Will Obama Fight For Financial Reform?

President Teddy Roosevelt's refusal to work out an out-of-court arrangement to his 1902 antitrust suit against JP Morgan contrasts with President Obama's March 2009 meeting in which he made no changes to the operations of the country's largest financial institutions. Although has has recently expressed willingness to take a tougher stance against the financial services industry, several economists believe he must go much further to truly reform the financial industry. See the following post from Economist's View.

Johnson and Kwak (the original is quite a bit longer):

To battle Wall Street, Obama should channel Teddy Roosevelt, by Simon Johnson and James Kwak, Commentary, Washington Post: In late February 1902, J.P. Morgan, the leading financier of his day, went to the White House to meet with President Theodore Roosevelt and Attorney General Philander Knox. The government had just announced an antitrust suit -- the first of its kind -- against Morgan's recently formed railroad monopoly, Northern Securities, and this was a tense moment for the stock market. Morgan argued strongly that his industrial trusts were essential to American prosperity and competitiveness.

The banker wanted a deal. "If we have done anything wrong, send your man to my man and they can fix it up," he offered. But the president was blunt: "That can't be done." ...

Just over a century later, on March 27, 2009, 13 bankers were summoned to the White House. The global financial system was verging on collapse, in no small measure because of the bankers' concentrated power and their manifest inability to manage the risks of their "financial innovation." Banking had to be rescued ... and only the Obama administration had the power to save the day.

But instead of specific new regulations or changes in the way they operate -- or even any constraints on their power -- what did these 13 bankers find waiting for them? On this day and in the months that followed, the administration provided generous expressions of unconditional financial and moral support, both explicit and implicit, along with gentle and nonbinding admonitions. ... All 13 bankers, no matter how discredited, kept their jobs, their salaries, their bonuses, their pensions, their staff and, most remarkable given the near-complete breakdown of governance, even their boards of directors. ...

Since that meeting, the country has seen no discernible changes in the financial management and incentive systems that for 30 years have given Wall Street the benefits of the upside and Main Street the costs of the downside. And politically, our financial titans have bitterly opposed the mild reforms that the Obama administration eventually proposed. ...

There is no way that Teddy Roosevelt would have stood for this. He saw finance and economics through the lens of political power. In his book, it did not matter how important you were, or claimed to be, to the economy. If you were too powerful, and if your actions were hurting other people in the economy, Roosevelt wanted to take you on -- and he instructed his lawyers accordingly. ...

Unfortunately, Wall Street and its intimate connections to Washington have not become any safer for the American economy since this crisis began. ...

Since Democrats lost the special Senate election in Massachusetts in January, the president has shown some new fire. In a major potential course correction, he proposed the "Volcker Rule,"... which would constrain the risk-taking and the size of the largest U.S. banks. The move blind-sided Wall Street. In the sound bite of Jan. 21, Obama sounded just like Teddy: "If these folks want a fight," he said, "it's a fight I'm ready to have."

It is now time for that fight. ... It doesn't help that Wall Street has vast amounts of cash to spend on lobbying and political ads. Yet, if framed correctly, the reform message cuts across the political spectrum. ...

Will the administration stand up and fight now, before we have another crisis? Surely this is what Theodore Roosevelt would have done. ...

There are at least three goals for financial reform. The first is to prevent bubbles from happening, or at least reduce their frequency. The second is to reduce the consequences should a bubble occur, and then pop, and the third is to reduce the political power and influence of the financial industry, and to take other measures that reduce the chance of regulatory capture. Regulations won't help if they can't be sustained, or if they are used to cement existing market and political power rather than reduce it.

Breaking up banks certainly helps with the third goal, but I don't think breaking banks into smaller entities is enough by itself to reach the first two goals. It may help to prevent bubbles, but long ago when banks were smaller we still had these problems so reducing size alone does not prevent bubbles from inflating. As for the second goal, reducing the fallout when problems do occur, it's not at all clear to me that one thousand highly interconnected small banks failing is easier to deal with (from the perspective of saving the economy) than one large bank.

There are parameters other than size that are important. One of these parameters -- a key one in my view -- is interconnectedness. If banks are highly interconnected, then they are likely to fail en masse and create problems. Another is the distribution of risks across banks. If there are 1,000 small banks, but 500 of them all have just one type of asset in their portfolios (or have very similar assets in what is supposed to be a diversified portfolio), they will all be subject to the same risks and they are likely to fail together. And if they are connected to the other 500 banks in the industry -- e.g. they have borrowed a lot from these banks -- then the failure of one half of the market would threaten the other half.

Thus, while reducing the size of banks is important from a political economy perspective, and also from a market power perspective, it is not enough. We need leverage limits, limits on connectedness, limits on the concentration of risks, etc.

I do not believe we can guarantee that a financial bubble will never happen again. It will. We can make it harder, and do our best to prevent bubbles, reduce their frequency, etc., but the next bubble is inevitable. It's simply a matter of time. Thus, while I very much agree with the thrust against bank size for all the reasons outlined above, I do not want that thrust to come at the expense of other important changes that must be made in the financial industry, changes that insulate the system from a large fallout when the next bubble hits. We must rein in bank behavior as well as bank size, and in my view the current legislative proposals come up short on both fronts.

This article has been republished from Mark Thoma's blog, Economist's View.