Friday, February 5, 2010

Revisionist History on Financial Reform

I'm getting so tired of people who refuse to read financial reform proposals before dismissing them as woefully inadequate. This time it's James Kwak, who writes (quoting a senior administration official during the background briefing on the Volcker Rule):

“The basic authority is provided in Chairman Frank’s legislation, for regulators to break apart major financial firms or to address problems with risky activities to the extent that they cause the firm to act in an unsafe or unsound manner that threatens the financial system. So we worked very closely with Chairman Frank on that already.”

Not exactly. The “basic authority” referred to must be the Kanjorski Amendment, which allows regulators to take action regarding a specific firm because it is a danger to the system (not just because it is a danger to itself). I don’t recall the Kanjorski Amendment being in Treasury’s initial regulatory proposal. (The Kanjorski Amendment is also hemmed in with all sorts of restrictions, like needing Tim Geithner’s approval for any action affecting more than $10 billion in assets.)

Or, more precisely, the answer is technically correct–they are claiming that they worked with Frank on the Kanjorksi Amendment, which may be true–but it dodges the spirit of the initial question, which was “Why didn’t you do this back in June?”

I know that administration officials have a tough job when they have to go out and spin new policies that (a) are significant changes from past policies and (b) may turn out not to be serious anyway. But that doesn’t mean I have to give them a pass.
This is 100% false. I know James is still a law student, but that doesn't mean I have to give him a pass either (especially since both he and Simon Johnson like to pass themselves off as experts on financial reform).

Both Treasury's initial proposal and Barney Frank's discussion draft contain the "basic authority" to prohibit specific firms from engaging in activities that regulators consider a threat to financial stability. Kwak clearly didn't bother to read either Treasury's proposal or Frank's discussion draft, which is sad because he just co-authored a book on financial reform.

Frank's discussion draft very clearly contained this "basic authority," in Section 1104(a)(5):
(5) MITIGATION OF SYSTEMIC RISK.—If the Board determines, after notice and an opportunity for hearing, that the size of an identified financial holding company or the scope or nature of activities directly or indirectly conducted by an identified financial holding company poses a threat to the safety and soundness of such company or to the financial stability of the United States, the Board may require the identified financial holding company to sell or otherwise transfer assets or off-balance sheet items to unaffiliated firms, to terminate one or more activities, or to impose conditions on the manner in which the identified financial holding company conducts one or more activities. (emphasis added)
It doesn't get much clearer than that. And it's not like this provision was buried hundreds of pages into the discussion draft — it was on page 19. Of course, admitting that this provision was in Frank's discussion draft — which was the product of lengthy negotiations between Frank and Treasury — would go against Kwak's little narrative, in which Treasury is in the pocket of the Evil Wall Street Banks.

What's more, Treasury's initial proposal, which they released last Jun, also gave the Fed a couple of ways to prohibit activities that threaten financial stability. First, Treasury's proposal gave the Fed the authority to order Tier 1 financial holding companies (i.e., large complex financial institutions) and their subsidiaries to terminate "conduct, activities, transactions, or arrangements that could pose a threat to global or United States financial stability." Treasury's proposal also gave the Fed the authority to prohibit risky activities at Tier 1 FHCs through its Prompt Corrective Action (PCA) provisions. Essentially, Treasury's proposal allowed the Fed to treat even Tier 1 FHCs that are technically "well capitalized" under the law as "undercapitalized" for purposes of PCA, which would've then allowed the Fed to order Tier 1 FHCs to terminate or restrict risky activities.

What self-proclaimed "reformers" probably don't realize is that the Kanjorski Amendment significantly reduced the likelihood that a financial institution will be ordered to terminate activities that threaten financial stability. Under Frank's discussion draft, the Fed had the authority to prohibit activities that "pose a threat to financial stability." Under the Kanjorski Amendment, however, the activities have to pose a "grave threat to financial stability" before regulators can order a financial institution to terminate the activities. The Kanjorski Amendment also shifted the authority to prohibit risky activities from the Fed to the Financial Services Oversight Council (meaning multiple regulators have to sign off on the action), and added a whole bunch of cumbersome procedural requirements to boot. This is just terrible policymaking, which is why the Kanjorski Amendment was such a bad idea.

And yet for some reason, people who like to think of themselves as reformers cheered the Kanjorski Amendment on, and patted themselves on the back when it passed. This is what the financial reform debate has come to.


Anonymous said...

I posted the basics of this in the comments section over there.

Nothing like having a professional like EoC do it right!

urban legend said...

Have not followed this as closely as I should have, but isn't "grave threat" a huge overreach as a loophole? And isn't the responsible centrist compromise -- yes, merely saying " a threat" is arguably an invitation to regulatory abuse -- "significant threat" or "material threat"? Of course, this would be the court-supplied standard no matter how it's worded, but spelling it out would help disarm opposition.

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