Financial reform’s breakthrough year

ZANZIBAR – Here’s an odd prediction for the coming year: 2013 will be a watershed for financial reform. True, while the global financial crisis erupted more than four years ago, and the Dodd-Frank financial reforms were adopted in the United States back in 2010, not much has changed about how Wall Street operates – except that the large firms have become bigger and more powerful. Yet there are reasons to expect real progress in the new year.The US Federal Reserve is finally shifting its thinking. In a series of major speeches this fall, Governor Dan Tarullo made the case that the problem of “too big to fail” financial institutions remains with us. We need to take additional measures to reduce the level of systemic risk – including limiting the size of our largest banks. News reports indicate that the Fed has already started saying no to some bank mergers.At the same time, the US Federal Deposit Insurance Corporation has become a bastion of sensible thinking on financial-sector issues. In part, this is because the FDIC is responsible for cleaning up the mess when financial-sector firms fail, so its senior officials have a strong incentive to protect its insurance fund by preventing risks from getting out of control. The FDIC is showing intellectual leadership as well as organizational capabilities – Vice Chairman Tom Hoenig’s speeches are a must-read.Wall Street is pushing back, of course. But the rolling series of scandals surrounding global megabanks makes it difficult for anyone to keep a straight face when executives insist that our largest banks must maintain their current scale and scope. Do we need HSBC to facilitate global money laundering? Do we need Barclays and UBS to manipulate Libor (a key benchmark for interest rates around the world)? Do we need still more losses at poorly run trading operations for JP Morgan Chase?The pro-bank lobby groups are positioning themselves to argue that the new resolution powers under Dodd-Frank have ended the too-big-to-fail problem, and we can expect a public-relations drive in this direction early in the new year. But the consensus view at the most recent meeting of the FDIC’s Systemic Resolution Advisory Committee (of which I am a member) was that this claim should not be taken seriously. Under Dodd-Frank, it is arguably easier for the FDIC to handle the failure of a single large financial institution than it was in pre-Dodd-Frank days. But what if two or three or seven firms are all in trouble at the same time?The answer, as former Fed Chairman Paul Volcker implied at the meeting, is that we would be right back where we started – in the panic and frozen credit markets that followed the collapse of Lehman Brothers in September 2008. Indeed, the idea that substantial shocks could soon hit the US financial system is not far-fetched. The European debt crisis, for example, remains far from being resolved. A significant sovereign-debt restructuring there would bring down European banks and potentially damage US banks – as well as financial institutions around the world.Meanwhile, the continuing problems at European banks are a stark reminder that operating highly leveraged, thinly capitalized firms is incredibly risky. And the regulatory failures in Europe – consider the German Landesbanks, for example – will become only more obvious in the coming months. Creating a common supervisory authority will mean nothing unless it can clean up the mess created by the existing supervisors. And that cleanup will expose more of the rot in banks’ current operations.The need for banks to finance themselves with more equity and relatively less debt will be the focus of one of the main publishing events in economics in 2013. Anat Admati and Martin Hellwig’s The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About it? will appear officially in March, but advance copies are already being closely read in leading central banks. Bankers everywhere will rush to read it before their regulators do.The road to the ongoing financial and economic crisis was built on a foundation of intellectual capture: not only regulators, but academics, too, became captivated by modern finance and its methods. Admati and Hellwig are at the vanguard of the counterrevolution, challenging the great myths of banking head-on.Do we need financial institutions to be so highly leveraged (that is, carrying so much debt relative to equity)? No, they argue. If banks of all kinds were financed with more equity, they would have stronger buffers to absorb losses. Both the equity and the debt issued by well-capitalized banks would be safer – and therefore cheaper.Bankers want to be so highly leveraged for a simple reason: implicit government guarantees mean that they get the upside when things go well, while the downside is someone else’s problem. Contrary to bankers’ claims, this is not a good arrangement for society.Admati and Hellwig are confronting the bankers and their allies in no uncertain terms, grounding their argument in deep financial thinking, yet writing for a broad audience. Whatever else happens in 2013, we can be sure that they will not win the Goldman Sachs Business Book of the Year award.Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan and a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario.Copyright Project Syndicate