What Financial Reforms Do We Still Need?

BY busadmin  September 16, 2009 at 9:18 AM EDT

Wall Street bull; via Flickr

Editor’s note: All this week on the Business Desk, we are featuring contributions from economists, financial journalists, and other experts on the origins and impact of the financial crisis.

Today, we asked several experts to weigh in on the single piece of reform that should be implemented but has not been, in order to prevent another crisis of this magnitude.

Stephen Roach:

The Federal Reserve has gotten off far too easily in the rush to post-crisis reform. The Obama administration has even favored a proposal that would expand the Fed’s power to cover managing “systemic risks” of an interdependent financial system. Yet I would place the reckless and irresponsible conduct by America’s central bank near the top of the list of crisis culprits. For over a dozen years, it was predisposed toward easy money and regulatory laxity – thereby condoning many of the excesses that eventually brought the financial system and the U.S. economy to its knees.

The remedy here is straight forward: The Fed’s mandate must be changed to include the addition of “financial stability” to its policy contract with the U.S. Congress. First and foremost, that would force the Federal Reserve to be pre-emptive in leaning against incipient asset bubbles – thereby limiting bubble-induced distortions on the real side of asset-dependent economies such as the U.S. The severity of this post-crisis shakeout shows it is ludicrous to embrace a reactive policy strategy aimed at post-bubble cleanup operations. An expanded policy mandate will also require the U.S. monetary authority to be more vigilant and disciplined in deploying its supervisory and regulatory arsenal. The aim here is to avoid excess leverage and a profusion of potentially toxic new financial instruments.

Monetary discipline was all but lost in the Era of Excess. The Fed cannot be trusted with self-regulation to atone for its sins. Congress must take explicit action to insure this never happens again.

Stephen Roach is chairman of Morgan Stanley Asia. His new book, The Next Asia, will be out next month.

Dean Baker:

None of the changes put in place to date, or that appear likely to pass, will address the fundamental problems of the financial system. The main problems are its bloated size – the expansion of the narrowly defined financial sector (investment banks and commodity dealers) as a share of the economy over the last decade sucks almost $250 billion out of the economy each year. More importantly, it promotes the growth of speculative bubbles, like the $8 trillion housing bubble, the collapse of which has wrecked the economy.

The most important single reform to change behavior would be to hold people accountable for their past failures. In other words, fire people. This should have been done first and foremost at the level of the regulators, starting with the Fed. It was ungodly incompetence to either not recognize the housing bubble or not realize that its collapse would devastate the economy. If the Fed and other regulatory agencies were held to the same standard as dishwashers and custodians, virtually all of their top staff would be looking for new jobs.

Unfortunately, even the suggestion that these people should be held accountable for their performance like ordinary workers appears outrageous. This lack of accountability virtually guarantees future disasters.

It will always be difficult to challenge powerful financial interests, however this is exactly what effective regulation requires. If failing to challenge powerful financial interests carries no consequences, even when this failures leads to an economic disaster like what we are now experiencing, then regulators will never challenge powerful financial interests. The incentives that we have created in the current crisis guarantee this outcome. That should be obvious to anyone who understands any economics.

Dean Baker is co-director of the Center for Economic and Policy Research.

Thomas Palley:

There are two competing views about the deep causes of the crisis and those views matter for policy. One is the “Massachusetts Avenue” view, which dominates the Obama administration. It interprets the crisis as a purely financial affair. Fiscal stimulus and easy monetary policy can therefore pump-prime the economy and restore growth and full employment. The only structural change that is needed is financial sector reform that limits leverage and changes incentives for risk-taking.

The second view can be labeled the “exhausted paradigm” view. It holds the crisis signals the exhaustion of the economic paradigm of the last thirty years during which the U.S. relied on borrowing and asset price inflation to fuel growth. As trade deficits and wage stagnation cannibalized the system, the economy needed bigger and bigger asset bubbles. Housing provided the ultimate bubble, but when it burst it pulled the system down because of the reliance on debt.

If the latter view is right, growth will be hard to come by. Monetary and fiscal stimulus can stabilize the economy but they cannot generate growth. That needs a new growth model, key features of which must be global re-balancing and restoration of the link between productivity growth and worker wages. As for financial sector reform, it is still needed to ensure financial stability but will do nothing to promote growth which is the fundamental challenge.

A first down-payment on the new growth model should be tackling the trade deficit and bringing manufacturing investment back to the U.S. This will yield immediate job and wage dividends. However, the unwillingness of China to accept global rebalancing poses grave risks that may trigger renewed financial and economic disruption.

Transitions between economic paradigms are always difficult, and the exhausted paradigm view holds a transition is needed and has only just begun.

Thomas Palley is a fellow of the New America Foundation.

Glenn Hubbard:

The conventional take on the present financial and economic crisis places blame on a dearth of regulation. The truth is that the financial crisis is the result of not so much a lack of regulation as the lack of effective regulation. A focus on effectiveness should lead quickly to a discussion of reducing systemic risk.

Existing capital requirements leave much to be desired. The elaborate and detailed structure currently in place to regulate bank capital, the international Basel Accord, proved unable to live up to the task of preventing systemically important financial institutions from failing. Indeed, the crude leverage ratio turned out to be a more reliable constraint on excessive risk taking than the complex Basel rules. The investment banking sector, which did not have a leverage ratio in its regulation, was not as fortunate. The disparity demonstrates that more detailed regulation does not necessarily make for more effective regulation. Larger banks should have higher capital ratios, and the leverage ratio should be strengthened. This is a much better approach than putting size limits on U.S. banks, which will make them uncompetitive with their European and Asian counterparts.

Three changes are important. Institutions that have the ability to borrow from the Fed in its lender-of-last-resort role should be subject to capital regulation. In addition, given the cyclicality of bank losses, a fixed capital requirement forces banks to raise capital in a downturn as losses mount and capital levels are depleted. An alternative to letting capital requirements fall during a downturn would be to allow, or require, banks to hold some form of contingent capital as losses mount. Finally, given the concentration of risks to taxpayers, large institutions should be held to a higher solvency standard. The market can also play a role in this process. If investors are given more information about the solvency of banks, as was given to them by the stress tests, they can demand more capital from banks.

Glenn Hubbard is professor of finance and economics at Columbia Business School and author of this month’s Aid Trap: Hard Truths About Ending Poverty.