JPMorgan Chase’s recently announced trading or investment loss of US$7.5 billion (A$7.3bn) highlights how the world’s financial system ran smoothly from the 1930s to 2008 largely because commercial and investment banking were separated in the US for most of that time.
The new Dodd-Frank Act, which will once again split savings and investment banking in the US, aims to usher in as successful a regulatory regime as the one provided by the Glass-Steagall Act of 1933 until its final, fatal repeal 13 years ago.
But the Wall Street Reform and Consumer Protection Act of 2010, known as Dodd-Frank after its authors Senator Chris Dodd and Congressman Barney Frank, is onerous and flawed lawmaking. It has since been nibbled at by bank lobbyists and is not yet complete – 11 bodies are fleshing out the law’s intent in regulations.
While the biggest overhaul of US finances since the 1930s will provide an employment boost for lawyers and regulators, the law may be too feeble to prevent a systemic collapse. Yet don’t lose heart. The world’s financial system has some things helping keep it in check including a powerful invisible force.
The main aims of Dodd-Frank are to prevent a systemic financial crisis, to control derivatives and to provide a coping mechanism for when a too-big-to-fail financial institution fails. And it does make worthwhile attempts at these goals. Oversight has been consolidated to some extent and many derivatives will now trade on public exchanges, so they will be less opaque and less debt-laced.
The biggest test of the act will be how it copes with the failure of a non-bank whose collapse threatens the financial system such as the demise of Lehman Brothers did. (US policymakers have long been able to handle a failing bank and protect depositors – they have closed more than 445 banks in the past four years with little fuss.) In 2008, authorities only had the bankruptcy process (Lehman’s option) or bailouts for creditors (the solution for AIG) as options when non-bank giants struck trouble. Under Dodd-Frank, authorities can put a non-bank posing a systemic risk in receivership and either sell it or split it into a bad bank and a viable bank, which still operates. In this insolvency process, depositors are supposed to get their money back, shareholders are ruined and creditors accept an appropriate loss. The aim, as always, is to stop a wider run on banks.
One problem is that the new law was written by those who think the US government overstepped its power after Lehman failed in 2008 when Washington provided taxpayer-funded bailouts to save institutions that floundered due to speculation.
The act forbids many of the rescue measures that were adopted four years ago. Banned are company-specific support as was done for companies such as AIG and Citigroup, government help for money-market funds and guarantees on bonds issued by financial firms unless approved by Congress.
One problem is that it’s harder for the Federal Reserve to help sound banks facing a liquidity crisis – a key plank of central banking. Other flaws of the insolvency process under Dodd-Frank are that it makes no allowance for how to treat a US institution’s international assets, it assumes authorities will act pre-emptively and it presupposes that policymakers can formulate an acceptable formula of losses for creditors without sparking wider repercussions. Ultimately, we will only know if Dodd-Frank can cope with a systemic threat when it’s tested.
The Volcker rule
The most renowned part of Dodd-Frank is the contentious Volcker rule, named after former Fed chairman Paul Volcker who pushed for its inclusion. This tenet from next year resurrects the part of Glass-Steagall that bans banks that accept deposits from trading (speculating) with shareholder funds. In other words, it separates commercial and investment banking. The rule aims to stop speculators from gaining access to the taxpayer support that deposit-taking commercial banks enjoy. Authorities want to protect deposit-taking or savings banks (and their lending) from gambles that go awry. The US Government Accountability Office calculates that the six largest US bank holding companies lost nearly US$16 billion on proprietary trading in the 18 months ending December 2008, Bloomberg reports.
The Volcker rule allows savings banks to conduct short-term trades for hedging or market-making, while limiting bank investments in private-equity and hedge funds to 3% of tier-one capital. (Glass-Steagall, in practice, was tougher because it banned speculation and market making and most underwriting.) The new restrictions may limit banks’ trading profits – the pre-2008 source of much bank revenue and large banker bonuses. In response, many big US banks have shut or sold proprietary trading desks or started hedge funds run by their former prop traders.
Bankers are lobbying to weaken a rule that they have two years to comply with because they say it will increase risk, limit liquidity, boost costs for investors, spur gaming and create litigation. JPMorgan Chase’s antics will make their job harder as its CEO Jamie Dimon was one of the strongest advocates of watering down the Volcker rule – he helped create a loophole for “portfolio hedging”, the frolics that cost his bank so much. They won’t stop trying though.
The power of memory
Dodd-Frank has its flaws. Big banks were not broken up, so they still threaten the system if they collapse. Much of the so-called shadow banking system is untouched and the law barely covers Fannie Mae and Freddie Mac, the government-sponsored home-lending agencies that received the largest bailouts in 2008. There is no international insolvency formula in place. Lobbyists are trying to thwart the transparent trading of derivatives. The law imposes costs on banks that will reduce earnings and lending and thereby economic growth. On top of all this, presumptive Republican presidential candidate Mitt Romney wants to repeal the law.
Should we worry about the safety of the US, hence global, financial system? Probably not – for two reasons.
Firstly, the finance industry is offering up enough scandals to shatter its political support, even with all the money thrown at US lawmakers. The billions of dollars lost by JPMorgan Chase’s London-based trading unit is undermining the credibility of those trying to stave off a wider divide between savings and investment banks. The US Senate finding in July that the UK-based HSBC exposed the US to “a wide array of money laundering, drug trafficking and terrorist-financing risks” and similar accusations against Standard Chartered by New York regulators reinforce the lack of ethics among bankers. They perhaps even overshadow for amorality the fraud involving the world’s biggest banks centred around the rigging of the London and Euribor interbank offered rates, which are the benchmarks for about US$10 trillion in personal and commercial loans and about US$350 trillion in derivatives.
These scandals are shaping up as ones that will have devastating political (as well as financial) costs for banks. If they fail to usher in harsher regulatory regimes, it will only take a few more displays of such rottenness to leave banks defenceless against populist calls for rabid regulation. In one of the most telling U-turns among bankers to date, Sandy Weill, the man who championed the repeal of Glass-Steagall so he could forge Citigroup through acquisition, called for big banks to be broken up so that we have a system “that’s not going to risk the taxpayer dollar, that’s not too big to fail”.
Secondly, there is an invisible power policing finance that is more effective than the most draconian and watertight of laws – memory. The greatest force in favour of the smooth running of the world’s financial system is that people remember what recently went wrong and why. While the world is still dealing with the aftermaths of the US sub-prime crisis and financial booby traps planted before 2008 may still explode, it’s likely that bankers will find it harder to misbehave for a while.
Investors, regulators, voters and even bankers acknowledge the malpractices that led to the global financial crisis. So they are mending their ways – if anything, they have overcompensated for their risk taking or laxness.
Within banking, while rogue traders will always exist, compliance departments are more powerful, stricter lending standards are in force and senior management and boards are more suspicious of financial wizardry and trading units somehow earning a fortune, even if not at JPMorgan Chase until it lost billions. Most bankers realise that if there is another financial catastrophe soon their industry will be overregulated for a long time. Regulators are more vigilant and empowered, so much so they risk stifling innovation with their thousands of pages of laws and tougher capital controls. Rating agencies are more conservative with their approvals. Investors are so risk averse they prefer cash and government bonds to higher-yielding equities, let alone something like mortgage-backed derivatives banged together by US investment banks. Most people now understand that home prices can fall. Voters want finance regulated and are wary of free-market ideologies, even if they are electing conservative governments. Free-market zealots will find it harder to be appointed as heads of central banks and, if any are, they would never carry the aura of Alan Greenspan at his most untouchable.
The memory of the economic woes triggered by the US sub-prime lending crisis will linger in the worst-hit countries for generations. The time when proper regulations will be needed will be when people now in their twenties are well retired and their grandchildren are shaping society. After all, it was not until six decades after the Great Depression that bankers were able to convince US lawmakers to ditch Glass-Steagall to allow the marriage of investment and commercial banks, thereby giving utilities – for that’s what savings banks more or less are – the ability to gamble away billions and help trigger a global financial crisis.
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The invisible force aiding global banking regulation
JPMorgan Chase’s recently announced trading or investment loss of US$7.5 billion (A$7.3bn) highlights how the world’s financial system ran smoothly from the 1930s to 2008 largely because commercial and investment banking were separated in the US for most of that time.
The new Dodd-Frank Act, which will once again split savings and investment banking in the US, aims to usher in as successful a regulatory regime as the one provided by the Glass-Steagall Act of 1933 until its final, fatal repeal 13 years ago.
But the Wall Street Reform and Consumer Protection Act of 2010, known as Dodd-Frank after its authors Senator Chris Dodd and Congressman Barney Frank, is onerous and flawed lawmaking. It has since been nibbled at by bank lobbyists and is not yet complete – 11 bodies are fleshing out the law’s intent in regulations.
While the biggest overhaul of US finances since the 1930s will provide an employment boost for lawyers and regulators, the law may be too feeble to prevent a systemic collapse. Yet don’t lose heart. The world’s financial system has some things helping keep it in check including a powerful invisible force.
The main aims of Dodd-Frank are to prevent a systemic financial crisis, to control derivatives and to provide a coping mechanism for when a too-big-to-fail financial institution fails. And it does make worthwhile attempts at these goals. Oversight has been consolidated to some extent and many derivatives will now trade on public exchanges, so they will be less opaque and less debt-laced.
The biggest test of the act will be how it copes with the failure of a non-bank whose collapse threatens the financial system such as the demise of Lehman Brothers did. (US policymakers have long been able to handle a failing bank and protect depositors – they have closed more than 445 banks in the past four years with little fuss.) In 2008, authorities only had the bankruptcy process (Lehman’s option) or bailouts for creditors (the solution for AIG) as options when non-bank giants struck trouble. Under Dodd-Frank, authorities can put a non-bank posing a systemic risk in receivership and either sell it or split it into a bad bank and a viable bank, which still operates. In this insolvency process, depositors are supposed to get their money back, shareholders are ruined and creditors accept an appropriate loss. The aim, as always, is to stop a wider run on banks.
One problem is that the new law was written by those who think the US government overstepped its power after Lehman failed in 2008 when Washington provided taxpayer-funded bailouts to save institutions that floundered due to speculation.
The act forbids many of the rescue measures that were adopted four years ago. Banned are company-specific support as was done for companies such as AIG and Citigroup, government help for money-market funds and guarantees on bonds issued by financial firms unless approved by Congress.
One problem is that it’s harder for the Federal Reserve to help sound banks facing a liquidity crisis – a key plank of central banking. Other flaws of the insolvency process under Dodd-Frank are that it makes no allowance for how to treat a US institution’s international assets, it assumes authorities will act pre-emptively and it presupposes that policymakers can formulate an acceptable formula of losses for creditors without sparking wider repercussions. Ultimately, we will only know if Dodd-Frank can cope with a systemic threat when it’s tested.
The Volcker rule
The most renowned part of Dodd-Frank is the contentious Volcker rule, named after former Fed chairman Paul Volcker who pushed for its inclusion. This tenet from next year resurrects the part of Glass-Steagall that bans banks that accept deposits from trading (speculating) with shareholder funds. In other words, it separates commercial and investment banking. The rule aims to stop speculators from gaining access to the taxpayer support that deposit-taking commercial banks enjoy. Authorities want to protect deposit-taking or savings banks (and their lending) from gambles that go awry. The US Government Accountability Office calculates that the six largest US bank holding companies lost nearly US$16 billion on proprietary trading in the 18 months ending December 2008, Bloomberg reports.
The Volcker rule allows savings banks to conduct short-term trades for hedging or market-making, while limiting bank investments in private-equity and hedge funds to 3% of tier-one capital. (Glass-Steagall, in practice, was tougher because it banned speculation and market making and most underwriting.) The new restrictions may limit banks’ trading profits – the pre-2008 source of much bank revenue and large banker bonuses. In response, many big US banks have shut or sold proprietary trading desks or started hedge funds run by their former prop traders.
Bankers are lobbying to weaken a rule that they have two years to comply with because they say it will increase risk, limit liquidity, boost costs for investors, spur gaming and create litigation. JPMorgan Chase’s antics will make their job harder as its CEO Jamie Dimon was one of the strongest advocates of watering down the Volcker rule – he helped create a loophole for “portfolio hedging”, the frolics that cost his bank so much. They won’t stop trying though.
The power of memory
Dodd-Frank has its flaws. Big banks were not broken up, so they still threaten the system if they collapse. Much of the so-called shadow banking system is untouched and the law barely covers Fannie Mae and Freddie Mac, the government-sponsored home-lending agencies that received the largest bailouts in 2008. There is no international insolvency formula in place. Lobbyists are trying to thwart the transparent trading of derivatives. The law imposes costs on banks that will reduce earnings and lending and thereby economic growth. On top of all this, presumptive Republican presidential candidate Mitt Romney wants to repeal the law.
Should we worry about the safety of the US, hence global, financial system? Probably not – for two reasons.
Firstly, the finance industry is offering up enough scandals to shatter its political support, even with all the money thrown at US lawmakers. The billions of dollars lost by JPMorgan Chase’s London-based trading unit is undermining the credibility of those trying to stave off a wider divide between savings and investment banks. The US Senate finding in July that the UK-based HSBC exposed the US to “a wide array of money laundering, drug trafficking and terrorist-financing risks” and similar accusations against Standard Chartered by New York regulators reinforce the lack of ethics among bankers. They perhaps even overshadow for amorality the fraud involving the world’s biggest banks centred around the rigging of the London and Euribor interbank offered rates, which are the benchmarks for about US$10 trillion in personal and commercial loans and about US$350 trillion in derivatives.
These scandals are shaping up as ones that will have devastating political (as well as financial) costs for banks. If they fail to usher in harsher regulatory regimes, it will only take a few more displays of such rottenness to leave banks defenceless against populist calls for rabid regulation. In one of the most telling U-turns among bankers to date, Sandy Weill, the man who championed the repeal of Glass-Steagall so he could forge Citigroup through acquisition, called for big banks to be broken up so that we have a system “that’s not going to risk the taxpayer dollar, that’s not too big to fail”.
Secondly, there is an invisible power policing finance that is more effective than the most draconian and watertight of laws – memory. The greatest force in favour of the smooth running of the world’s financial system is that people remember what recently went wrong and why. While the world is still dealing with the aftermaths of the US sub-prime crisis and financial booby traps planted before 2008 may still explode, it’s likely that bankers will find it harder to misbehave for a while.
Investors, regulators, voters and even bankers acknowledge the malpractices that led to the global financial crisis. So they are mending their ways – if anything, they have overcompensated for their risk taking or laxness.
Within banking, while rogue traders will always exist, compliance departments are more powerful, stricter lending standards are in force and senior management and boards are more suspicious of financial wizardry and trading units somehow earning a fortune, even if not at JPMorgan Chase until it lost billions. Most bankers realise that if there is another financial catastrophe soon their industry will be overregulated for a long time. Regulators are more vigilant and empowered, so much so they risk stifling innovation with their thousands of pages of laws and tougher capital controls. Rating agencies are more conservative with their approvals. Investors are so risk averse they prefer cash and government bonds to higher-yielding equities, let alone something like mortgage-backed derivatives banged together by US investment banks. Most people now understand that home prices can fall. Voters want finance regulated and are wary of free-market ideologies, even if they are electing conservative governments. Free-market zealots will find it harder to be appointed as heads of central banks and, if any are, they would never carry the aura of Alan Greenspan at his most untouchable.
The memory of the economic woes triggered by the US sub-prime lending crisis will linger in the worst-hit countries for generations. The time when proper regulations will be needed will be when people now in their twenties are well retired and their grandchildren are shaping society. After all, it was not until six decades after the Great Depression that bankers were able to convince US lawmakers to ditch Glass-Steagall to allow the marriage of investment and commercial banks, thereby giving utilities – for that’s what savings banks more or less are – the ability to gamble away billions and help trigger a global financial crisis.
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