Scoring The Obama Financial Reform Plan

The Obama Administration released its eagerly anticipated financial reform plan in June. The white paper was surprisingly detailed and will help Congress as it now turns to writing one or more financial reform bills.

On the proverbial 1-10 scale, I give the plan an “8” and explain why in this essay.

In scoring the plan, it is essential to ask how it would address three key questions: 

1. Had the plan been implemented, would it have significantly mitigated or prevented the current financial crisis?

2. Does the plan significantly reduce the future probability of the need for bailouts of creditors of large financial institutions, which was one of the undesirable consequences of the current crisis?

3. Does the plan establish a framework that will make future financial crises less likely and/or less severe?

As I discuss below, I believe that the plausible answer to each of these questions is “Yes,” although in reaching this conclusion I must make some educated guesses (which some critics will contest) about how some aspects of the plan would have been (or will be) implemented. At the same time, the plan has a few shortcomings, which I discuss in a concluding section.

Plan Summary

The main elements of the plan are widely known. Nonetheless, to tee up answers to the questions I have posed, it is useful to briefly summarize the key features.

--The plan would subject all financial firms deemed to pose systemic risks (“Tier 1” financial institutions) to strong consolidated supervision and regulation by the Federal Reserve, working in concert with a council of other federal financial regulators.

--Capital and liquidity standards for financial institutions (especially Tier 1 institutions) would increase and possibly would be tied to the economic cycle (the details of this aspect of the proposal remain to be worked out, and could be implemented in large part by regulators without new legislation). Hedge funds would be subject to reporting requirements so that federal authorities could determine whether they were systemically important.

--The plan would give the Treasury and the FDIC essentially the same “resolution authority” to take over troubled non-banks (including bank holding companies) as the FDIC now has over troubled banks.

--New regulations would govern the securitization of loans (requiring originators and/or securitizers to have some “skin in the game” so as to give them some monetary incentives to be more prudent in their activities than was the case during the huge expansion of securities backed by subprime mortgages).

--Standardized over-the-counter (OTC) derivatives contracts would have to be cleared by a central clearinghouse, while customized OTC derivatives would be subject to regulation (collateral and capital requirements in particular).

--A new Consumer Financial Protection Agency (CFPA) would be created to regulate financial products aimed at consumers, including credit, savings and payments products (it appears that most of this regulation will take the form of disclosure mandates rather than approval of the details of specific products or services).

--Credit ratings agencies, which permitted far too many securities backed by subprime mortgages to receive AAA ratings and thereby to be easily sold to too many investors, would be subject to tougher disclosure standards.

--The United States would work with other countries to raise international financial regulatory standards and to improve coordination.

In sum, the Obama plan would subject virtually all aspects of the financial industry to tougher regulatory scrutiny, and to a lesser degree, would subject key financial institutions to greater market discipline (principally in the form of higher capital and liquidity requirements).

Would The Plan Have Prevented/Mitigated The Financial Crisis?

The recent financial crisis essentially had two causes:

1. Risky subprime mortgages that could not be paid back without ever-increasing residential real estate prices increased beyond any reasonable bounds; and

2. Too many financial institutions – principally commercial banks and the formerly independent investment banks – were allowed to operate with far too much leverage.

When home prices quit rising, and indeed began falling, in late 2006 and 2007, subprime mortgages and the roughly $1.5 trillion in securities backed by them suffered mounting losses, which a highly leveraged financial system could not sustain.

Several features of the Obama plan, at least in principle, would have significantly addressed both causes, and thereby largely could have prevented the financial meltdown that actually occurred (even if the Federal Reserve’s low-interest-rate monetary policy had been left unchanged).

A consumer financial products regulator plausibly never would have permitted mortgage lenders to originate mortgages with no money down or without requiring documentation, and at least would have warned of the dangers of low-teaser rate mortgages (or prohibited lenders from qualifying borrowers at those low initial rates rather than at the higher reset rates). In addition, a systemic risk regulator, even one that would have been restricted to monitoring the financial system and not permitted to supervise Tier 1 financial institutions, plausibly would have raised red flags about such loans and requested the CFPA to regulate them. It is also at least conceivable (admittedly I am not putting a lot of weight on this claim) that a different ratings system for structured products (which the plan recommends) might have constrained investors’ enthusiasm for the collateralized debt obligations (CDOs) that were backed by subprime mortgages, and thus constrained the origination of these instruments. More convincingly, had originators and/or securitizers been required to share at least 5 percent of the risk of subprime mortgages without hedging away that risk (as the plan envisions), then lenders would not have been as eager as they were to originate those mortgages. In short, the Obama plan has a series of backstops that plausibly would have restrained the enormous growth in subprime mortgages which sparked the crisis.

As for the excessive leverage that greatly magnified the impact of the subprime mortgage losses, even though the plan’s details of higher capital (and liquidity) standards, especially for Tier 1 financial institutions, have not yet been ironed out, there is little doubt that had the plan been in place leverage throughout the financial system would have been significantly curtailed. Had this occurred, even a large increase in subprime mortgage originations and the losses that followed would not have caused as much damage to the financial system as actually materialized. It is also conceivable that some of the larger financial institutions that failed or that have become partial wards of the U.S. government thus would not have suffered this fate.

Admittedly, I advance these claims with the benefit of hindsight, and this surely is one of the critiques that will be advanced against them. In particular, it will be fairly noted that there was strong interest group and political support (in both parties) for extending home ownership to families, especially minorities, with limited financial means and less-than-perfect credit records. This meant that any effort by a CFPA or a systemic regulator/monitor to regulate and/or warn of the dangers of subprime mortgages would have been stoutly resisted. I will even concede that this resistance might have had some success: in particular, given the pressure for higher home ownership rates from many quarters, it is quite likely that down payment requirements would have been lowered in any event.

But I do not concede that timely recommendations from a consumer and/or systemic risk regulator that mortgages not be extended without document verification would have gone unheeded. Admittedly, I am less confident that at that time, when the financial industry was lobbying so heavily against a leverage ratio, that a warning from the systemic risk regulator about the dangers of off-balance sheet structured investment vehicles or lower capital standards for standalone investment banks would have promoted a constructive response. But if you cut me some slack on the counter-factual, and assume as I think fair, that if the Obama plan’s higher capital standards for financial institutions actually been in place, then the system as a whole would have been far better able to withstand any subprime mortgage meltdown that one chooses to assume.

Does The Plan Significantly Reduce The Moral Hazard Created By The Bailouts?

Even defenders of the various bailouts of financial institutions that were mounted by regulators in the middle of the crisis will concede what the critics voice vociferously: that the bailouts have had a long-term cost by creating and/or enhancing the “moral hazard” that risky behavior has not been properly punished. To be sure, shareholders of the failed institutions have suffered mightily, as have their managements. But the bailouts have protected both short-term and longer-term creditors, and thereby set the precedent that such creditors are highly likely to be protected in the future if they have loaned money to “too big to fail” (TBTF) institutions.

Is there any way to put this particular cat back in the bag and thus credibly signal that at least some creditors of TBTF financial institutions will be forced to take “some hit” in the event these institutions should fail in the future? Several elements of the Obama plan may do so, but admittedly it is too early to tell if they will:

--The plan would require Tier 1 financial institutions to file with the Fed (or presumably any other systemic risk regulator) so-called “burial plans,” which in principle should spell out which creditors take what kind of hit in the event of future failure.

--The plan would create a new resolution system, analogous to the bridge bank procedure now in place for failed banks, for Tier 1 financial institutions. Although this would enable federal authorities to extend short-term credit to troubled/failed Tier 1 institutions, it would not require them to protect longer-term creditors who cannot easily run.

--The plan announces that Treasury will be convening a working group to study various ideas for raising capital standards for Tier 1 institutions, including a possible requirement that such entities issue so-called “contingent capital,” or long-term debt that would automatically (upon some defined event) convert to equity and thus help replenish a depleted capital account for the institution. The conversion feature would effectively impose some haircut or hit on the buyers of such instruments.

--The plan’s proposal to clear credit default swaps through one or more central clearinghouses, as well as regulation of issuers of customized derivatives, also should reduce the need for regulators in the future to bail out non-depository issuers of such instruments.

There is a reasonable chance that the combination of these steps at least would mitigate the moral hazard problem. Creditors will still apply some discipline as long as they know there is not a 100-percent chance that they will always be bailed out. I think it is fair to conclude that if all of the foregoing ideas are implemented, long-term creditors of Tier 1 institutions will have some doubt that they will be fully protected under all circumstances. And that is what it takes to mitigate moral hazard.

In addition, as just noted, the plan envisions the Fed identifying and more stringently regulating Tier 1 financial institutions. Such factors as size, leverage, and the degree of interconnectedness with the rest of the financial system would be used to make these identifications.

The chief criticism of this idea is that it would aggravate rather than reduce moral hazard by in effect creating more GSEs – institutions whose creditors would interpret the Tier 1 designation as the equivalent of a government guarantee (just like those given to creditors of Fannie Mae and Freddie Mac). I have several responses to this understandable concern.

For one thing, Tier 1 designation would not necessarily imply that long-term creditors or suppliers of contingent capital would always be protected. Admittedly, subordinated long-term creditors of Fannie Mae and Freddie Mac were protected in the recent crisis, but that was primarily because banks were heavy purchasers of these instruments. In the future, it is not clear that Tier 1 institutions will purchase each other’s debt or contingent capital. The systemic risk regulator also may want to (and should) limit such purchases.

Equally if not more important, the tougher regulation of Tier 1 institutions envisioned under the Obama plan would offset some or perhaps all of the moral hazard effects of the Tier 1 designations.

The proposals for tougher regulation have already attracted a very different sort of criticism: that regulation of Tier 1 institutions could become so harsh as to discourage financial institutions from growing, thereby inhibiting innovation. It is true that various features of the Obama plan penalize size and complexity in financial institutions, but some sort of penalty is appropriate and necessary to internalize the externalities that the potential failures of Tier 1’s impose on the rest of the financial system and indeed the entire economy. Could regulation go overboard? Of course. But a financial system with a greater number of smaller players, which is one of the likely outcomes if much or all of the Obama plan is implemented, would be less bureaucratic and potentially more innovative (in a good way) than a system dominated by TBTF institutions whose excessive risk-taking contributed greatly to the recent financial crisis.

The plan’s designation of the Fed as the systemic risk regulator – and front-line supervisor of the Tier 1 institutions -- is one of the more contentious issues presented by the plan. Whichever agency (or body of agencies) is given this function is not as important as ensuring that at least some regulator is in charge. As long as that supervision takes place under a regime of tighter regulation, then this, too, should reduce the moral hazard created by the recent bailouts.

Will The Plan Reduce The Frequency And/Or Severity of Future Crises?

It seems that every time a financial crisis occurs policymakers race to install “never again” measures. But then at some point yet another crisis happens. Will the Obama plan – for the first time in history really – actually prevent all future financial crises?

Of course not, and no plan should be held to that standard. The key test is whether any plan will reasonably reduce the frequency and/or severity of future crises. Several features of the Obama plan enable it to pass this threshold:

--Higher capital and liquidity standards for Tier 1 financial institutions should reduce their likelihood of failure, and any knock-on effects these events would have.

--The suggested reforms for derivatives instruments should reduce the risk to counter-parties that they won’t be paid if a large issuer of derivatives goes down.

--In addition to more stringently supervising systemically important financial institutions, a systemic risk regulator would be charged with warning policy makers of future developments in financial markets that pose a threat to the safety and soundness of the entire financial system. Admittedly, there is a danger that the regulator will issue “false positives” – warnings that prove unfounded. But we also now have a hard lesson in the opposite danger: the huge consequences of a failure to warn when there were so many red lights flashing. I would accept the costs of false positives if we can get a better handle on true positives, which I believe is possible.

Can the plan adapt to future financial innovations and the emergence of new Tier 1 institutions? In principle, the answer is yes. The systemic risk regulator would have the power to add new Tier 1’s to the list (and to remove those that no longer qualify). And, at least in principle, the systemic risk regulator should be able to prevent attempts by Tier 1’s to circumvent capital standards by creating supposedly “off-balance” entities that in reality are supported, by reputation or by more formal legal obligations (such as lines of credit or guarantees), by the Tier 1 institution.

Shortcomings

No reform plan for anything is perfect. The political process demands compromises. In formulating its plan the Administration clearly bowed to certain political considerations. In an ideal world, they wouldn’t have had to. But that they did is one reason I can’t score the plan a perfect 10.

Perhaps the clearest area of unfortunate compromise is the failure of the plan to rationalize the financial regulatory structure. In my view, the Paulson Treasury was on the right track in recommending a single federal solvency regulator and consolidation of the SEC and CFTC. The Obama Treasury team ended up taking the far more cautious route of recommending the consolidation of only the Office of the Comptroller (which regulates national banks) and the Office of Thrift Supervision (which regulates federally chartered thrifts and unitary thrift holding companies). This is one area where the crisis seems to have been wasted.

Second, the Obama plan missed the opportunity to bring oversight of the insurance industry into the 21st century in failing to endorse the optional federal charter for insurance companies (and instead proposing to create a federal office only to monitor the industry and represent the U.S. on insurance issues in international forums). This is an unfortunate omission especially in light of the costly failure of AIG (which suffered huge losses not only from its derivatives operations, but also from unwise investments by its insurance subsidiaries in securities backed by subprime mortgages).

Third, while I am all for the new financial consumer protection agency, I worry about the potential dangers of failing to seek federal preemption for the agency’s rules and enforcement activities. In the future, this could greatly increase the cost of introducing new financial products nationwide if states start adding their own bells and whistles and enforcement initiatives to the federal baseline protections.

In the end, however, the bulk of the plan moves in the right direction for the reasons outlined in the earlier sections. The plan deserves a solid 8.

Robert E. Litan is Co-editor of FinReg21's Lombard Street; Vice President for Research and Policy, The Kauffman Foundation; and Senior Fellow, Economic Studies, The Brookings Institution.