Monday, June 15, 2009

Geitner and Summers on Reform

Today's issue of The Washington Post contained an article coauthored by Treasury Secretary, Timothy Geitner, and Director of the National Economic Council, Larry Summers.

In it, they unveiled the proposed reform of the financial sector that many have been waiting for. There are a couple of interesting aspects to this proposal that, for economic educators, could be valuable examples for the classroom. I'll share my thoughts, and I hope you'll share yours.

My only real point of contention with the authors is in the first paragraph, and I suspect many would say I'm nitpicking. Geitner and Summers state that the financial system failed to perform its function as a reducer and distributer of risk. Now, I won't disagree about risk-reduction. But I don't see how risk could have been distributed any more widely than it was. The sub-prime mortgages, converted to mortgage-backed securities, and then hedged with credit-default swaps managed to inflict losses all around the world; with the subsequent impact of causing a crisis in global credit markets and a recession that has hit just about everyone. I'm not sure how much farther the risk could have gone.

Anyway, that comment was not part of the reform package, so it probably doesn't merit any more attention. The four main points of the proposal do.

The first point calls for increased capital and liquidity requirements for large firms to offset the impact of potential systemic stress. And those firms that are the most interconnected will now be subject to consolidated supervision by the Federal Reserve. The first part means that bigger firms need to have a bigger cushion to offset not just risk, but the magnitude of risk they face because of the firm's wider exposure. The last part, by my reading, seems to be a restatement of the "umbrella regulator" idea that was included in Gramm-Leach-Bliley at the end of the 1990s; i.e., a form of it has been proposed before, just not carried out to this extent.

The second point is fairly logical. It basically links the lender to the borrower to a greater extent. In essence, it creates a stronger incentive for originators to make good loans because it will affect the bottom line. Hopefully, firms will no longer just write them, repackage them, and get rid of them. With some skin in the game, the incentive is to provide greater scrutiny. How much? We don't know yet, but I suspect the incentive is linked to amount of interest the originator is required to maintain.

Consumer and investor protection through stronger regulation seems to be the key to point three. I suspect much of this may rely on greater transparency - more information for consumers and investors - and greater access to recourse.

Fourth, the creation of a process to quickly resolve financial problems seems to be in order. However, a process that is not enforceable is as good as no process. The trick here may be how to protect the taxpayer and the investor/consumer without denying due process. This could be one of the tougher points to carry out.

Finally, there is a call for greater international cooperation. And while that also sounds commendable, it's a different thing to bring sovereign nations to the table and suggest they give up some sovereignty.
If you don't believe it, look up Doha.

We all need more detail on this and the details now vs. the detail on the final legislation are entirely different matters. Nevertheless, it will be interesting to watch.

I look forward to and welcome your thoughts.

This post references the following Keystone Economic Principles:
2. There ain't no such thing as a free lunch.
3. All choices have consequences.
4. Economic systems influence choices.

5. Incentives produce "predictable" responses.

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