The Good, the Bad and the Irrelevant

If I’m not mistaken, the Senate election last week was held not in Michigan, nor in Mississippi, but in Massachusetts: America’s highest-ranked state by health-insurance coverage and education, and the third-highest by per-capita income.

If I’m also not mistaken, the winning candidate lured voters not with his ruthless bank-bashing (on the contrary!), but by flagging himself as an “independent” with a (supposedly) fiscally conservative agenda.

Against this backdrop, the knee-jerk reaction that came out of the White House shortly after Tuesday’s results is not just bad (polarizing, desperate) politics; it’s also bad policy—irrelevant and potentially harmful policy.

Starting with irrelevant: The proposed “Volcker Rule”, which would prohibit banks “to own, invest or sponsor hedge funds [or] private equity funds” or engage in proprietary trading does exactly nada to address the causes of the financial crisis. These were:

(a) the inability of banks and their regulators to grasp, let alone contain, the level of systemic risk resulting from their highly leveraged operations;

(b) abundant liquidity, easy credit and the search for yield (call it greed if you like); and

(c) as a result of (a) and (b), too little capital to support the ballooning debt in the financial system and the real economy (esp. households).

Constructive initiatives to address systemic risk and capital adequacy are already underway, with high-level institutions like the Bank of International Settlements preparing proposals in these areas. These would include more effective and transparent rules for loss provisions, pro-cyclical capital buffers, a resolution framework for “too big to fail” institutions and stricter liquidity requirements.

What does the Volcker Rule add to this discussion? What… you said more protection to the taxpayer from the high risk takers?! Well, no.

Basically, the Volcker “rule” is grounded on an erroneous assumption: That only institutions that receive deposits from the man on the street are worth stabilizing with taxpayer money (e.g. through deposit guarantees) because of their special role in economic growth.

But this is clearly misplaced. Non-bank financial institutions such as money market funds, finance companies and securities lenders/dealers are absolutely instrumental for the flow of corporate finance and household credit. As such, they are very much “systemic” from an economic growth point of view. One can only recall the complete meltdown of the US and the global economy when Lehman was allowed to fail! Lehman was not a “bank”—yet it warranted an orderly resolution, which—at that stage—had to risk taxpayer money.

In light of this, the relevant policy response is not to –effectively– force financial institutions to make a choice between their deposit-taking (ie banking) services and their “non-bank” activities. Instead, it is to recognize that what are seen as “non-bank” services are often very much “bank-like” and should be regulated approrpiately with the view of promoting sensible risk-taking across the balance sheet.

By “bank-like” I mean, first of all, maturity transformation. Take finance companies: They borrow short-term commercial paper to invest in instruments like mortgage-backed securities, which are backed by long-term assets. That’s not far from plain vanilla banking. I also mean liquidity services: For example, securities dealers take deposits from their hedge fund customers, which are redeemable on demand, but then use the cash to fund their activities in credit market instruments whose liquidity can dry up instantly. This prompts funding uncertainties and a potential run on the dealers… and thus needs to be addressed.

Yet, rather than a targeted regulatory proposal, we get the Volcker rule–a waste of precious political capital and resources for a measure that is ultimately irrelevant!

Then you have the greed problem—and a problem it is! But containing it requires effective regulation, not populist one-off measures (which can backlash).

So what type of regulation can be effective in reining in greed in executive pay? Once again, some initiatives are already underway. The Federal Reserve for example has made a set of recommendations to better align incentive compensation with the risks undertaken by financial sector employees and also with their long-term performance.

But more may need to be done–if, for example, high executive pay turns out to be the by-product of an unduly monopolistic environment in the financial sector, which in turn leads to abnormally high earnings. Indeed, as I argued here back in November, a comprehensive assessment of the benefits and costs of the financial sector’s existing market structure and the identification of measures to improve it should be a top policy priority.

Yet, what we get is a bank tax! OK, may-be one can justify it by the extraordinary, government-backed recovery in financial markets and the, admittedly, business-as-usual attitude by some banks in the sphere of bonuses until it was too late. But it may also end up being harmful: If competition in the financial sector is limited, banks will have the market power to pass on the cost of business to their customers! And this can’t be good for lending nor for the economy more broadly.

Beyond the irrelevance of the proposals, what is far more disappointing is the new tone coming out of the leadership. Here you have the sober, Harvard-educated President, who excited many an independent voter with his intellectual approach to politics and policy back in 2008, employing an increasingly populist vocabulary.

Not only does this alienate independents further. It also raises the level of political risk for businesses and the markets, undermining the one visible achievement this Administration can claim credit for: The restoration of some sense of stability and order in financial markets and, with it, the recovery of a substantial amount of households’ financial wealth and confidence more broadly.

It would really be a shame if the (mis)reading of an electoral outcome ignited a policy agenda that is ill-focused, time-consuming and potentially unsettling. One can only hope it’s not too late to change tack.

Originally published at Models & Agents and reproduced here with the author’s permission.