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Week of 7.24.09

Transcript: Wall Street Reform and You

I know there are distractions this time of year, maybe activities in the sun with your family, or understandably you may be worried about your job. But you should know there's a plan on the table right now to rebuild our shattered financial system, that powerful players are working to shape if not water down even as we speak. The idea had been to re-engineer Wall Street and make capitalism safer for you and me. That was the concept, but to help us with a reality check, we sat down with Zanny Minton Beddoes, economics editor of The Economist magazine, an outfit that while championing capitalism does not hesitate to cast a critical eye on its successes. Our conversation is part of a beat that we call "Out of the Woods", rebuilding after the great collapse.

Well, Zanny, good to see you.

BEDDOES: It's great to see you again.

BRANCACCIO: You know, if the news media would devote a tenth of the energy on fixing the financial system that they've devoted in recent weeks to this Michael Jackson thing—the world, I think, would be a better place, don't you think?

BEDDOES: Well, the world would be a different place. You know, it's just not sexy. Michael Jackson was the King of Pop, the king of—you know, this—I'm not quite sure what financial regulatory reform is. But even—even seasoned journalists, seasoned economic journalists start yawning when you say, "We really need to write about financial regulatory reform."

BRANCACCIO: Financial regulatory reform is this kind of white paper that the Obama Administration came out. What is it, like a roadmap or something?

BEDDOES: Well, it says on the front cover, you can see that. Is says, "It's a new foundation." And the idea is, that we've just had the biggest financial bust since the Great Depression. As you know, in the Depression, there was a huge amount of rewriting of the rules of finance. And so, this is gonna be the new foundation for the new, safer financial system. Question is, is it a new foundation? Is it a new set of walls, or is it a bit of interior redecoration?

BRANCACCIO: Well, I mean, it doesn't—reading through it, it's 88 pages. It's not the final legislation or anything. But it doesn't seem revolutionary. It tinkers with the system, it makes some improvements.

BEDDOES: I think it's very consciously not revolutionary. Because it was written very much with an eye to getting something passed. And they came up with a compromise that they think is sort of within the realms of the possible. And there's a lot of good stuff in there. There's a lot of things that, in my view, that are not done that ought to be done. Not the least of which is actually rationalizing this cacophony of regulators that—

BRANCACCIO: Well, 'cause—

BEDDOES: —the U.S. has.

BRANCACCIO: —people need to understand that, in the United States of America, there's loads of different bank regulators.

BEDDOES: Yeah—loads of different bank regulators. There are loads of federal regulators for the financial system. And then, there's a whole load of state regulators, too. It's an absolute patchwork. And so, if you have that, it means that a—a financial institution can kind of regulatory shop. It can figure out what kind of charter should it have. What sort of financial institution would it—should it be to get the most friendly regulator? And that, in a—in a sort of national, and let alone an international capital market, is—is terrible. 'Cause it means that, things fall through the cracks, and people can kind of arbitrage around the rules. So, in my view, in an ideal world, you had—would have a much more streamlined set of regulators, far fewer than you have in the U.S. But I think that kind of—that issue is very, very politically fraught. And they decided, "You know what, there are more important things to do." Such as, for example, you know—one of the big problems of this crisis was that it was a crisis of the non-bank financial sector. It wasn't just banks that were in trouble. But it was the—securitized mortgage market that was outside the banking sector.

BRANCACCIO: There's a lot of things in our financial markets in 2009 that walk like banks, talk like banks, but aren't technically called banks. And so, they escaped the big regulation.

BEDDOES: They escaped the big regulation. And so, there was a—there's a recognition now that we need to do something about that. And that has several levels. So, one is, what they call, "orderly unwinding mechanism" for dealing with these institutions if they go bust. 'Cause the problem with Lehman, was that you couldn't do anything about Lehman, because there was no orderly way of dealing with a Lehman bankruptcy. And so, that's one thing that's in now. We need to create a mechanism for dealing with these institutions if they fail. The second one is to try and plug the cracks, if you will. To try and expand the regulatory net, so that it includes the important organizations, even if they're not technically banks. So, hedge funds, for example. Hedge funds are now gonna have to register with the SEC. There's going to be more disclosure requirements on hedge funds. And big institutions, what they call, "systemically important institutions", the kind of institutions that could rock the system if they failed, they will be regulated by the Fed. Whether—whatever kind of financial institution they are; if they're big enough to be a systemic problem, then they're under that regulatory net.

BRANCACCIO: The idea is, if I, the taxpayer, are gonna have to pay to bail the thing out if it fails, maybe somebody should watch over it. But you mentioned hedge funds. It's not like this thing proposes widespread, detailed regulation of hedge funds and—in a way that, say, a bank is regulated.

BEDDOES: And I think, in my view, rightly so. Because actually, for all the harrumphing about hedge funds, and a lot of this harrumphing has been in Europe where they're viewed very, very askance, hedge funds were not really at the center of this crisis. And hedge funds were not the biggest problem. And so, I think that, to turn around and say, the lesson of this crisis is that we must regulate the heck out of hedge funds would actually be the wrong conclusion to draw. But I think, the—the bigger point is that, to the extent that you are systemically important, whatever the label on your door, then you need to be part of the regulatory net. You need to be covered by it. That's—that's sort of one important fact. The second one is, that a lot of the innovation that's taken place around, to kind of get around the rules; the idea is to make—have more transparency, and to make markets work better. So, take for example, derivatives. Huge explosion in derivatives trading in the last few years. And here, rather than trying to kind of roll the clock back, and have what you might call, regulation by nostalgia. This approach—and indeed the approach taken several—

BRANCACCIO: Regulation by nostalgia? In other words—get rid of the rules that followed—

BEDDOES: —get—

BRANCACCIO: —the Great Depression? So—

BEDDOES: Absolutely, let's re-impose Glass-Steagall. Let's say, that banks should be banks, and they can't do all these other things. Which—and there are—you know, some people who argue, that that's what we should do. It seems to me, that that's actually a—a kind of—practically a—a—the wrong-headed way to go. Because we have now a sophisticated modern global capital market. And we can talk about this, but in my view, that's actually brought quite a lot of advantages. And we want to keep those advantages. We just want to make it safer, without stymieing its innovation, without stymieing it's efficiency.

BRANCACCIO: But surely—

BEDDOES: That's the—

BRANCACCIO: —one of the lessons here has to be, we need more transparency in these systems?

BEDDOES: Absolutely.

BRANCACCIO: And derivatives, not always that transparent, certainly hedge funds, not always that transparent—

BEDDOES: But take derivatives, take derivatives. One of the main proposals for derivatives is indeed, to make them more transparent, and make them—put them on either—on exchanges, where they are going to be regulated exchanges that you trade these der—derivatives on. Or, through clearing houses. And if you want to have a, what they call, over the counter derivatives, so, one that's written by—just for one institution—

BRANCACCIO: Kind of a standard plain vanilla derivative?

BEDDOES: If it's—not standard one. If it's the standard one, fine. If it's not gonna be a standard one, then you have a higher capital charge for it. So, this is a very sensible approach. It doesn't ban anything. It doesn't say, you can't do this. But you just have to—take a higher capital charge if you're gonna do this stuff. And that kind of incentive—strikes me as being extremely sensible. So, I think in those areas, actually, they've done very well. Where the U.S. stood out—in a not terribly positive light, compared to large chunks of the rest of the most advanced countries, was this patchwork of regulators that we talked about. And I think where we have been sort of somewhat disappointed with this approach, is that this—if—if the aftermath of the biggest crisis in 80 years doesn't give you the political opportunity to really kind of restructure this labyrinth of regulators and get a better one, then when are you ever gonna do it?

BRANCACCIO: And this doesn't propose getting rid of the labyrinth of regulators. It gets rid of the Office of Thrift Supervision, or something. But the other—

BEDDOES: —one, absolutely.

BRANCACCIO: —ones are still around.

BEDDOES: And I—that's—that's—that is a very clear political decision not to have that battle. And the—the Obama Administration clearly thought about it, and clearly thought, "We can have a very ambitious approach but it is gonna get tied in knots in Congress." When you know, one senator wants his particular regulatory agency to stay, and you have fights about, who does the regulating. For my money, it's insufficiently ambitious on that. I think—I—I—I—as I said, I think if you—if this is not the time to have a big regulatory overhaul, than I don't know what is. I hope we don't have an even bigger crisis.

BRANCACCIO: One of the things that shocks people, if they did take the time to take a look at this is, as we went into this crisis, there was no U.S. based regulator that worried about the health of the entire financial system. There wasn't anybody really laying awake at night wondering, "Is this whole thing gonna collapse?" Now the report acknowledges that problem. Do they come up with a solution?

BEDDOES: They do, to a point, actually. And one of the most interesting—lessons of this crises, not just in the U.S., but broadly, is the recognition that financial regulation, financial supervision is what you might say, more than the sum of its parts. So, you can have a regulator for each financial institution. And that's what we've had in the past. And people have said, "Well, if institution A, B, and C, bank A, B, and C are all well regulated, well capitalized, we'll be fine." And what we've learned is that actually, you can have systemic risk. You can have risk that builds up in the system overall, which you don't see if you're just looking at individual institutions. And so, the idea now is to have what's called, a macro-prudential supervisor. And that's the new buzzword of the hour. That new—

BRANCACCIO: Oh my goodness—macro-prudential—

BEDDOES: Prudential supervisor. That's—


BEDDOES: That's go—that's what's gonna kind of drag you back from the beach to read about financial regulation. You need to know about macro-prudential—

BRANCACCIO: All right the Bigfoot—


BRANCACCIO: —regulator worrying about the whole—

BEDDOES: Yeah, not worrying about—

BRANCACCIO: —shebang?

BEDDOES: —the individual institutions, but worrying about—looking across the field, if you will. Or, you know, across the forest. Not regulating the individual trees, but looking across the forest and saying, "Actually, you know, there's some risk—you know, building up there. Actually, what's going on in subprime mortgages looks a bit dodgy." The question for it is—and it seems really quite sensible. You hear that, and you think, "Yeah, what a great idea." You want someone looking at the whole playing field. But what would—A, what does this macro-prudential supervisor do when they see risk coming? Do they simply have their chairman give speeches, saying, "There is a danger coming"? Do they have power to override decisions made by individual supervisors of individual institutions? What we haven't yet worked out, is what this macro-prudential supervisor will do that would, for example, have prevented this crisis. I mean—you know, cast your mind back three, four, five years. There were people saying that risk was under priced. There were people saying things, you know, the party had been going on for too long. What—when would a macro-prudential supervisor have stepped in? And how would they have stopped the excesses?

BRANCACCIO: The—some parts of the financial meltdown are bewilderingly complicated to understand. But some are actually pretty simple. Credit rating agencies. These are the people that went in and would rate, is this stuff risky? Is it not so risky? We did some reporting on this earlier in the year. And take a look at some of the problems

MANN: The rating agencies get paid per deal. So it's a conflict of interest. The - the more they rate Triple A, the more business they get.

HINOJOSA: Julian Mann is a vice president in a Los Angeles investment firm that manages more than 9 billion dollars in pension and mutual funds.

MANN: I'm getting tired of hearing about how no one could see this coming. I would say that anybody should have been able to see this coming.

BRANCACCIO: So, you'd think, the plan would be, crack down on our friends in the credit rating agencies. Eliminate apparent or real conflicts of interests. This doesn't really propose doing that.

BEDDOES: There is a lot of discussion about what to do about credit rating agencies. And you're absolutely right, you know, there is this inherent conflict in their business model. But I think—

BRANCACCIO: That the people who get the ratings, pay for the ratings?

BEDDOES: Absolutely, but it's—it's quite hard to work out an alternative way of doing that. The problem with credit rating agencies, is that they are both profit maximizing firms, and they are also part of the regulatory system. You have to have a—you know, a certain credit rating for certain investors to be able to buy your bonds. My own view is actually that—I don't think that's the central part of where we need to focus our attention looking forward. They are so discredited. They are having such a tough time, that they're going overboard in being tough on their ratings. I think a much bigger point going forward, is that we've had a huge bailout of the financial sector. I mean, an absolutely enormous stepping-in of government. Not just to deal with failing firms, but also to guarantee banks' debt, recapitalizations across the board. And it's not clear to me that, is—in doing that, can we then credibly step back and say, when the next crisis comes, actually we're not going to jump in and spend the tax payers' money to this extent. And do we, or have we created the mother of all moral hazards now? I mean, have we created a kind of financial system where everybody knows, when things get tough, the government's going to come in, and it's gonna come in not just into banks, but in all other financial institutions? And if we have, then I think we've set up a system that is really, ultimately quite dangerous. Because we've—you know, increased the amount of effective public subsidy. But have we got the sort of effective regulation that goes along with that? For example, the question of, you know, are institutions too big to fail? And what do you do about institutions—

BRANCACCIO: And the report really—

BEDDOES: —that are too big to fail?

BRANCACCIO: —goes into that at length, musing on this notion of, there's a special tier, a special class of really big institutions that everybody kind of knows, if they go down, the system goes down.

BEDDOES: Absolutely.

BRANCACCIO: So then, those institutions know that ultimately they will get bailed out?

BEDDOES: And so do the people who lend to them. So does—so does everyone who's sort of associated with them.

BRANCACCIO: Yeah, we can lend to them because—you know, the government will bail them out?

BEDDOES: Exactly, and so, for example, in the U.K., there is a much more—vibrant discussion about whether that's really a state of affairs you want to have. And the governor of the Central Bank of England, Mervyn King, has said, and I'm paraphrasing slightly, but, "An institution that is too big to fail, may be an institution that's too big." And so, one, you know, very radical approach would be to say, actually, some of these financial institutions are just too big. You know, the corollary of that would be, that they ought to be broken up. But if you don't have the political appetite to rearrange the regulatory supervisors, you're certainly not gonna have the political appetite to go down that route. There is some good stuff in here. But it's a relatively modest—rearranging of the financial supervisory structure. I—I'm not sure that it's a new foundation. I do think it's more—interior design, than it is a whole new foundation.

BRANCACCIO: Well, to—well, to stay on this home improvement metaphor, there is one part of this that seems a bit like they've built an annex on the present dwelling. It's this notion of a consumer product safety commission, but not for toys, or cars, but for financial products. In fact, I was sitting in a room very similar to this late last year with Harvard professor, Elizabeth Warren. And she proposed this idea. And suddenly, it shows up as a proposal.

BEDDOES: That's not—entirely a coincidence, I don't think.

BRANCACCIO: What do you make of this? They would be watching out for essentially, dangerous products that would hurt you and me.

BEDDOES: There were clearly a whole lot of very dumb products there that were sold to consumers, and consumers didn't really understand. So, to say that—

BRANCACCIO: Mortgages that were ridiculous?

BEDDOES: Absolutely, so—so, there is a need for that kind of—activity. Whether this agency becomes—an effective means of doing that, is less clear to me. And I worry about two things. Firstly, it seems to me, that already this agency has become the sort of locus for all industry lobbying. The industry is terrified that this is going to, you know, prevent them from innovating, it's going to prevent them from introducing really sensible products. And that's a risk. If you have too draconian a view of what is good for people, too paternalistic a view, you may not have—you may not allow very sensible innovation. And you know, I think in this political environment, it is possible to—to sort of over-react. And you know, some people say, "Oh, all s—subprime mortgages were terrible." Actually, you know, quite a lot of people took out subprime mortgages, bought—were able to borrow money to buy a house that they wouldn't have been able to do if there hadn't been the subprime mortgages. And they're much better off for it. So, while there was a lot of excess, and there were a lot, you know, ninja-loans, low-income, no jobs, no assets—

BRANCACCIO: Liars loans—some people call them?

BEDDOES: —all that stuff. Innovation actually is good. And you need new types of financial products. And you also need financial products which have the potential to be misused. If you have something that is so safe that it's impossible to misuse it, I suspect it's too conservative for the average person. And you want to—you want a financial system that allows firms to innovate and provide people with new products. So, I'm—I'm worried that this—if this new agency takes its remit too strictly, and too narrowly defined, it really will bar innovation. But on the other hand, I think it'll also dominate discussion about this whole financial reform. Because that's where industry is most concerned. And they're gonna laser-like—they're focusing on this new agency. What does it mean? What's it going to stop them doing? And I fear that it will prevent discussion on a lot of the other stuff that we've been talking about. Which is less immediately tractable.

BRANCACCIO: But you know, it's interesting, I mean, you are full of the realpolitik of all of this. A lot of what we're talking about—

BEDDOES: I've been in Washington too long.

BRANCACCIO: No, exactly. I mean, you're based here in Washington, and—and it's gotten back a number of times in our discussion to, what Congress would actually do. That in a sense, is a bigger question about, can we make the changes necessary to make the financial system safer and more in the public interest? And we have a political system where a lot of these moneyed interests contributed to the campaigns of the people who are deciding these rules.

BEDDOES: Absolutely. And you see already the way that the terms of the debate about the TARP, the—the financial bailouts are being, you know—history is being rewritten, in a sense. Now that the stronger banks are repaying their capital, we're rewriting history, and we're—we're forgetting quite what a mess the entire banking sector was in. And you're right; this is a very powerful industry. It's an industry which, notwithstanding the beating it's recently had, is politically—well-connected, politically very powerful. So, we—I—I think, we—you know, we have a window of opportunity that is not very long to push through, you know, reasonably substantive reform. And interestingly, that's the sort of irony, you know. People say, after the Great Depression, or during the Great Depression, we had the biggest rewriting of financial rules. And we had that huge rewriting in part, because the Depression was so awful, and it went on for such a long time. And it—things haven't gotten that—that bad this time around, because we've had a much bigger policy response, a much more dramatic policy response—

BRANCACCIO: They were much quicker this time, much quicker.

BEDDOES: Much quicker and much bigger, and much bolder, which is—which is great. I mean, thank goodness, we haven't had to relive the 1930s. But it's not because the initial financial collapse didn't have the potential to be as bad. It easily had the potential to be as bad. We just reacted more quickly. But ironically, because policy makers have reacted more quickly, we may have less room for the long-term reforms that we had—than we had 80 years ago. Because there will be less appetite if it looks as though the system was—you know, turning around. This is going to be—I'm actually more pessimistic than most people about the economic outlook. In the medium term I think it's gonna be pretty grim. But—you know, if it's—if it's not cataclysmic, then it becomes much, much harder to push through really radical reform in the face of very stiff opposition from powerful interest groups.

BRANCACCIO: In recent weeks the Vice-President of the United States, Joe Biden—spoke out. And he said, he's—essentially taken aback by how bad the economy got. That—his administration hadn't predicted double digit unemployment rates. And that maybe there's more work to be done. I mean, I don't know what numbers he was looking at that he was surprised. You know this guy, Ken Rogoff at Harvard—

BEDDOES: I know him very well. He's terrific.

BRANCACCIO: Yeah, bigshot economist at Harvard. And on this program in the spring, he—he's looked at the last 400 years of financial meltdowns, and he says, "This one's gonna go to eleven or 12 percent unemployment." And yet, the administration is surprised it's this bad? You're—remain fairly pessimistic?

BEDDOES: I remain fairly pessimistic. And I—you know, I—when this administration's economic projections first came out, and a lot of us were scratching our heads about the pace of the economic recovery, and the speed of the economic recovery, and the vigor that they were predicting. That said, I think that it's—it's—you know, there's a lot of politics involved in the debate right now. Because it quickly becomes, do we need more stimulus? And do we need a second round of—

BRANCACCIO: Yeah, when someone says, "We need to do more," it means more stimulus?

BEDDOES: It means more stimulus. But I think the—the sort of—underlying lesson of—you know, Ken Rogoff's last 200, 300, or however many years of—of financial history he looked at; is that the hangovers of financial crises are long-lasting. You don't have a very quick recession, and then things bounce back, most of the time. And if you do have that, it tends to be because you're a country like Sweden or Korea, which exported its way to a quick recovery, because the rest of the world was doing fine. But when you've got the—most of rich world in a huge mess, the notion that you're gonna export your way to a quick recovery has gone. So, I think we're looking at, and I've long thought we're looking at, you know—growth that is below trend. So, below enough to—that is not high enough to stop unemployment from rising further, for really quite a protracted period of time. And you've got a huge adjustment that this country has to make.

BRANCACCIO: One of my favorite parts of this—blueprint is this exhortation. The administration says, "You know a really good idea," it says, "is to raise international regulatory standards. Not just the United States, but all the countries. And improve international cooperation." Sure. Why don't—

BEDDOES: The sarcasm is dripping—

BRANCACCIO: —we do that.

BEDDOES: —from your voice.

BRANCACCIO: Well, it's a bit like it's very easy to play the clarinet. All you do is run your fingers up and down the keys in the right order. I mean, how are we gonna do that? It's hard enough in this country.

BEDDOES: Well, you know, let me—let me slightly play Devil's advocate a bit. I—I agree with you. It's easy to write that stuff. And of course the underlying point is that in a global capital market, which is what we have now—we have a global financial market. The U.S. is the biggest player in it. But we have a global financial market. It is extremely important to have global standards and a global effort at addressing this. Because otherwise, banks are just going to move to the locations where they have looser rules. So I think there's a—there's a—bottom line is it's—it's not just motherhood and apple pie. It's absolutely essential for this whole financial regulatory—overhaul to work that it be done on a global basis. But what's interesting is that there are actually several of the strands that we've been discussing are coming through very loud and clear in debates across the globe, particularly in the U.K. and in Europe, which are the other two sort of big financial centers where these debates are being had. So for example, the idea of a macro-prudential supervisor is one that's being debated and, indeed, you know, the—the—the seeds of that have been created, both in the U.K. and in continental Europe. The question of capital, capital being the banks have to hold more capital. Financial institutions have to hold more capital. That's one of the—the main—conclusions that have been reached as a result of this. This has been reached across the board, the notion of having—an orderly way of unwinding non-banks, so a kind of bankruptcy mechanism for non-banks, also conversations that are happening in Europe. Conversations that are happening in—in the U.K. So I'm—I'm actually quite pleasantly surprised about how the divergent voices are sort of—basically converging not to—a single, global blueprint, but to at least agreement on where the main areas that need work are. And there is something called the financial stability board, which is now a sort of international group of regulators who are working together on the—the main areas. So I think, you know, contrary, perhaps, to the—the note of sarcasm that you—you—you had at the beginning in raising the question, that actually we are making progress internationally. And my goodness me, we have to. Because this is a global problem. We have a global capital market. And only if we have a global set of—of regulatory standards are we gonna really make progress.

BRANCACCIO: Well, Zanny Minton Beddoes, Economics Editor of The Economist magazine, thank you very much.

BEDDOES: Thank you.

BRANCACCIO: On this whole plan for financial regulation there is no legislation yet but a key congressional committee is holding hearings for the rest of the summer. The White House says it wants a law ready for the president's signature by the end of the year.

And that's it for NOW. From New York, I'm David Brancaccio. We'll see you next week.

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