Monday, April 26, 2010

Financial Reform: Unsung Proposals that I Wish Were on the Table

We will be getting reform, and soon, it appears. Mike over at Rortybomb nicely table-izes six big areas/rules/issues to watch as legislation takes shape.

Maybe I'm just getting jaded, but what's on the table doesn't excite me much.

Transparency in derivatives through exchange trading? Yes, deeply important, but lobbyists will probably carve out small exemptions that Wall Street banks will then funnel as many of their trades through as possible. Too big to fail? Yeah, sure, cut 'em down to size, but Krugman is right on this one. Smaller banks, sufficiently interconnected and freighted with risk, can haul down the system too.

Hard leverage cap? I wholeheartedly support limiting leverage, but remember: leverage is a number. As Repo 105 and the continual perversion of accounting for capital under the Basel Accords show us, annoying numbers can be massaged. So under a hard leverage cap, I predict an explosion in "leverage-friendly financial innovation." Just wait.

So what is there to do? It won't happen during this round -- maybe the system has to seize up again, horribly, in the next few years -- but I wish we would look more at meta-type solutions. Here are some unsung proposals that I wish would get more consideration:

1. Contingent debt. This comes from the Republican side of the aisle, and though I confess to not having studied in great detail how the idea would work, I like the gist of it: banks hold a chunk of bonds that, when they come under duress, automatically convert to equity, boosting their cushion of capital. The percentage of such debt could be adjusted, if need be. The concept is market-oriented, as investors help police the institution's risk-taking. As Greg Mankiw writes:
This contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.
2. Financial transaction tax. I know, I know: to have efficient and liquid markets, you want participants to be able to trade as freely as possible. But I think that, sometime over the last decade or two, the amount of trading vaulted through the point of maximum efficiency and into something else -- something born of supercomputers run amok that just encourages volatility and instability. We need to slow down the financial machine a little. A small tax might encourage the bloated financial sector to shrink a little (a good thing) and raise money for our deficit (also a good thing).

3. "Deep clawback." Misaligned incentives are clearly an issue. And there'll be some feeble attempts to better align pay with long-term performance, but little will probably change. What we need is a way to get deeper into the pockets of bank executives and directors who allow their companies, through negligence or a desire for risky growth, to spin out of control, endangering the financial system. It sounds radical, but let's consider putting their personal houses and cars on the line -- or at least make them easier to prosecute criminally. Then behavior will change. If bankers hate "deep clawback," there's an alternative: Regulate the financial industry like a utility.

4. Move away from a rules-based to a principle-based system. This would be tremendously useful. With a squadron of lawyers and accountants in tow, every major Wall Street bank knows how to game and evade and twist every single rule that's been thrown at them. They will ALWAYS beat a rules-based system. But what if, in certain places in our laws, we used the language "what a reasonable accountant would ..." or something similar? This would stop them dead in their tracks. Because then they can't simply say in defense, "Well, you don't explicitly prohibit what I'm doing, so it must be okay."

So those are some of my favorite ideas that aren't seriously part of the discussion, unfortunately. We will get reform. It may not be that impressive. But if the financial system blows up again -- and relatively soon -- someone in Congress may get the idea that what we really need is more meta-reform -- and less tinkering around the edges.

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