Obama ‘More of the Same’ Overregulation Plan Won’t Fix Financial Crisis
President Should Lessen Burdensome, Ineffective Mandates, Like Sarbanes-Oxley
Washington, D.C., June 17, 2009 – President Obama is scheduled today to unveil a financial regulation plan that would impose new restrictions and government controls on the nation’s banking system. Competitive Enterprise Institute financial policy expert John Berlau offered the following analysis:
Statement by John Berlau, Director of CEI’s Center for Investors and Entrepreneurs, on the Obama administrations financial regulatory framework
Early on in the Obama administration, there were encouraging signs that his economic team was pursuing true regulatory reform and modernization, consolidating and combining functions of key financial agencies and moving away from the "more is better" approach to regulation that had been followed even in some Republican administration in response to a crisis. Even this week, administration officials Tim Geithner and Larry Summers wrote in a Washington Post op-ed that the current "framework for financial regulation" contains "jurisdictional overlaps, and suffers from an outdated conception of financial risk.
Initial reports indicate, however, that these early hopes of a more accountable regulatory structure have been dashed. What the Obama administration is likely to put forward will do little to address the "jurisdictional overlaps" cited by Geithner and Summers. It leaves the status quo among regulatory agencies largely in place, and only adds additional layers of "systemic" regulation from "super" agencies such as the Federal Reserve. This new mountain of red tape could choke many small businesses, the engines of economic recovery, and do little to prevent the next crisis.
The new Obama regulations should be also be viewed in light of another systemic issue in the economy: stimulating innovation. A recent Business Week cover story reports that "there’s growing evidence that the innovation shortfall of the past decade is not only real but may also have contributed to today’s financial crisis." If financial regulation chokes off financing for entrepreneurial firms in technology and other sectors, as the Sarbanes-Oxley accounting mandates have already done to a great extent, the economy could suffer the systemic effects of stagnation.
As details of the Obama plan emerge, CEI analysts will have more detailed assessments of the specific proposals. Here are some general thoughts on some of the key concepts of what’s likely to be proposed and important facts in the regulatory debate.
1. The George W. Bush presidency was not an era of deregulation, but overregulation and failed financial supervision.
In 2002, Bush signed the Sarbanes-Oxley accounting legislation, the biggest expansion of securities regulation since the New Deal. The law had a slew of unintended costs and effects, such as reduced numbers of stock offerings and the tripling of auditing costs for smaller public companies, that led even Democrats such as House Speaker Nancy Pelosi and Sen. John Kerry to criticize some of its provisions. A Brookings-American Enterprise Institute study found that the law has cost the U.S. economy more than $1 trillion in direct and indirect costs, and the Supreme Court recently said it will hear a constitutional challenge to Sarbox in a case in which CEI attorneys are serving as co-counsel. However, as costly as it was, Sarbox failed at its intended goal of providing more meaningful accounting information about complex financial instruments such as derivatives and mortgage-backed securities, and did nothing to lessen the current financial crisis
The Bush administration greatly increased overall regulation as well. As CEI vice president for policy Wayne Crews points out in his study "10,000 Commandments," the Bush administration increased the total cost of regulation to $1 trillion per year in 2007 and the number of pages in the Federal Register to more than 70,000. These did not seem to have much of an impact of financial fraud and systemic risk either.
2. Regulatory "gaps" and "arbitrage" are often caused by overregulation. Lessening excess rules on the more regulated entity should be a priority.
President Obama and others speak often of "gaps" in the system whereby more heavily regulated entities such as banks are passed over in favor of less regulated vehicles such as hedge funds, private equity, and various methods of securitization. And the answer always seems to be to "level the playing field" by adding rules for the lesser regulated entities.
Yet there is another way to level the field that would achieve many of the goals of transparency and boost economic growth at the same time: Loosen the red tape on the more regulated entities. Excess regulations are often the reason for firms going to the so-called "dark corners" of finance. Smaller public companies delisted themselves from stock exchanges and were acquired by private equity firms because of the accounting mandates from Sarbanes-Oxley, which even Democrats agreed went too far. Similarly, overly strict capital standards, such as those embodied in the international Basel agreements and in the wake of the savings-and-loan crisis in the ’90s, discouraged traditional savings institutions form carrying mortgages on their own books and helped give rise to complex mortgage securitization.
Simplifying red tape on the more heavily regulated banks, credit unions and public traded companies — instead of, or in addition to, tighter regulation of the newer financial entities — would bring more financial activity in the light while reducing the chance of negative affecting economic recovery.
3. Capital requirements shouldn’t necessarily be raised, but revised with more accurate measures of financial assets. Put less reliance on mark-to-market accounting rules that accelerate booms and busts.
In their Washington Post op-ed, Geithner and Summers speak of "raising capital and liquidity requirements for all institutions." But what is really needed is more accurate measures of capital. Mark-to-market accounting, utilized by both the SEC for investor disclosure and by bank regulators to measure solvency, has been shown to be pro-cyclical — overstating the value of financial assets during a boom and understating them during a bust. Also, in the current crisis, mark-to-market mandates put fuel on the proverbial fire by requiring healthy banks to mark down thinly traded assets such as mortgages-back securities to fire sale prices, even if the loans in question were still being paid and showed little signs of default. Members of Congress and economists on both sides, from conservative Steve Forbes to Obama stimulus champion Mark Zandi, have criticized mark-to-market for making the crisis worse.
Capital measurements should be based, for the most part, on financial instruments’ cash flow and expected default rates. Mark-to-market valuations should not be utilized for thinly traded assets, for which there does not exist much of a market. The Obama administration’s stress tests, which largely disregarded mark-to-market in measuring financial assets and led to healthier banks returning bailout money, would be a good example to follow in setting capital requirements.
4. The proposed Financial Product Safety Commission is paternalistic and could undermine regulation for systemic risk.
One of the proposed elements of the Obama administration’s plan is a new financial agency based on the Consumer Product Safety Commission (CPSC), to potentially ban financial products it deems "unsafe." But financial products are not power tools, and their "failure" for one set of consumers does not justify restricting their availability to consumers they could potentially help. It should be noted that the CPSC itself has recently come under bipartisan fire for rules that could ban the sale of used children’s clothing that contain minute amounts of lead. In both consumer and financial products, the focus should be on banning fraud and improving public education to prevent misuse, not on limiting consumers’ choices.
Moreover, a banking agency devoted exclusively to consumer protection could develop myopia and ignore overall risks to the financial system, the very purpose of the Obama plan. For instance, limits on risk-based pricing seen as beneficial to consumers could lead an overall lack of credit availability or system-wide losses based on misprice risk.
5. "Resolution authority" to seize non-banks could lead to politicized bankruptcies such as GM and Chrysler.
The Obama administration wants resolution authority to seize non-bank "financial institutions" that the government deems a systemic risk, similar to the government’s current power to take over troubled banks. But this would give the government too much arbitrary power to confiscate what could be a broad array of businesses. In statutes such as money laundering, "financial institution" is defined broadly to cover businesses unrelated to banking such as jewelry stores, travel agencies and auto dealers. The system for seizing troubled banks isn’t perfect, but it can be said that banks and their stockholders consent to this process by purchasing deposit insurance. In the case of other businesses, there is no such service the government provides to justify this confiscatory power.
Moreover, giving resolution powers to an administrative agency, rather than a bankruptcy court, could lead to a politicized process. As in the Obama administration’s bankruptcy reorganizations for Chrysler and General Motors, certain constituencies could be favored, while bondholders and secured lenders could see their contractual rights ripped apart. This could lead a greatly reduced investment in the American financial system.
In conclusion, if President Obama wants to be the pragmatist he says he is, he would lessen burdensome and ineffective mandates such as Sarbanes-Oxley even at the same time he was tightening regulation over other entities such as credit default swaps. But the plan likely to be unveiled today is simply "more of the same" overregulation Americans experienced under the Bush administration.
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