three steps to financial reform, by George Soros, Commentary, Financial Times: ...I am not an advocate of too much regulation. ... While markets are imperfect, regulators are even more so. ... Three principles should guide reform. First, since markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan ... expressly refused that responsibility. ...

Second,... we must also control the availability of credit..., we must ... use credit controls such as margin requirements and minimum capital requirements. ... Margin and minimum capital requirements should be adjusted to suit market conditions ... to forestall ... bubbles.

Third, we must reconceptualise the meaning of market risk. The efficient market hypothesis postulates that markets tend towards equilibrium and deviations occur in a random fashion...

But the efficient market hypothesis is unrealistic. Markets are subject to imbalances... If too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, a collapse. In that case the authorities may have to come to the rescue. That means that there is systemic risk ... in addition to the risks most market participants perceived prior to the crisis.

The securitisation of mortgages added a new dimension of systemic risk. Financial engineers claimed they were reducing risks through geographic diversification: in fact they were increasing them by creating an agency problem. The agents were more interested in maximising fee income than in protecting the interests of bondholders. ...

To avert a repetition, the agents must have “skin in the game” but the five per cent proposed by the administration is more symbolic than substantive. ...

It is probably impractical to separate investment banking from commercial banking as the US did with the Glass Steagull Act of 1933. But there has to be an internal firewall...

Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. ... Custom made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. ... Consider the recent bankruptcy of AbitibiBowater and that of General Motors. In both cases, some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else’s life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed.

Third, in response to this, and more generally to the recent argument that calls to extend regulation to the shadow banking sector are unfounded because this sector had nothing to do with the crisis (which is incorrect), for the second time recently here's well-know socialist sympathizer Robert Lucas, the Nobel prize winning economist at the University of Chicago. It seems he also favors extending regulation to the unregulated banking sector:
The regulatory structure that permitted these events to occur will have to be redesigned... The regulatory problem that needs to be solved is roughly this: The public needs a conveniently provided medium of exchange that is free of default risk or "bank runs." The best way to achieve this would be to have a competitive banking system with government-insured deposits.

But this can only work if the assets held by these banks are tightly regulated. If such an equilibrium could be reached, it would still be possible for an institution outside this regulated system to offer deposits that are only slightly more risky but that also pay a higher return than deposits at the regulated banks. Some consumers and firms will find this attractive and switch their deposits. But if everyone does, the regulations will no longer protect anyone. The regulatory structure designed in the 1930s seemed to solve this problem for 60 years, but something else will be needed for the next 60.
And you don't need everyone to switch, just enough to create systemic risk.

This article has been reposted from the Economist's View. The full post can also be viewed on the Economist's View.


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