Week in Review | The Global Picture

Transcription

EVANS : I'm David Evans, from FinReg21.com. It's Friday, September 25th. I'm joined today by Bob Litan of the Kauffman Foundation and also Brookings, John Taylor of Stanford and Hoover, and Larry White from the Stern School at New York University. Good day, gentlemen. Hope you're all doing very well.

WHITE : Indeed, good day, David.

EVANS : The G20 met yesterday in Pittsburgh, and it's meeting again today. John, what do you think they'll accomplish, if anything?

TAYLOR : Well, I think you have to lower your expectations to some extent. Here, they're – it's good they're getting together. It's, of course, just the third meeting at the leaders' level. It's an important time. The last time they met was April 2nd, and they made some big decisions.

But I'm not too optimistic there's going to be more than just statements that we should correct imbalances, raise capital standards, without specific agreements at this point.

EVANS : Larry, do you agree with that?

WHITE : I think, you know, that this is a big political thing. These are sensitive issues. I think it's important that there be public statements on things like raising capital standards, as John just indicated.

I'm hoping that the issue of trade protection and not going down that road gets some attention and public statements, and people going on the record about this. But it's unlikely that there are going to be any big, major understandings, agreements that will come out. There will be some nice words, and then we have to see what action follows.

EVANS : And Bob, is that a bad thing, do you think, going forward, given what everyone wants to accomplish in terms of financial reform?

LITAN : That's about all you can expect. In terms of financial reform, we're probably going to get into the details on the weeds. I think, actually, there's going to be a greater effort to get consensus on some core principles that go deeper than just rebalancing your macro position.

And oh, by the way, I would say, just on the macro position, it's a lot easier if you're an autocracy like China to follow through on anything they say than for democracies to do this, because by definition, heads of state of democracies cannot commit their entire countries at any international forum.

EVANS : Do you think, Bob, that we're going to get an international agreement on, for example, capital requirements for banks?

LITAN : Eventually, yes, only because the alternative is probably something they can't contemplate. But in the meantime, individual countries, including the United States, are going to go ahead and do what they feel is necessary to bolster bank capital.

These international agreements take years to negotiate. The last one took about eight or ten years. I've never been a fan of them, but it seems like governments feel compelled to do this, in large part, because their banks don't want to face what they claim is unfair competition from other countries, so the heads of state, or at least their financial types, talk about these things.

But as I said, in the interim, while all the diplomats are talking, the countries go ahead and do what's in their own interest.

WHITE : Let me just add to what Bob just said. And he was referring to what's often – well, first, Basel I, back in 1988, that took a while to be implemented, and then the development of Basel II, which is still sort of in a nether world.

But the issue is essentially an effort to try to deal with what's perceived as implicit, or what has come to be explicit subsidy. Back in the '80s, the large American banks complaining that European, and especially Asian banks, were operating at lower levels of capital, which meant that this was implicitly a subsidy from those governments allowing those banks to operate at lower costs.

The Basel I agreement was an effort, moderately successful, to try to get everybody to maintain the same understanding about capital levels.

Now, implementation – there's always a lot of slippage there, and what you count as capital, and how you do your accounting. But still, I think it was a healthy effort in the right direction. Basel II was an effort to try to deal in a more fine-grained way with risk. That's sort of blown up on us.

But I think the effort to try to get everybody to understand different capital levels in different countries will implicitly – and as we've discovered, explicitly – mean subsidy, I think that's a healthy thing to be doing.

EVANS : John, do you have any comments on that?

TAYLOR : I have a couple of things. First, I think it's significant also that they're moving towards a G20 discussion, away from G7 or G8. So that brings in countries like China and Brazil and India, into the discussion, and in a more substantive way than is usual.

Now, that can be unwieldy, of course, too. It can be just people making statements in a rather generic communiqué. But I view this as, the communiqué from this meeting, which isn't really an agreement, is sort of an instruction, if you like, to other people in the governments, the regulators in some cases, the finance ministries in others, to get their act together and start working on this. So it seems to me, it's a step, and bringing – having the G20 do it, I think is significant, because it begins to address the problems that Larry is referring to.

EVANS : Let me turn to a related topic. Brussels and DC have both been focused quite a bit recently on regulating derivatives. Both governments would like to see derivatives contracts move to clearinghouses, or I think ideally, some of them would like most things to go to exchanges.

Bob, do you agree that that's the right approach?

LITAN : In principle, yes. I think there is a role for at least more standardized instruments going to clearinghouses, so that you eliminate this counterparty risk, and so that the risk is only concentrated with the clearinghouse.

That said, though, there are a lot of customized derivatives, which you can't clear. And so, the issue becomes, how do you strike this balance? And rather than have the regulators try to figure out what's standardized and what's customized, it seems to me, the best approach – and I don't know if it's going to be followed, but the best approach is to put a capital charge, an extra capital charge, on stuff that is – or the derivatives that are not standardized, as a way of giving a market-like incentive for institutions to develop and use standardized stuff, so – to send it to exchanges.

By putting a capital charge, you're tipping the balance, if you will, without having the government call the shots and identify what's customized and what's standardized.

EVANS : John, Larry – do either one of you want to take that on?

WHITE : I do like that idea – oops, John, you go first.

TAYLOR : So just a really quick point. I think there's – as my colleague Darrell Duffie points out, it can be a problem if you have too many clearinghouses. It actually – it's, create more inefficiencies and coordination issues than having one. So I think they need to worry about, if you like, proliferation of these.

And also, quite frankly, I would go back to, is this – was this really the big concern in the financial crisis? And even today, I don't see a lot of discussion about the causes of this that are coherent in my view.

Well, it will be interesting to see what comes out, if they make another attempt to try to explain what happened.

EVANS : Do any of you guys happen to know what fraction – I'm sorry to interrupt, Larry, but let me get this out of the way, then we can get to you. Do any of you guys happen to know what fraction of derivatives are not standardized over the counter?

WHITE : Good question. I don't know the answer to that.

TAYLOR : Well, I do know that most of the AIG problems were non-standardized, so again, even if there were a clearinghouse available before AIG, most likely, it wouldn't have handled a major part of that problem.

WHITE : But that, John, goes to the – that at least as far as AIG was concerned, there was a derivatives problem. As we know, they were writing a whole bunch of these insurance contracts, and not setting aside any capital or reserves, even though they're an insurance company.

I think Bob's idea of a capital charge is a nice one. It essentially addresses the negative externality by putting a tax on the thing that we think could have negative consequences – good standard way to be dealing with negative externalities.

I like the idea of clearinghouses, but I think it's important to recognize that the potential downside is that this creates yet another entity, the clearinghouse itself, that may be too big to fail. You've got to worry about that, and I'm not – you know, I think the advantages are worth that potential downside, but that's worth remembering as we go down that road.

EVANS : Bob, as I understand it, one of the major reasons to have a clearinghouse is, it's a way to collect information. Maybe not the only reason, but certainly, an important reason.

Why not simply require that anyone who enters into a derivatives contract have to report it, and have a central repository of information? Wouldn't that be more efficient than imposing capital charges?

LITAN : Well, actually, I think the administration is backing the idea of having reporting, whether something is customized or standardized, but they're not recommending that customized instruments actually be cleared.

I think there is a benefit to going beyond just reporting and having central clearing, because in essence, you eliminate the bilateral problem, where my obligation is to you, and that is multiplied throughout the system, and then really, nobody knows exactly how many dominoes will fall if one part of the network falls. Really, the only thing that's at risk in a standardized clearing arrangement is the clearinghouse itself, as Larry said. So that's why regulators have to be here, to ensure that the clearinghouse is backed by appropriate capital, has the necessary liquidity.

I agree with him, too, that on balance, I'd rather have one clearinghouse and concentrate the risk and watch it closely. I guess it was Andrew Carnegie who talked about watching the one egg really carefully in the basket, as opposed to having many eggs in different baskets. And with derivatives, you've got a lot of eggs around, and I'd feel more comfortable if we watched the one basket a lot more closely.

EVANS : So the idea would be to have one national clearinghouse, and presumably there would be some outside the U.S. as well, right?

LITAN : Well, there would be some – you know, in an ideal world, I'd like one global one, because the more netting, the more traffic if you will at one, I think the better. But the reality is, is that each country is going to want its own, and that gets to the point that John has raised. Based on the work of Darrell Duffie, he has shown that if you get a proliferation of all these national things, you end up with fragmentation, and you don't end up solving a lot of the problem.

Now, as a practical matter, though, so much of the traffic involves U.S. institutions that at least, if we get our act together, we could at least improve the situation relative to where we were before AIG.

EVANS : Let's turn to executive compensation. There continues to be lots of discussion – and again, on both sides of the Atlantic, over regulating compensation at financial institutions. The Fed said last week that it wants to be able to veto bank compensation plans.

Where is the administration going on this? And is Tim Geithner really on board for regulating bank pay, do we think?

WHITE : I think so. The Federal Reserve put out a proposal a week, week and a half ago, that would apply to bank holding companies, and to state chartered member – Federal Reserve member banks. The crucial has to be, do you think either levels or more, I think, likely and more appropriately, structure of executive compensation generates a potential safety and soundness issue for banks? If the answer is yes, then that's a legitimate area for any financial institution that is subject to a prudential regulatory regime. That's fair game.

I think you need to keep that separate from – I don't know, for want of a better word, the political optics of just politicians, and arguably, the general public being, A, unhappy about, outraged by large, absolute levels of executive compensation, whether in the financial sector or anywhere else, and B, the perception banks have received bailouts, but still senior executives are getting substantial amounts of pay.

The general issue of levels of executive compensation is, to a very great extent, an issue of – if it's an issue of all, it's an issue of corporate governance, and whether shareholders ought to be having a, as the phrase goes, a greater say on pay.

The only, I think, interesting issue from our perspective, for this discussion, is this safety and soundness prudential regulatory link.

EVANS : Which is less a question of level as opposed to the structure?

WHITE : I think so, yeah. Although obviously, if you pay out too much of the bank's profits, and hence, its capital, as payment to senior executives, that's a way of draining the bank just as much as paying too much in dividends or making bad loans. All of those things can drain the bank and leave it with inadequate capital, and in principle, even drive it into insolvency.

EVANS : John, is there a role for the government regulating either the level or the structure of compensation of financial institutions?

TAYLOR : No, I think the distinction Larry makes is a good one in principle, but in practice, it just seems to me it reeks with all sorts of political problems. And also, just – once you start doing this, you can imagine, you're talking about safety and soundness even beyond financial institutions. We've seen that bailout mentality spread beyond financial institutions.

And so, I have a great concern about this approach. Unless it's tied in specifically –obviously, a bank regulator has to look at the risk on the bank's balance sheet, and if there are some aspects of that that are effectively off balance sheet that should be, and that it could include some promises on pay, then they should look at it.

But I think I'd be – I'm very wary of this. The way the proposals have been described do raise lots of questions, it seems to me, about the role of government in setting wages, and ultimately, prices.

EVANS : The other big news this week was Barney Frank's decision to make some fairly significant modifications to the administration's Consumer Financial Protection Agency Act of 2009 bill. Bob, what did Chairman Frank do?

LITAN : OK. As I read the news accounts, he did two big things, and I think on the plate is a third thing, potentially.

So the first thing he did is, he made it very clear – or wants to make it very clear – that the Agency would not regulate the financial activities of non-financial institutions. Like for example, the GEs or the GMs, or any other company in America that extends credit, is not going to be within the ambient of this organization, unless they're specifically selling a financial product, like GM Capital, or General Motors Acceptance Corporation.

But other than that, there was a lot of concern that supplier financing, and so forth, would be caught up in this. And the bill is going to make very clear that that's not covered.

Number two, there was a requirement in the original administration proposal to say that if you're offering a financial product, you had to offer a plain vanilla version of it. If you're also going to offer a more complex version, this would be a way of simplifying financial activities.

This proposal aroused a storm of protests. People couldn't figure out what plain vanilla would actually mean, would it be onerous and so forth. And the bottom line is, is that Frank appears willing to drop the idea. In fact, Tim Geithner, I think, trashed the idea himself in testimony this week.

So those are two big changes.

EVANS : But that's –

LITAN : The third thing, that we're unclear of what's going to happen, is whether the federal legislation will preempt state consumer protection regulation. And that one is a very touchy one, because the consumer community very much wants the states to be able to regulate on top of the feds. The banks, on the other hand, are very worried about 51 different laws governing their activities.

I think there's a way to split this baby, actually. My own personal view, and actually – I belong to the Shadow Financial Regulatory Committee, and we issued a statement last week that actually tried to split the baby. And we advocated preemption of the rules. So there would be only one set of federal rules, but you would still allow state enforcement agencies to enforce the federal rules.

And in that way, you wouldn't have a huge bureaucracy trying to enforce a body of rules in every one of the states. It's not a perfect compromise, but at least it's one I would throw out there.

EVANS : I have two follow-up questions to that, Bob. First of all, your understanding is that Frank has actually proposed a change in the federal preemption part of the bill? Because I had –

LITAN : I think what he said is that he's willing to look at it, in so many words.

WHITE : Yes, that's my understanding as well.

EVANS : And then, a question for all of you. I was rather surprised to see Secretary Geithner, in effect, trash the plan that – or, a significant part of the plan that the Treasury Department released only about two months ago. What do you make of that? Larry, John, Bob, anyone?

TAYLOR : I don't – can't explain why he changed, other than, he listened to people and realized that it wasn't such a good idea, which is a promising development, quite frankly.

WHITE : That sounds right to me.

EVANS : Bob?

LITAN : Yeah, man.

EVANS : Do you think the changes make the bill better or worse for the public? Bob?

LITAN : Well, my view is, I think in principle, it would be better to have consumer protection be done by a designated agency, only because I do not think the banking agencies, any of them, put the highest priority on consumer protection. Their main mission has always been safety and soundness, but in the case of the Fed, they also care about the integrity of the payment system, and also, monetary policy, inflation, and so forth.

So the bottom line is, the banking agencies will never, no matter how much harder they try to convince the public, this is not going to be something that they're going to put a high priority on.

And so, given that, I think it makes sense to have it done in a separate agency, and if you can be – if you can accompany it with the right set of restrictions, and focus it on disclosure rather than on trying to have the feds write all the rules and be very proscriptive, that I think it would be a constructive step.

EVANS : Let me end our discussion today by giving each one of you just a little bit of time to say what you think is going to be happening over the next month – what are the big things we ought to be looking for, just quickly? John, any thoughts?

TAYLOR : Well, I think these discussions we're having about the consumer protection, etc., even the executive pay, don't really address the financial crisis and why it occurred. So I'd really – this is more or less a suggestion, recommendation, that they come back to these issues about the bailout mentality, the crisis that we had last year – trying to prevent that in the future. And it's sort of becoming a back burner issue now.

It's, of course, important to get it right, have these kinds of discussions, but it seems to me, they're now going in directions that are more politically popular, rather than addressing the fundamental problems we have.

EVANS : Larry?

WHITE : Well, I think Chairman Frank has said he's going to try to move actively on the pieces of the administration's legislation, hold hearings, etc., etc. So I'm hoping that the kinds of things that John was talking about do get put back on the front burner. Hearings are often a big staged show, but still, they are a way to – if you have the right people testifying, and my guess is, we're going to see more people from the Treasury coming back, either Mr. Geithner or his Assistant Secretary, who's basically honchoing this thing, Michael Barr.

And I'm hoping we do get that discussion, because it is important. Certainly things like capital requirements, getting a risk that a regulator for the entities, a prudential regulator for the entities that aren't currently covered, getting a resolution regime, receivership regime for the large entities that aren't currently covered. I think those are terrifically important.

EVANS : Bob, you've drawn the last word.

LITAN : I agree with both of the comments. I would just focus on the debate that I think is going to be a big deal next after consumer protection is, are we going to get a systemic risk regulator or monitor, who's it going to be, what's it going to do exactly? I think people should watch out for that debate, because that really gets to the heart of what John and Larry have been talking about, getting into trying to prevent the next big crisis.

EVANS : That sounds like a good topic for next week. Thank you guys, very much, for the discussion today. Have a good rest of the day, and we'll talk to you soon.

WHITE : Thank you.

	Robert E. Litan is the vice president for Research and Policy at the Ewing Marion Kauffman Foundation in Kansas City, where he oversees the Foundation's extensive program for funding data collection and research relating entrepreneurship and economic growth. Dr. Litan also writes frequently with the Foundation's president, Carl Schramm. Their book, Good Capitalism, Bad Capitalism, and the Economics of Growth and Prosperity, co-authored with William Baumol, (Yale University Press, 2007) has been translated into ten languages and is used as a college text around the world.
	John B. Taylor is the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution and the Mary and Robert Raymond Professor of Economics at Stanford University. He has served as the director of the Stanford Institute for Economic Policy Research and was founding director of Stanford's Introductory Economics Center. Taylor's fields of expertise are monetary policy, fiscal policy, and international economics. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on President Ford's Council of Economic Advisers in 1976, as a member of President Bush's Council of Economic Advisers from 1989 through 1991, as economic adviser to the Bob Dole presidential campaign in 1996, and as economic adviser to the George W. Bush presidential campaign in 2000.
	Professor White has been with NYU Stern for more than 30 years. His primary research areas of interest include financial regulation, antitrust, network industries, international banking and applied microeconomics. He has published numerous articles in the Journal of Business, Journal of Economic Perspectives, Journal of Political Economy, American Economic Review, Review of Economics and Statistics, and Quarterly Journal of Economics. He is the author of The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation, among other books and he is the co-editor (with John Kwoka) of The Antitrust Revolution, 5th edition, which was published in 2008