Guest Post: Conservatives and Liberals Agree: Proposed Bank Oversight Bill Will Make Things Worse

By George Washington of Washington’s Blog.

When a liberal labor leader and a conservative financial policy analyst unite against something, you know that something is really bad (actually, I don’t believe in the whole false left-right dichotomy; I think its Americans versus those trying to steal our wallets and our rights, but that’s another story).

Today, AFL-CIO president Richard Trumka has slammed the Fed and the proposed “Tarp on steroids” legislation in his testimony to Congress today. Here are the must-read parts of Trumka’s prepared remarks to the House Financial Services Committee:

We are deeply concerned that the Committee’s work thus far on the fundamental issues of regulating shadow financial markets and institutions will allow the very practices that led to the financial crisis to continue. The loopholes in the derivatives bill and the failure to require any public disclosures by hedge funds and private equity funds fundamentally will leave the shadow markets in the shadows. We urge the Committee to work with the leadership to strengthen these bills before they come to the House floor.

However, these powers must be given to a fully public body, and one that is able to
benefit from the information and perspective of the routine regulators of the financial system. We believe a new agency, with a board made up of a mixture of the heads of the routine regulators and direct Presidential appointees would be the best structure. However, if the Federal Reserve were made a fully public body, it would be an acceptable alternative.

But we cannot support the discussion draft made public earlier this week because it gives dramatic new powers to the Federal Reserve without reforming its governance so that the banks themselves are removed from the governance of the Federal Reserve System. Even more alarmingly, the discussion draft would appear to give power to the Federal Reserve to preempt a wide range of rules regulating the capital markets—power which could be used to gut investor and consumer protections. If this Committee wishes to give more power to the Federal Reserve, it must make clear this power is only to strengthen safety and soundness regulation and it must simultaneously reform the Federal Reserve’s governance. Reform cannot be put off until another day.

The Federal Reserve currently is the regulator for bank holding companies. In that
capacity, it was responsible throughout the period of the bubble for regulating the parent companies of the nation’s largest banks. While regulatory authority rests in the Board of Governors of the Federal Reserve in Washington, routine responsibility for regulatory oversight has been delegated by the Board of Governors to the regional Federal Reserve Banks. The Federal Reserve System’s regulatory expertise resides in these regional banks.

The problem is that these regional Federal Reserve Banks are actually controlled by their member banks—the very banks whose holding companies the Fed regulates. The member banks control the selection of the majority of the regional bank boards, and the boards pick the regional bank presidents, who are effectively the CEO’s of the regulatory staff.

These arrangements may explain why the Federal Reserve has never given any account of how it allowed bank holding companies like Citigroup and Bank of America to arrive at a point where they required tens of billions of dollars of direct equity infusions from the public purse to avoid bankruptcy.

Giving the Federal Reserve with its current governance control over which financial
institutions are bailed out in a crisis is effectively giving the banks the ability to raid the Treasury for their own benefit.

We are also deeply troubled by provisions in the discussion draft that would allow the Federal Reserve to use taxpayer funds to rescue failing banks, and then bill other nonfailing banks for the costs. The incentive structure created by this system seems likely to increase systemic risk.

We believe it would be more appropriate to require financial institutions to pay into an insurance fund on an ongoing basis. Financial institutions should be subject to progressively higher fee assessments, and stricter capital requirements, as they get larger. This would be a way of actually discouraging “too big to fail.”

In addition, language in the draft that appears to limit taxpayer bailouts of bank
stockholders actually does no such thing, rather it simply ensures that when stockholders are rescued with public funds, bondholders and other creditors are rescued with them…

Finally, and not least, the discussion draft appears to envision a process for identifying and regulating systemically significant institutions, and for resolving failing institutions, that is secretive and optional—in other words, the Federal Reserve could choose to take no steps to strengthen the safety and soundness regulation of systemically significant institutions. In these respects, the discussion draft appears to take the most problematic and unpopular aspects of the TARP and makes them the model for permanent legislation.

Instead of repeating and deepening the mistakes associated with the bank bailout,
Congress should be looking to create transparent, fully publicly accountable mechanisms for regulating systemic risk and for acting to protect our economy in any future financial crises.

Conservative Peter Wallison – financial policy study analyst at the American Enterprise Institute – largely agrees. In his prepared remarks to Congress, Wallison says:

The Discussion Draft of October 27 contains an extremely troubling set of proposals which, if adopted, will bring economic growth in this country to a standstill, essentially turn over the control of the financial system to the government, and seriously impair competition in all areas of finance.

Rather than ending too big to fail, the Draft makes it national policy. By designating certain companies for special prudential regulation, the Draft would signal to the markets that these companies are too big to fail, creating Fannies and Freddies in every sector of the economy where they are designated. This will impair competition by giving large companies funding and other advantages over small ones.

The idea that the designation of these companies will be kept secret is, with all due respect, absurd; securities laws alone will require them to disclose their special status; simple truthfulness will do the rest…

If this legislation is passed, every industry will be in Washington, asking for special treatment or exemption. Competition in the market will become competition before this committee or in the halls of the Fed, lobbyist-to-lobbyist and lawyer-to-lawyer…

This will not only create uncertainty and moral hazard, but it will give the large and powerful companies special advantages over small ones. Those that seem likely to be taken over by the government will have easier access to credit, at lower rates, than those likely to be sent to bankruptcy.

In other words, the Draft proposes nothing more or less than a permanent TARP, using government money to bail out the large or politically favored companies, and then taxes the remaining healthy companies to reimburse the government for its costs of competing with them…

The [proposed bill] would take control of the financial industry in the United States, stifle risk-taking and initiative, and change competitive conditions in every sector of the economy so that they favor large, government-backed, too big to fail enterprises…

The Draft … would now give the Fed authority to regulate any financial company that the Council determines should be subject to “heightened prudential standards,” even if there is no insured bank in the group…

The result is that the question becomes one of political clout, with industries fighting in Congress for the competitive result they want. Some industries want to invade others’ turf; the invaded industry uses the law to fend off the competition; consumers are the losers. Congress becomes the battleground. It’s not just unseemly; it’s a frightening example of what happens when the government starts picking winners…

Congress will be injecting itself into competitive fights between firms and industries, further politicizing what should be economic or financial decisions…

The Designated Companies are under the complete control of the Fed. They will not be able to initiate new activities without the Fed’s approval, or enter new competitive fields, or perhaps even open new offices in new places. This is a degree of political control of business that has never been attempted before. Not only will it place the dead hand of government on the activities of financial companies, but it will almost certainly drive many financial companies out of the United States before they submit to these restrictions.

The effect of these restrictions for the U.S. economy will be dire. First, Designated Companies will clearly have been labeled as too big to fail. In effect, the government has notified the capital markets that these firms will not be allowed to go into bankruptcy—they will be rescued in the ways I will describe below. This means they will be less risky borrowers than smaller companies that are not going to be controlled in the same way. As less risky borrowers, the Designated Companies will have lower costs of funding and will be able to drive smaller competitors from the markets they enter. Sound familiar? Yes, it’s Fannie Mae and Freddie Mac all over again. The existence of these Designated Companies will impair competition in every market they are allowed to enter, and will force the consolidation of competitors so that markets become dominated by government-backed giants like themselves….

[The bill assumes that] our entire financial system must be subjected, today, to far-reaching control by the Federal Reserve Board. With all due respect, this is absurd, and certainly disastrous for economic growth in the future.

The Draft also contains language that suggest some of the problems of identifying Designated Companies in advance—and thus creating the Fannie/Freddie too big to fail problem—can be avoided if the designation of these companies is not disclosed to the public. This, too, with all due respect, is absurd…

In addition, there is very little incentive for the government not to rescue failing Designated Companies, because the Draft provides that the surviving members of the financial industry larger than $10 billion in assets—whether Designated Companies or not—will be taxed to reimburse the government for its costs in the bailout…

As in the GM and Chrysler bailouts, preferences are going to go to favored groups, and disfavored groups will suffer disproportionate losses. It will be a political free for all, with important legislators pressing the FDIC to treat their constituents better than someone else’s constituents.

What we know is that no losses will be taken immediately by creditors. This is because the objective of the resolution authority is to prevent a “disorderly” failure, which actually means a failure in which creditors suffer immediate losses…

The proposals in the Draft reflect very bad policy—far more likely to be destructive of the financial system and damaging to the economy than an improvement on what exists today.