The Three Essentials of Financial Reform

As the White House unveils its long-awaited proposals to prevent another Wall Street meltdown in the future, keep a lookout for three essentials. Without them the Street will revert to its old ways as soon as the coast clears. In fact, now that the government has bailed out the Street, the biggest banks will take even larger and more irresponsible risks because they’re officially too big to fail. So these three reforms are critical.

1. Stop bankers from making huge, risky bets with other peoples’ money. At the least, require they back their bets with a large percentage of their own capital, and bar them from raising money off their balance sheets through derivative trades. Also require they take their pay in stock options or warrants that can’t be cashed in for at least three years, so they’ll take a longer-term view. Best of all would be a requirement that investment banks return to being partnerships and the capital on their books be their own, not yours or your pension fund’s. When investment banks were partnerships, every partner took an active interest in what every other partner and trader was doing. The real mischief started once they started selling shares to the public.

2. Prevent any bank from becoming too big to fail. Separate commercial from investment banking, as they were before the late 1990s. Commercial banks should return to their basic function of linking savers with borrowers. Investment bankers should return to their casino function of placing bets in the stock market and advising you and others about where to place your own own bets. Combining the basic utility with the casino only made bankers far richer and subjected you and me to risks we didn’t bargain for. If separating commercial from investment banking isn’t enough to bring all banks down to reasonable size, use antitrust laws to break them up.

3. Root out three major conflicts of interest. (1) Credit-rating agencies should no longer be paid by the companies whose issues are being rated; they should be paid by those who use their ratings. (2) Institutional investors like pension funds and mutual funds should not be getting investment advice from the same banks that profit off their investments; the advice should come from sources without a financial stake; (3) the regional Feds that are responsible for much bank oversight should no longer be headed by presidents appointed by the region’s bankers; non-bankers should have the major say, and the regional presidents should have to be confirmed by the Senate.

These three reforms will reduce the possibility that you and I and other taxpayers will ever again have to spend billions bailing out bankers who robbed us blind while amassing fortunes. But because that would make it next to impossible to make such fortunes in the future, the big bankers will fight every one of these with all guns blazing, and their lobbyists in full force. They’ll try to inundate you in a blizzard of buzz words. They want your eyes to gaze over, but don’t let them. Keep focused on these three issues. Congress, for its part, may not be much help. It’s awash in money from Wall Street. Big Finance is second only to the health-industrial complex in owning a large portion of the Hill. Barney Frank at House Banking can be relied on to try his best but others in the House and Senate may well roll over. The President wants to do the right thing but he’s spread thin and spending political capital on health care. Tim Geithner doesn’t have the stomach to take on the Street; the plan he announced a few days ago to regulate pay is a bad joke. Expect lots of blather about rearranging boxes on the regulatory organization chart.

Bottom line: Genuine financial reform will be almost as difficult to achieve as real universal health care. Immense private interests are amassed against the public interest in both cases because staggering amounts of money are at stake. But they are the two most important domestic issues right now. Keep careful watch, and weigh in.

Originally published at Robert Reich’s Blog and reproduced here with the author’s permission.

2 Responses to "The Three Essentials of Financial Reform"

  1. Guest   June 18, 2009 at 8:55 am

    Do you see anything in Obama’s proposals that relates seriously to these points?He seems to want to create a new regulatory safety net that effectively makes large US corporations equivalent to existing government sponsored entities like Fannie Mae and Freddie Mac. This increases moral hazard rather than reduces it!Experience in the EU shows that when governments subsidize lame duck industry as the US is doing with bankrupt auto and financial institutions, this takes a life of its own with the expanded political patronage. Obama as a Chicago politican comes from this tradition. The prospects of an expanded captive electorate would excite any politician. The financial consequences are grave.The deadwood sustained by the government becomes a permanent drag on the economy resulting in permanantly lower growth rates. Public debt rises faster than GDP growth.Small wonder the IMF and former IMF advisers like Simon Johnson have taken such a negative view on the US right now. The US preaches fiscal responsibility to others but is practicing crony corporatist capitalism. Many Russian economists at the recent St. Petersberg economic forum were mocking the US for this hypocrisy.

  2. Felix   June 19, 2009 at 3:26 am

    Stop bankers … bets with other peoples’ money. … When investment banks were partnerships, every partner took an active interest in what every other partner and trader was doingLove it. But, didn’t Lloyd’s have a problem in this situation? The killer on this is that there is a bigger entity than all of these financial institutions. That entity is all about “other people’s money”. How can that situation be fixed?Prevent any bank from becoming too big to fail.Agreed, but again, why stop with banks? Robert, are there any other entities you can think of that are “too big to fail”?Big Finance is second only to the health-industrial complex in owning a large portion of the Hill.Looking at campaign contributions, it looks like the financial guys are #1. Certainly for the presidential dollars, weren’t they? Makes sense, though, this election round. They knew they’d need a patsy real soon.Any highly regulated industry or government sector is guaranteed to toss in some pretty hefty cash bags. They’d be criminal and incompetent not to.Hey, what happened to telcom? Didn’t they used to be the #1 contributor of the non-government monopoly sectors?