Financial market concepts and characteristics

Financial reform in 2009: A palpable absence of political will

Only a year ago, the world was paralyzed with the fear that the global economy was about to be catapulted into another Great Depression. Now, the atmosphere has almost returned to 'business as usual' in some sectors of the economy. The stock market has rebounded and Americans were greeted with the best job report since the recession began on December 4, 2009: "only 11,000 jobs disappeared...and the unemployment rate actually dipped, to 10%, from 10.2% the previous month" (Uchitelle, "Jobs," 2009)

As fears of another depression have been quelled, so have calls for reform. Goldman Sachs even made the bold claim that it could have survived the financial crisis last year without federal assistance. "The entire U.S. financial system and all the major firms in the country, and even small banks across the country, were at that moment at the middle of a classic run, a classic bank run," Treasury Secretary Timothy Geithner said, disagreeing with Goldman Sachs' assessment (Bloomberg News, 2009). All of the banks who received bailout money would rather forget the past, and put it behind them, and many have repaid the money so as not to be subject to federal scrutiny of their business practices, bonuses, and executive pay.

Secretary Geithner has called for more stringent requirements put upon executive compensation, an issue near and dear to the heart of the Obama Administration. Other than satisfying populist anger, it is difficult to see how executive pay limits will place real constraints on the risky practices that gave rise to the crisis, such as risky loans, credit default swaps, and derivatives. Geithner has also been criticized for his perceived bias and being too conservative in his approach to regulating the financial industry, as he has long had close personal ties with Wall Street firms and regulators and worked within the industry himself.

The Obama Administration has called for legislation that would allow for greater federal oversight on the exotic financial instruments that were cited as major contributing factors in the financial crisis. While the Obama Administration's proposal for reform "languishes" in Congress, "giants like Goldman Sachs have re-engaged in old trading practices, once again earning big profits and planning big bonuses" (Uchitelle, "Volker," 2009). President Obama called for legislation in May 2009 to regulate derivatives, but the October "43-to-26 vote by the Financial Services Committee was mostly along party lines," suggesting little broad-based support for change and the bill has yet to be passed in any form ("Financial regulatory reform news," The New York Times, 2009). Also, rather than more stringent regulation of the instruments themselves, the bill "is designed to push the trading of these opaque instruments onto exchanges or clearinghouses where regulators and participants can better assess who is at risk. But the bill would let transactions remain private if they involve nonfinancial companies that are trying to protect against fluctuations in their costs of doing business, a practice known as hedging" ("Financial regulatory reform news," The New York Times, 2009). Although theoretically consumers would have greater protection, a substantial amount of the financial sector would still be opaque and merely farmed out to a more shadowy subsector.

The former chairman of the Federal Reserve Paul Volcker has argued that such half-measures and targeting specific types of financial instruments with regulation are ultimately ineffective. Currently the head of President Obama's Economic Recovery Advisory Board, Volcker argues that "regulation by itself will not work. Sooner or later, the giants, in pursuit of profits, will get into trouble. The administration should accept this and shield commercial banking from Wall Street's wild ways" (Uchitelle, "Volcker," 2009). In other words, even if derivatives and credit default swaps are heavily regulated, the financial industry will merely create a new, risky financial instrument that puts consumer savings at risk. Volcker has argued for a return to the historic piece of legislation passed during the Great Depression, the Glass-Steagall Act of 1932 which separated Wall Street speculative financial activities from commercial banking. Significantly, the Act was revoked in 1999, the year when many of the types of practices that contributed to the crisis began to be developed.

The Obama Administration, however, has shied away from such a radical step, which would force J.P. Morgan Chase to give up the trading operations it acquired by merging with Bear Stearns. Bank of America and Merrill Lynch would have to be separated and Goldman Sachs could no longer be a bank holding company. "Commercial banks would take deposits, manage the nation's payments system, make standard loans and even trade securities for their customers -- just not for themselves. The government, in return, would rescue banks that fail. On the other side of the wall, investment houses would be free to buy and sell securities for their own accounts, borrowing to leverage these trades and thus multiplying the profits, and the risks. Being separated from banks, the investment houses would no longer have access to federally insured deposits to finance this trading. If one failed, the government would supervise an orderly liquidation. None would be too big to fail -- a designation that could arise for a handful of institutions under the administration's proposal" (Uchitelle, "Volcker," 2009).

The Volcker proposal seems sensible, as depositors would be insulated from risk, be able to make standard loans and have their deposits insured. Commercial banks would have the confidence that they could make such loans to consumers with the support of the government. Investment firms could take larger risks, but only consumers with an appetite for such transactions would become involved in such firms. However, while the firms would be less closely regulated, they would also have less financial support from the government, should they fail (Uchitelle, "Volcker," 2009).

But the bank lobby is powerful in Washington, D.C. In 2006, banking lobbyists vigorously opposed seemingly sensible and moderate attempts to rein in the industry practices, including limitations on banks that held large commercial real estate properties. Regulators have been reluctant to curtail speculation during 'good times' and often do not vigorously enforce legislation 'on the books.' "Of the nation's 8,100 banks, about 2,200 -- ranging from community lenders in the Rust Belt to midsize regional players -- far exceed the risk thresholds that would ordinarily call for greater scrutiny from management and regulators" (Dash 2009, p.1). This suggests that further regulation, without a will to enforce it on the part of the government, may accomplish little.