Wednesday, July 17, 2024

Capitalize it

Fine Print – September 2010

Capitalize it
By G.D. Gearino

Considering the effect financial reform will have on North Carolina — after all, our homeboys at Charlotte-based Bank of America Corp. not only operate the country’s biggest bank but own a global investment operation, thanks to their acquisition of Merrill Lynch — at the very least we ought to know the bill’s full and proper name: It’s the Dodd-Frank Wall Street Reform and Consumer Protection Act.

I’ve got two specific quibbles with the new law, but first let’s take sour amusement at how perfectly the bill’s formal title reflects three unfortunate trends in these political times. There’s a healthy dose of narcissism on display (after all, politicians aren’t required to insert their names into bill titles); there’s the Alinsky-like identification and isolation of the target (notice that it’s “Wall Street” being reformed, certainly not Congress — despite its significant contribution to the mess we’re in); and there’s the reflexive claim that the bill is designed to protect the little guy. (Forgive me for being cynical about how much “protection” we can endure. Remember, these are the same people who recently reformed health care on behalf of the little guy. The bill’s in the mail, by the way.)

But on to my two quibbles. The first is rooted in financial geekery — you know, those fine points of the regulatory apparatus that cause the eyes of most citizens to glaze over. A few weeks ago, I came across this sentence in a Charlotte Observer story about the lengths the feds have gone to in the name of reform: “[Former BofA CEO Hugh] McColl said regulators already have the most important tool: capital requirements that have the effect of reigning in excessive risk-taking.” I was puzzled by that myself right from the beginning. Why not simply require all institutions to have more skin in the various games? I’d even go a step further and dictate that individual members of boards of directors also have some exposure when things go bad, hugely and expensively. That would cure two problems at once: reckless investments and lax corporate governance.

Actually, the feds might yet get around to McColl’s way of thinking. The reform act, despite its 2,300-page bulk, is a remarkably unfinished product. By the U.S. Chamber of Commerce’s count, there are “520 rulemakings, 81 studies and 93 reports” authorized by the bill but yet to be completed. Maybe the capital-requirement light bulb will go off above somebody’s head. For the moment, though, one of the few moves in that direction is that larger banks will no longer be able to count their “trust preferred securities” as capital. (Without going too deep into geekery, I’ll just explain that it’s a hybrid instrument issued by banks that looks like an equity investment in a bank-owned trust but smells more like a loan.)

My second quibble is with the government’s belief that it can head off future problems by creating a super-regulator called the Financial Stability Oversight Council. According to the bill, its job will be in part to “monitor the financial services marketplace to identify potential threats to the stability of the U.S. financial system … [and] adopt stricter prudential standards for the firms it regulates in order to mitigate systemic risk.” In English, that means the council is supposed to anticipate problems and then head them off before they turn into crises. This is, of course, a little like forming a panel of doctors and telling it to cure cancer — a job much easier ordered than accomplished.

The problem, of course, is that every crisis starts out in life as an opportunity. As a general rule of economics, a crisis (or as it’s otherwise called, a “bust”) reveals itself only after it has spent a long time pretending to be a boom. That boom-to-bust transition is part of the free market’s DNA, and history is littered with examples of failed attempts to alter that genetic imperative. Occasionally, a cartel is formed around a single commodity — oil being the best example — and that market is temporarily brought under control. But it never lasts. Who even remembers that there once was a plate-glass cartel?

You might believe that hopeless as the task might be, there’s no harm in trying to head off a crisis. In fact, giving bureaucrats the responsibility of monitoring the marketplace and protecting it from risk can lead only to disaster. To understand why, ponder the real-life example of the meltdown in the subprime mortgage market, which dragged the world into history-making bad times. Even with the benefit of hindsight, can anyone cite with certainty the exact moment when feds should have stepped in to “mitigate systemic risk”? By the time the problem was obvious, the damage was done. Prior to that, the feds would have been closing down the party early — right when everyone was having a great time. And that, of course, is what the Financial Stability Oversight Council will end up doing: smothering every boom market in the crib, lest it grow into a monster.

That brings me back to McColl and his simple, wise observation that capital requirements are a powerful tool. It seems vastly smarter to engineer mitigation into the system rather than apply it afterward in a time of crisis. Don’t set out to regulate the market. Instead, design the levers of pressure so that the market creates its own dampening effect.

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