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Saturday, March 16, 2013

Addressing Systemic Risk: Beyond Dodd-Frank

After the financial crisis in September 2008 in the U.S., the former chairman of the Federal Reserve, Alan Greenspan, admitted to a Congressional committee that his free-market notion that a market will automatically self-correct itself had a major flaw. He had come to this realization because the financial market for mortgage-backed bonds had failed to correct in terms of price for the dramatic increase in risk. Instead, that market, and that of overnight commercial paper, had seized up rather than simply adjust price to the decreased demand. Fear had paralyzed what had hitherto been thought to be a self-correcting market. The failures of Bear Stearns and Lehman Brothers introduced us to the concept of systemic risk, wherein the failure of a bank (or company) causes a market to collapse. Such a bank is thus too big to fail. If actualized, such risk interferes with even the basic operation of a market, not to mention its self-correcting feature. One question is whether banks that are too big to fail should merely be more adequately regulated or broken up, as the U.S. Supreme Court broke up Standard Oil in 1911.
                                                                    Alan Greenspan, former chairman of the U.S. Federal Reserve Bank
In March 2013, Alan Greenspan said in a TV interview that banks like JPMorgan that are too big to fail should be allowed to fail. “[What] we ought to do is to allow banks to fail, go through the standard Chapter 11 type of process of liquidation, and allow the markets to adjust accordingly,” said the 87-year-old Greenspan. “That has worked for a very long time.” Had he forgotten his own Congressional testimony in which he had admitted that markets may not “adjust accordingly” to irrational exuberance and systemic risk? Decades of the central banker’s experience had not prepared him for the “financial cliff” that the financial system nearly went over in the fall of 2008. Apparently for Greenspan at least, old habits (of thinking) die hard.
Greenspan said that the Dodd-Frank Act of 2010, which was oriented to saving the banks from their own risky excesses and providing such banks with an orderly liquidation process should they declare bankruptcy, had been a failure. He said the “too big to fail” problem was getting worse, not better. Banks such as JPMorgan had been “gaming” the new regulations, attracted by the high profits gained from risky trades outlawed by the Volcker Rule. That FDIC deposits were used at JPMorgan to make the trades suggests that the taxpayers have been underwriting the continued high risk, at least in part. In other words, free-market capitalism does not completely account for the risk that banks willfully assume even though it can cause the financial sector to suddenly seize up as a big bank goes under.
Greenspan’s answer to the failure of Dodd-Frank involves a return to his faith in the free market, as if the freezing of commercial paper had not occurred in September 2008 after Lehman failed. A year after that crisis, the former central banker had urged the break up of the big banks too big to fail. “If they’re too big to fail, they’re too big,” Bloomberg News reports Greenspan said in October of 2009. “In 1911 we broke up Standard Oil -- so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.” One might add that the sheer existence of a bank with over $1 trillion in assets is too big for not only the financial markets, but also the republic as well. Even after the banks’ culpability had been made transparent in the financial crisis, Wall Street still had considerable lobbying pull over Congress—enough to get lawmakers to scrap Sen. Dick Durbin’s amendment that would have allowed judges merely to adjust mortgages that are in foreclosure. The allure of large contributions is simply too overpowering to a candidate or elected official for such concentrations of private wealth to be compatible with representative democracy. One or the other must inevitably give way. Relying on chapter 11 bankruptcy and market re-adjustment does not even begin to touch such ramifications.
In short, Dodd-Frank can be viewed as a piece of legislation that did not go far enough. This is perhaps no coincidence, given the power of the banks in Congress. Furthermore, as the $6.2 billion trading loss at JPMorgan demonstrates, bankers are able to evade and obstruct whatever incremental strengthening of financial regulation that lawmakers and regulators are able to enact over the objections of the bankers. The Volcker Rule, which bars the risky proprietary trading of banks, is no match for the wizzes on Wall Street. Systemic risk demands public policy beyond some additional regulation, or even a return to New Deal regulation. Going back to the Glass-Steagall Act of 1933, which had separated investment from commercial banking, would be insufficient, as banks had been gaming that law for decades before it was repealed in 1998 by Bill Clinton and Sen. Phil Gramm. Systemic risk and risks to democracy warrant public policy that changes the economic map, rather than merely giving the existing players some additional instructions or letting them fail and hoping the market will not collapse as a result. Addressing systemic risk warrants a systemic rather than an incremental or laissez-faire approach. I suspect that in addition to the obvious vested powerful interests, an aversion to substantive change and an associated preference for incrementalism account societally for much of the aversion to breaking up the big banks, as they had become ensconced in the system as part of the status quo.


Caroline Fairchild, “Greenspan Says Too Big To Fail Problem ‘Is Getting Worse, Not Better’,” The Huffington Post, March 15, 2013.