Obama Scolds Bankers, Appeals to Moral Compass: Caroline Baum

Commentary by Caroline Baum

Sept. 16 (Bloomberg) -- It says a lot about the shift in the center of gravity from Wall Street to Pennsylvania Avenue when the main focus of the trading day is what the president of the United States says.

Last week it was health care; health-care stocks went up.

This week it’s financial regulation; financial stocks rose Monday when President Barack Obama took his case for overhauling financial regulation to Wall Street. At times he sounded more like a parent scolding a disobedient child than a president proposing a new regulatory framework.

“We will not go back to the days of reckless behavior and unchecked excess that was at the heart of this crisis,” Obama said in a speech at Federal Hall in New York City. (“You will not stay out until 2 a.m. again.”)

Obama’s regulatory revamp would create a new consumer protection agency to -- what else? -- protect the consumer from himself, as well as from predatory lenders; a “resolution authority” to seize and wind down insolvent non-banks; and an oversight council to share information across markets and plug regulatory gaps “that don’t fit neatly into the organizational chart.”

He said that. Honest. By the time regulators figure out their reporting channels, bankers will have identified and wiggled their way through new loopholes.

“Regulation is static. Markets are dynamic,” said Allan Meltzer, professor of political economy at Carnegie Mellon University in Pittsburgh.

Trees, Not Forest

The president didn’t anoint the Federal Reserve as the new systemic risk regulator, which suggests to Meltzer a move away from the Treasury position, and for good reason.

“The Senate Banking Committee doesn’t want to give the Fed more power,” Meltzer said. “I’ve never seen such unanimity, and I’ve been testifying before the committee since 1962.”

Obama blamed the patchwork system of financial regulation for the current crisis. So many agencies and regulators were responsible for oversight of individual financial firms that no one was minding the store or, as he put it, “protecting the whole system.”

Obama said his reforms are designed to promote “transparency and accountability,” buzzwords of his administration.

Don’t hold your breath. When it comes to the “particulars of a given industry or instrument, they are only transparent ex- post,” said Bob Barbera, chief economist at ITG/Hoenig, a New York brokerage. “You are overstating your skill set if you think you will see through the potential pitfalls.”

Bankers Outfox Regulators

It is fantasy to believe a new, bigger, better regulator will ferret out problems before they grow to system-sinking size. Those being regulated are always one-step ahead of the regulator, finding new cracks or loopholes in the regulatory fabric to exploit. When the Basel II accord imposed higher risk- based capital requirements on international banks, banks moved assets off the balance sheet.

What’s more, regulators tend to identify with those they regulate, a phenomenon known as “regulatory capture,” making it highly unlikely that a new regulator would succeed where previous ones have failed.

The single biggest problem with Obama’s speech on financial regulation was the failure to dent the doctrine of too big to fail. Obama warned “those on Wall Street” against taking “risks without regard for consequences,” expecting the American taxpayer to foot the bill. But his words rang hollow.

Learn by Example

You can wag a finger at bankers and brokers and try to appeal to their moral sense, reminding them of the debt they owe to the American people for bailing them out.

But you can’t, with words alone, alter the perception -- now more entrenched than ever -- that the government won’t allow large institutions to fail.

How do you convince bankers they will pay for their risk- taking when they’ve watched the government prop up banks, investment banks, insurance companies, auto companies and housing finance agencies?

They learn by example. The system of privatized profits and socialized losses has suited them fine until now. It is accepted wisdom that allowing Lehman Brothers Holdings Inc. to fail a year ago was a huge mistake, one that shut down, and almost brought down, the financial system.

Failure as Success

One solution, according to Meltzer, is to insist that bigger must be made better. Regulators could “make sure capital requirements rise more in proportion to asset size,” he said.

Another option is to excise proprietary trading from the banking and brokerage business, according to John Cochrane and Luigi Zingales, professors at the University of Chicago Booth School of Business, as outlined in a Sept. 15 Wall Street Journal op-ed.

In other words, institutions deemed “systemically important,” shouldn’t engage in systemically destabilizing activities.

Then there’s a third unpalatable option. When it comes to the doctrine of too big to fail, nothing succeeds like failure.