Value Added


How to Do Financial Reform the Right Way

Steven Goldberg

If Congress bows to Wall Street lobbyists over financial regulation, look for the next financial crisis to be even nastier.



When I talk to people about the benefits of investing in the stock market, a growing number think I must be joking. Wall Street, they say, is nothing but a casino. The big players make all the money by bending the rules, and there’s not much, if anything, left for the little guy. Folks would rather keep their money in the bank—even if it’s earning next to nothing.

Unfortunately, there’s too much truth in what they say. The Wall Street Journal looks like a police blotter these days. Hedge-fund players are charged with insider trading; financial advisers are caught running Ponzi schemes; brokers and investment bankers are charged with stealing from and misleading clients. The list of transgressions and transgressors seems endless.

The silver lining is that the people written up in the newspaper got caught. But you don’t have to be a cynic to believe that only a fraction of the malfeasance in the financial-services industry ever comes to light. What’s more, the majority of those caught are never charged with a crime or convicted—much less sent to prison, where they belong.

Congress needs to make the financial system safe again for individual investors. The financial-reform bill being debated in Congress is the most important regulation of the industry since the Great Depression. Wall Street lobbyists are doing everything they can to weaken it. The good news: I think there’s a better than even chance that Congress will enact effective reform.

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The immensity of some financial companies poses mammoth problems. If an institution is too big to fail without wrecking the economy, it’s probably too big to exist. Breaking up such companies would make the need for future taxpayer bailouts less likely. Simon Johnson, coauthor of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, argues that no commercial bank’s assets should exceed 4% of U.S. gross domestic product, and no investment bank’s assets should exceed 2% of GDP.

Such constraints, says Johnson, a former chief economist for the International Monetary Fund, would merely return banks to the size of the largest ones in the mid 1990s. Only six big banks would have to shrink. As Johnson points out, the number of huge banks has decreased because so many rivals failed or were absorbed during the 2008 crisis. The remaining big banks have become even larger—and thus, probably in need of even bigger bailouts during the next crisis.

Unfortunately, Congress lacks the political will to cut the banks down to size. That’s due in no small measure to the financial industry’s hefty campaign contributions to lawmakers. But other provisions being debated now would be necessary even if all banks were small—and could do almost as much good.

They include:

• Giving regulators the authority to increase capital requirements at large banks. That would lessen the risk of a big bank failing.

• Granting the government enhanced authority to shut down big banks in a quick and orderly way. That would prevent a repeat of the Lehman Brothers bankruptcy, which left creditors in such huge trouble that the entire system nearly collapsed. Much of the nightmare could have been avoided if some of those creditors could have been repaid right away.

• I’m also sold on the “Volcker rule.” It would forbid banks from trading for their own accounts. Currently, the big banks make the lion’s share of their profits through highly leveraged trading of stocks, bonds and derivatives. The idea of a big bank focusing on lending its money to small businesses is almost quaint today. That must change.

Paul Volcker is the former Federal Reserve chairman who put an end to rampant inflation of the 1970s by steadfastly maintaining high interest rates. He has abundant smarts and courage. Volcker stands in welcome contrast to Alan Greenspan, who kept rates far too low for too long and refused to prick the tech and housing bubbles—arguing that doing so would interfere with the wisdom of the free market. In hindsight, Volcker was an economic genius and Greenspan was a fool.

Volcker’s proposal is wise. President Obama, who appointed Volcker as an adviser, belatedly endorsed it. It has also gained the backing of no fewer than five former Treasury secretaries.

Here’s what it tells big bankers: You want to make highly leveraged bets on the direction of currencies, interest rates, mortgages or whatever esoteric derivatives you can dream up? Fine, but you don’t get federal deposit insurance, and you can’t come running to the government for a bailout if you run aground.

• Speaking of derivatives, they should be traded through exchanges, whenever possible. The companies that use these instruments to hedge risk would see bid and ask prices, just as investors do when they buy or sell stocks, before placing their orders. That would shrink the outrageous markups bankers currently charge on derivatives. Further, an exchange would be on the hook if a bank or other party to a derivative couldn’t pay off its side of a derivative transaction. Far better that an exchange, rather than taxpayers, foot the bill.

Outlaw high-frequency trading. Those aren’t the only changes I’d like to see in the financial system. We all recall the stock market plunging almost 1,000 points and then rebounding in a matter of minutes on May 6. It’s not clear yet what caused the flash crash.

Whatever the cause, high-frequency trading needs to be banned. Powerful computers control more than two-thirds of the stock market’s volume nowadays. That’s madness. Their programs are designed to pick up a few pennies or nickels on each trade. They never hold stocks more than 12 seconds.

There’s no economic benefit whatsoever to high-frequency trading. It simply costs other investors money. Change the rules to require that anyone buying a stock hold it at least 30 seconds. That would stop high-frequency trading in its tracks.

Free markets are a wondrous thing. The difficulty in any financial-reform package is crafting it in such a way that it prevents or lessens future blowups without crippling the markets.

But the status quo really isn’t an option. The technology employed in the markets today makes the reforms enacted in the 1930s terribly outdated, as we saw in the fall of 2008. Seventy-odd years are long enough between major efforts at financial reform. If bank lobbyists succeed in watering down reform in Congress now, the next financial crisis will likely be even worse than the last one.

Steven T. Goldberg (bio) is an investment adviser.



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