Despite the exhausting pace of financial regulatory reform in President Barack Obama’s first term, further changes are needed to improve the stability of the financial system and to make the U.S. capital markets more efficient and competitive internationally.
First, we must return to our regulators the tools -- taken away by the 2010 Dodd-Frank Act -- that enabled the U.S. to survive the most pernicious aspect of the 2008 crisis: the contagion following the collapse of Lehman Brothers Holdings Inc. Had Dodd-Frank been enacted in 2008, the financial meltdown would have been even more devastating.
The Federal Reserve can no longer provide liquidity to nonbanks without the consent of the Treasury secretary. The Treasury can no longer guarantee money-market-fund investors against runs, and the Federal Deposit Insurance Corp. can no longer insure senior debt or increase insurance on deposit accounts without congressional approval.
These backstops are politically unpopular, and should only be deployed in extreme circumstances, but they should be available if needed.
We need to further safeguard the financial system from contagion by limiting the dependence of banks on short-term funding. We should also extend insurance coverage, with appropriate fees, for the short-term funding that remains within banks and in shadow banks, such as prime money-market funds. The cost of the insurance should be risk-based and paid by the insured institutions, just like deposit insurance.
At the same time, we should revise our approach to the too-big-to-fail problem, starting with a re-examination of whether the failure of a large bank poses a real systemic problem. The Lehman meltdown did not set off a chain reaction of bankruptcies caused by financial firms’ direct exposure to one another. True, the Reserve Primary Fund lost two basis points (0.02 percent) of value due to its investment in Lehman paper. Yet the run on money-market funds generally, and the credit crunch more broadly, resulted from the fear that short-term creditors of all financial institutions, with or without significant Lehman exposure, were at risk.
There is also substantial evidence that the failure of American International Group Inc. would not have bankrupted its derivative counterparties that were hedged or had collateral. And central clearing requirements for derivatives have further reduced this concern.
What we do need to worry about is the possibility that a particular financial institution’s failure could put at risk the performance of a crucial financial-system function, like the payment system or clearing. This can be addressed through Dodd-Frank’s living-will requirement, which permits regulators to promptly transfer crucial functions of insolvent institutions to solvent ones.
Seen through this lens, we can let large banks fail and stop imposing such high costs on their current operations. The Basel Committee on Banking Supervision has implemented two potentially high-cost policies premised on the idea that we cannot let large banks fail.
First, required equity capital for large banks has been effectively increased to 9.5 percent from 2 percent. If we are prepared to let large banks fail, such high costs are unnecessary. And they are certainly an imperfect antidote to contagion where even higher levels of capital would be quickly depleted through fire sales of assets, compounding the contagion.
In addition, new untested Basel liquidity requirements would force banks to hold enough high-quality liquid assets (which may not even be available) to withstand withdrawals of as much as 3 percent of insured deposits over 30 days, even though runs may last much longer. While the initial proposals have recently been relaxed in terms of the time frame for implementation and what qualifies as a high-quality liquid asset, these requirements are still very costly. Traditional central-bank last-resort lending to solvent institutions is cheaper than requiring banks to add to liquid assets. More important, it is the only effective way to deal with runs.
What’s more, we must restore the competitiveness of the U.S. capital markets, a priority for some U.S. officials before the crisis. From 1996 to 2006, the U.S. share of global initial public offerings by foreign companies was almost 29 percent and the percentage of U.S. companies choosing to go public overseas was a mere 1.3 percent. In 2011, these figures were 8.6 percent and 6.9 percent, respectively. The source of competition, as with all matters economic, is increasingly China.
The Jumpstart Our Business Startups Act of 2012, passed with bipartisan support, addressed U.S. competitiveness by lowering the cost of going public for small companies, the engines of economic growth. These reforms could be extended by making it more profitable for securities firms to make markets in these stocks, for example by relaxing the requirement that they be traded in penny increments, which would improve their liquidity and increase their attractiveness to investors. At the same time, we need to better understand the impact of high-frequency and off-exchange trading in all stocks.
Finally, we need to ensure that all financial regulation is justified by cost-benefit analysis. While Obama has called on the independent agencies to do cost-benefit analysis, it has generally not been forthcoming, although recently the Securities and Exchange Commission has done a better job. The Committee on Capital Markets Regulation, the independent and nonpartisan research group that I direct, found that many of the rules issued under Dodd-Frank include no cost-benefit analysis. Very few considered meaningful economic effects, as opposed to paperwork costs and the like.
This failure exposes the rules to invalidation by courts, creating further uncertainty that negatively affects the economy. The president should require independent agencies to conduct cost-benefit analysis with the option of submitting their rules for review to the Office of Information and Regulatory Affairs within the U.S. Office of Management and Budget. This step, after all, is mandatory for government departments.
(Hal S. Scott is a professor of international financial systems at Harvard Law School and the director of the Committee on Capital Markets Regulation. The opinions expressed are his own.)
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