Comments by Howell E. Jackson
Comments by Howell E. Jackson
Abstract and Keywords
This chapter discusses the diagnosis of the economic crisis presented by previous chapters. The chapter first argues against the statement that the Glass-Steagall Act disrupted the period of financial stability between the 1930s to the early 1980s. The chapter then goes on to explain that the decision to allow the market in over-the-counter derivatives to balloon without any public oversight was a public-policy error of the first order. Therefore, the Glass-Steagall act was not a principal cause of the recent crisis. The chapter then discusses the problem of money-market mutual funds, which is viewed to have become a source of systemic risk that warranted action from the Department of the Treasury. The chapter goes to outline some theories and examples for how to balance these risks. The chapter ends with the imperative that practicing finance is more important than simply regulating finance. Hence, effective financial oversight is a necessity.
Glenn Hubbard and David Moss have played a major role in our policies toward the regulation of financial institutions, Hubbard through his work with the Capital Market Regulation Committee and Moss through various writings and through his contribution to the Troubled Asset Relief Program (TARP) Congressional Oversight Committee report in January 2009. Hubbard’s and Moss’s papers in this volume both make therapeutic allusions: prescriptions, the morning after, an ounce of prevention. So, one of the first things I want discuss is whether our economic physicians have properly diagnosed the disease.
Understanding the Economic Stability of the Postwar Era
In his paper, Moss presents an interesting chart of the crises before and after the Great Depression. The stable period he alluded to is a flat line that runs from roughly the 1930s to the early 1980s. Both Moss and Paul Volcker suggest that the repeal of the Glass-Steagall Act disrupted this period of financial stability. In the interest of disclosure, I did work with the Clinton administration on the work that led to the passage of the Gramm-Leach-Bliley Act, which repealed elements of Glass-Steagall, so forgive me if I start with a more charitable view of that piece of legislation and more skepticism that its enactment was an important cause of the recent financial crisis.
The low incidence of financial crises during the middle of the last century coincided for the most part with the post-World World II era. It was a time when much of the global economy was focused on rebuilding itself from the war’s devastation, and the United States was an unrivaled economic superpower. That comparative advantage was no doubt a contributing factor to the economic successes of the U.S. in the 1950s and the 1960s. It is conceivable that New Deal regulation was responsible for some of the (p.116) relative stability of the post-war years but undoubtedly a number of other factors were also involved. A general conservatism in business practices across the economy also likely played a role, as did the absence of serious competitive pressure from overseas.
Towards the end of this period, around 1980, many changes were afoot. Increasing overseas competition and the rise of corporate takeovers forced previously complaisant American managers to pursue more aggressive and risky business strategies. Within the financial-services sector, there was widespread concern that U.S. financial institutions were too small. At this time Japan was often cited as a potential new number one in economic power, and Japanese banks dominated the international league tables in size and in growth rate. As these competitive fears became more pronounced, the U.S. gradually relaxed its historic restrictions on geographic expansion of banks. Initially this was accomplished through liberalization of state branching laws and regional compacts on interstate expansion, but by the mid 1990s Congress had reformed federal policy, explicitly authorizing the creation of interstate commercial banks. Thus, when you talk about changes in the size of our commercial banking sector since 1980, much of the change reflects political decisions to bring the country into alignment with the rest of the world, and the elimination of quite unusual geographic restrictions, which themselves had contributed to other economic crises, including the savings-and-loan crisis of the 1980s and before that the many failures of small banks during the Great Depression.
A number of commentators, including some speakers at this conference, have decried the repeal of Glass-Steagall as a principal cause of the recent crisis. Our regulatory system undoubtedly suffered many supervisory failures, and the decision to allow the market in over-the-counter derivatives to balloon without any public oversight was a public-policy error of the first order. But the supposed connection between the repeal of Glass-Steagall and the recent financial crisis does not, in my mind, withstand careful scrutiny. To begin with, consider the most spectacular institutional failures of 2008: Bear Stearns, Lehman Brothers, American International Group, and the government-sponsored entities Fannie Mae and Freddie Mac. None of these institutions was affiliated with a commercial bank, and none was exploiting statutory reforms of the late 1990s. Similarly, the ability of financial institutions to enter into massive notional amounts of credit-default swaps and other over-the-counter derivatives without regulatory restrictions had nothing to do with the repeal of the Glass-Steagall Act. On the other hand, one might more plausibly argue that the repeal of Glass-Steagall empowered the institutional heroes of (p.117) the financial crisis—JPMorgan Chase and Bank of America—to take over failing investment banks (Bear Stearns and Merrill Lynch) in the midst of the crisis. To be sure, several major depository institutions, including Washington Mutual and IndyBank, did implode in the crisis, and Citicorp would have failed but for government intervention. But the failures of these firms stemmed directly from faulty mortgage-underwriting practices of the sort that were permissible before the repeal of Glass-Steagall and would remain permissible, at least as far as I can tell, were Paul Volcker’s recommended reforms to be enacted into law.
Quite conceivably, reform legislation will include some Glass-Steagall-like structural constraints on major bank holding companies and other systemically important firms. Though the legislation is not likely to re-impose the old distinctions between investment and commercial banking that Glass-Steagall sought to police, prohibitions with respect to proprietary trading and related forms of direct investment may well be included, and considerable ink will no doubt be expended on reducing these new restrictions into workable guidelines. But, at the end of the day, systemically important financial institutions will retain the capacity to incur substantial financial risks, and the enduring and complex challenge for financial supervisory will be how to devise appropriate safeguards to restrain those risks without impairing our economic vitality.
The Challenge of Regulating Financial Risk: The Case of Money-Market Mutual Funds
Hubbard discusses the problem of money-market mutual funds, and these entities offer a good illustration of the complexity of risk regulation in our modern economy. With cumulative assets of between $3 trillion and $4 trillion, money-market mutual funds have grown into a major financial force, and they got into trouble when the Reserve Primary Fund incurred losses on its Lehman Brothers paper and was forced to break the buck (that is, deviate from the nominal, stable dollar pricing per share that SEC Rule 2a-7 allows). This failure led to a government bailout in the form of an emergency guarantee program that the Department of the Treasury created to prevent runs on other money-market funds. Most analysts, I think, agree that money-market funds had become a source of systemic risk and view the Department of the Treasury’s intervention as an appropriate action, albeit one that we would hope not to repeat in the future. But how should the government identify such sources of systemic risk in the future, and what sort of ex ante regulation should now be imposed on the (p.118) mutual-fund industry to prevent a repeat of the Reserve Primary Fund’s difficulties and the cascading consequences?
One possible response is to create new regulations that aim to reduce portfolio risk. The Securities and Exchange Commission could amend Rule 2a-7 to smooth down asset fluctuations, and indeed such reforms are underway. By shortening permissible maturities or increasing credit-quality requirements, the SEC could reduce asset volatility. With this approach, the government would dictate the permissible level of risk for money-market mutual funds. Conversely, the government could follow Hubbard’s idea of allowing money-market mutual funds to buy derivatives and thus putting the burden on private parties to devise appropriate risk-mitigation strategies. We have gone down the path of firms’ buying derivatives. Maybe if the derivatives are exchange traded and sold through a central clearing house, this approach may work better than it has in the past. But the essence of this strategy is to look for market mechanisms to control the risks of money-market mutual funds. Another solution that Hubbard alludes to in his paper would be to have the government continue the Department of the Treasury’s guarantee, but to police it with risk-based pricing. Having tried risk-based pricing in the Public Benefit Guarantee Corporation and other contexts, we know that it is very difficult for the government to do it properly. Government officials have to understand the risk and get the pricing right, which is complicated and often politically challenging. But theoretically, the government could deal with the risks of money-market mutual funds by imposing an appropriate price. Alternatively, the SEC could tweak the regulation of credit-rating agencies in various ways. We could make them more reliable, or we could get rid of them, as Posner proposes (on the ground that investors should make their own credit assessments rather than relying on the determination of potentially fallible rating agencies).
Another interesting idea that has been proposed is to do away with the SEC-endorsed stable-dollar pricing rule that permits money-market mutual funds to compete effectively with bank deposits. Eliminating level pricing is an attractive governmental response because it was level pricing that created the risk of the run back in September 2008. The problem with level pricing is that it allows investors to trade shares at a price that is an estimate of the value of the underlying asset rather than the true net-as-set value. When the underlying value starts to deviate too much from the government-authorized level price, the smart money is going to run, forcing funds to liquidate assets and to impose more losses on the remaining shareholders. A quite reasonable government response would be “Well, (p.119) this form of product—the level priced money-market fund—is inherently risky and should be prohibited.” I think it is a promising idea. One of the problems is that the SEC would have to take such an action, and money-market mutual funds have been the SEC’s golden child for more than 30 years. The Commission generates a lot of revenue for both the industry and the federal treasury, and it would be difficult for the SEC to adjust the regulation of money-market mutual funds in a way that would reduce their competitiveness (even if such a change would be sound public policy).
As the case of money-market mutual funds nicely illustrates, regulating risk is no simple task. Even when government officials identify a potential source of systemic risk, many different risk-reduction strategies are theoretically possible, and coming up with an effective, measured, and politically feasible response is often a daunting task.
Policing Systemic Risk in a Highly Fragmented Regulatory System
As many observers have noted, the United States has an extraordinarily complicated regulatory system, with authority divided both along sectoral lines (banking, insurance, and securities) and between federal and state governments. Within some sectors—most notably, the oversight of banking and capital markets—the federal bureaucracy is further distributed among numerous bank supervisory agencies and a bifurcated SEC and Commodity Futures Trading Commission. The regulatory system is additionally complicated by the existence of the President’s Working Group on Financial Markets, which sits on top of the rest of the apparatus, providing a limited capacity to address cross-cutting problems. (See figure 1.)
The Obama administration’s reform proposal, which Moss and Hubbard both allude to, would add a new systemic-risk unit, possibly tied to the Federal Reserve, and give it oversight authority over the entire financial system for things that are systemically important. Then the President’s Working Group would be renamed the Financial Services Oversight Council, and would play a role in establishing the jurisdiction of the systemic-risk authority and, possibly, resolve disputes among regulatory bodies. As is illustrated in figure 2, this approach would superimpose a macroprudential function on our existing system of sectoral regulation. The basic idea of this structure is that the systemic-risk unit would oversee systemically important financial conglomerates, establishing a more stringent supervisory system than that which applies to ordinary financial institutions and thereby superseding the supervisory standards of traditional sectoral (p.120)
From a law professor’s perspective, this approach to systemic-risk oversight raises a number of quite interesting questions of jurisdiction. How do you draw the jurisdictional lines between the systemic unit and the frontline sectoral units? That is a real problem, because there are going to be boundary disputes and jurisdictional squabbles, and there may be redundancies. How these issues are resolved will have important implications when an institution is designated systemically important and also when such a designation is reformed.
One concern about this systemic unit is how precisely we should define which areas of the financial system present genuine systemic risk. As Moss discussed, designations of systemic significance will be politically charged, and the government bodies that make such decisions will be subject to (p.121)
Another concern is whether, even putting aside political constraints, government officials will be able to identify systemically important activities before risks reveal themselves in an economic crisis. Just as bubbles are hard to detect until they burst, systemic risk is hard to predict until it manifests itself in public losses. And the years leading up to the recent financial crisis offer plenty of examples of government agencies looking fairly hard at problems that ultimately produced systemic risks without understanding the potential significance of those problems. For example, much attention was devoted to the problem of subprime lending in the years 2000–2005, but the problem was overwhelmingly understood as an issue of consumer (p.122) protection rather than global financial stability. Similarly, the staff of the Federal Reserve Bank of New York identified credit-default swaps as potentially problematic in the years leading up to the financial crisis, but their concern was primarily with back-office operations and their investigations did not identify the central and destabilizing role that AIG was playing in certain segments of the market.
Pending legislation is also problematic in the manner in which it structures evaluation of systemic risk. The proposals proceed on an apparent assumption that systemic risks arise from either large firms (e.g., Lehman Brothers and AIG) or complex markets (e.g., the market in credit-default swaps). But one of the truisms of the crisis is that many problems resulted from interconnectedness outside of recognized markets, and even more from interdependent modeling failures (e.g., excessive reliance on credit rating agencies) that were not directly associated with specific institutions. Money-market mutual funds offer a nice case in point. As was discussed earlier, the run on the Reserve Primary Fund posed serious systemic risk. But it would not be fair to say that the Reserve Primary Fund was itself systemically important. Rather, what was systemically important was that many trillions of dollars of occasionally volatile assets were held within an artificial but government-sanctioned level-priced network of money-market mutual funds. Without considering the full interconnectedness of the industry, a policy analyst could not detect the systemic risks important in this organizational structure. This experience makes me worry about the ability of systemic-risk regulators to identify the true sources of systemic risk if they limit their purview to large firms and recognized markets.
Of course, how the government should organize itself to cast a net that is both appropriately broad and administratively manageable is a difficult question. My point here is simply to emphasize the complexity of the task and to note that where other countries have attempted similar efforts (here I am thinking of the British Financial Service Authority’s well-publicized initiative near a decade ago to deploy its resources in a manner that targeted systemic risks) the results have not been especially inspiring.
Compensation, Social Value, and Financial Services
Finally, I would like to say a few words about money and salaries. As recent press accounts have reported, many major financial services are already returning to profitability, and compensation levels have begun to return to pre-crisis levels. Though Goldman Sachs suffered an off year in 2008, with average employee compensation of “only” $300,000, average (p.123) compensation for employees of Goldman Sachs is expected to go back up to $700,000 in 2009. This relates to something that Benjamin Friedman wrote about in the Financial Times and Calvin Trillin more recently commented upon in the Wall Street Journal. The problem is that too many smart young people have entered the financial sector, drawn by the prospects of fast growth and large profits. This influx of talent is a major challenge to our society and one that we have not yet begun to address.
To be sure, much is being said and done about executive compensation. I count three major initiatives. One is that recipients of Troubled Asset Relief Program funds are being modestly constrained in their levels of executive compensation, and rightly so. But that is a short-term action. Eventually TARP recipients either will be liquidated or will repay their funds, so this mechanism of control is temporary. Say-on-pay proposals for shareholders may well be part of financial reform legislation, but these are also limited in that they are focused on controlling the compensation of top executives through greater shareholder monitoring and voice. There have been recent regulatory efforts to align incentives of trading units with long-term shareholder value. This third initiative may help to reduce some significant incentive problems on trading desks and to improve internal corporate governance. But none of these reforms is likely to have any direct effect on the overall compensation of most financial-firm executives, or on the rich entry-level salaries that have drawn so many talented young people into the financial-services industry in recent years. What is really pumping up salaries at financial firms is the revenue that can be gained from financial trading and related risk-sharing transactions—even transactions that offer no more social utility than bets placed at Las Vegas gaming tables. The scale of financial transactions of dubious social value raises the difficult question of whether we are spending too much on activities that offer society little in return on prodigious amounts of human capital. No doubt, many of these transactions offer some marginal benefits in faster price discovery or additional mechanisms for the sharing of risk. But are they worth the cost of dragging so many of our most talented young people into finance? To the extent that one agrees that this is a potentially serious problem, none of our current initiatives address it. What might be responsive is some sort of Tobin tax or some other form of excessive-profits tax on the financial-services industry that would reduce the attractiveness of a wide range of transactions and reduce the glamour of the financial-services sector.
My final point is about resources available to regulatory authorities. Volcker [in his keynote address, reproduced below] discussed the margin (p.124) of finance versus productive activities in the economy. I think that another margin we should be thinking about is practicing finance versus regulating finance. Top compensation for most regulators in the U.S. is roughly one-third the projected average compensation at Goldman Sachs in 2009. With salary differentials of this magnitude, financial supervision is not likely to become the career path of choice for many ambitious and talented people. Interestingly, the U.S. spends a lot of money on financial regulation, but our money is being spent on a fragmented system that is not attracting enough of the best people for long-term careers. It is very expensive to operate a fragmented regulatory structure. One thing you observe when you move toward regulatory consolidation is that compensation for regulatory officials goes up, because there are fewer of them and fewer redundancies. There is one well-paid American regulatory official at the Public Company Accounting Oversight Board, so under certain circumstances, Congress has proven itself willing to pay senior regulatory officials salaries in the range of $500,000–$600,000. If we ever hope to have effective financial oversight, we need, in my view, to have a larger cohort of top supervisors receive compensation at this level.