Sent: 29-06-2010 10:09:04
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US Financial Regulation Misses the Mark
Long awaited financial regulations largely miss the mark by failing to address the source of speculation while limiting lending.
United States Congressmen and Senators in conference have finally agreed to financial regulation legislation which should be put to a vote this week. Last minute changes by the occasional rogue congressman could still produce a surprise or two. However, the key conference participants now seem to agree that the debate is over, that the two houses will vote this week and that President Obama will have something to sign into law with high ceremony shortly after the Independence Day holiday.
Despite rhetoric urging speed, legislators have taken two years to get to this point. The upshot has been legislation likely to prompt a collective sigh of relief from those in the financial services industry.
The demonizing of financial institutions by U.S. politicians was expected to produce some draconian changes to how they could behave in the future. Abolition of derivatives trading, restraints on hedge fund investing and bans on proprietary trading were some of the measures threatening to erode profitability.
The most heavy handed policy proposals seem to have been abandoned. While there will be some limits placed on proprietary trading, for example, principle trades on behalf of clients - the majority of the trading by the banks - will be allowed.
Cutting back on derivatives trading risked a generally higher cost of capital for business as financial markets became less liquid.
The legislation does not seek to curtail trading but aims for all derivatives trading to be conducted through a clearinghouse in the same way as Chicago Board of Trade futures contracts and options, for example. This is intended to safeguard the financial system from counterparty risk by spreading the financial impact of a potential default across all those participating in the clearinghouse.
The largest US banks might be breathing easier but they have not left all their troubles behind. Voters are still angry. US mid-term elections due later this year might result in a further stirring of hostilities if candidates decide they can win by stoking the flames of resentment. This could still leave the industry facing a hostile group of legislators after November prepared to revisit the changes which were agreed last week.
The Basel III capital adequacy rules will be another speed bump for the industry. After being discussed at the G20 meeting this weekend, they are scheduled to be finalized in November. On present plans, the new rules requiring banks to carry more capital and retain greater short term liquidity will be put into effect in 2012.
Ultimately, these measures will reduce the amount banks can lend. To fund any given level of national output, banks will have to raise more capital in the future than in previous economic cycles. Investment returns from banks are set to be permanently lower after 2012.
All of these measures will constrain just how large banks can become. Legislators will be satisfied that they have shown the banks who is the boss. Unfortunately, the measures being implemented largely bypass the fundamental problem leading to the 2008 crisis.
The crisis in 2008 arose because of building speculative momentum largely centered on real estate prices. There were some new financial products along the way but the mania was by no means confined to Wall Street. To paraphrase the chairman of BP, the small people were caught up, too.
We do not know the source of the next crisis. To successfully avert a future crisis, any new rules need to be sufficiently general so as to cover destabilizing speculation from currently unknown and perhaps unsuspected sources. The fundamental challenge in dealing with a future crisis, therefore, is threefold:
- to work out how to accumulate information in a timely fashion about momentum trades that might result in economic bubbles, whatever their source;
- to determine rules that would guide policymakers in deciding when prices had gone too far; and,
- having enough political courage to cut short a trade from which a wide cross section of the population might be benefiting (at least at that time).
There might be good reasons why legislators did not respond to the 2008 crisis from this direction. Even with the benefit of hindsight it is hard to imagine legislators putting a lid on soaring house prices in 2003, for example, before they became dangerously unstable. They were equally unlikely to quell internet-related equity prices in 1999 before their collapse and while electors still saw their wealth building.
The reticence to act partly reflects a lack of political will. In part, it also reflects a lack of suitable analytical tools. Economists usually only know if prices are too high with the benefit of hindsight.
Against this background and however much we may wish otherwise, there is no reason to believe future crises will be averted, notwithstanding the legislative agreements last week. It is likely, however, that some time in the next seven or eight years we will bemoan the reluctance of banks to lend and begin asking why they are not supporting growth like they did before.
This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity. Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.