Ten Questions For Those Fixing The Financial Mess
The government is about to rewrite the rules for the nation's financial markets.
The process could take many months but the groundwork is being laid now, ahead of a big international conference in early April that will address regulatory changes world-wide.
But the real action will take place in Washington, where causes of the crisis will be argued and fixes debated. Changes could include beefing up the powers of the Federal Reserve, merging or abolishing some regulatory agencies and bringing most of the financial world under closer supervision.
Ahead of that discussion, here are 10 big questions facing the architects of the rules for a post-crisis world:
1. How much did deregulation contribute to the financial crisis?
President Barack Obama argued on the campaign trail that one bill -- the Gramm-Leach-Bliley Act of 1999 -- led to deregulation that helped cause the crisis. Among other things, that law allowed for the creation of giant financial supermarkets that could own investment banks, commercial banks and insurance firms, something banned since the Great Depression. Its passage, critics say, cleared the way for companies that were too big and intertwined to fail.
The law also had limits. It cemented the Federal Reserve as the top regulator for giant firms such as Citigroup Inc. and Bank of America Corp. But it didn't give any regulator sweeping powers over investment banks such as Bear Stearns Cos. and Lehman Brothers, or standalone insurance giants like American International Group Inc.
Supporters of Gramm-Leach-Bliley say the law might have prevented the crisis from becoming worse, as it allowed investment banks Goldman Sachs and Morgan Stanley to borrow money from the Fed to stay afloat.
But House Financial Services Committee Chairman Barney Frank (D., Mass.) has said a primary cause of the crisis was not so much deregulation, but 'nonregulation,' meaning that federal officials didn't enforce rules already on the books.
2. With so many regulators, how did problems on banks' books slip through the cracks?
At least 10 federal regulators oversee financial-services companies, not to mention regulators at the state level. But many of the products that led to the financial crisis, such as subprime mortgages, emanated from lightly regulated pockets of the economy. Mortgage-finance companies such as New Century weren't banks, so no one in Washington oversaw their business. Complex financial products such as credit default swaps were also largely left alone by government officials.
Commercial banks such as Citigroup, overseen by multiple federal agencies, were able to accumulate huge levels of exposure by housing risky assets in investment vehicles that weren't part of their balance sheets. One of the biggest blind spots in the commercial bank system turned out to be assets held off balance sheet.
3. What's the biggest likely change on the horizon?
The White House and top lawmakers already are wrangling over how to proceed. The Obama administration wants to present a plan to the Group of 20 leading nations in London in early April.
Rep. Frank, who will be an architect of any plan, has said policy makers should overhaul regulation in two steps. First, he wants lawmakers to pass a bill that would make the Fed a kind of super-regulator with powers to oversee risks across the broader economy. Nothing like that currently exists in the U.S. He also wants Congress to create a mechanism to allow the government to wind down a failed investment bank or insurance company.
Rep. Frank said the second step should be a more thorough overhaul of regulation, which many believe will include beefed-up consumer protections and the consolidation of some agencies such as the Office of the Comptroller of the Currency and the Office of Thrift Supervision. Senate Banking Committee Chairman Christopher Dodd (D., Conn.) has pushed instead for one legislative package that would include all of the reforms, though this is expected to proceed on a slower track.
4. Will hedge funds and credit-default swaps face government oversight?
For years, influential government officials, including former Federal Reserve Chairman Alan Greenspan, argued that regulating hedge funds and exotic financial products would do more harm than good. The idea was that large, sophisticated institutions should be able to use such products to offset the risk of other investments, and by doing so, would spread risk broadly around the financial system. Access to hedge funds and swaps also was limited to large and theoretically sophisticated investors.
Now, Congress is looking to ensure regulators know more about the interconnectedness of banks and hedge funds, particularly through credit-default swaps or CDS, financial instruments that can be used to bet on the direction of a company's credit or used to hedge exposures. AIG required a taxpayer bailout partly because an unregulated business unit sold CDS, which required AIG to post collateral once the underlying investments lost value.
Hedge funds are likely to face greater disclosure requirements of their investment and trading positions and operations. The idea is to give regulators more insight into potentially systemic problems. The hedge-fund lobby is backing the Federal Reserve as a regulator that would have oversight of its members, but it is strongly arguing that any new disclosures not be made public. The Securities and Exchange Commission is pushing for access to hedge funds' books and potential new disclosure rules.
5. How much overhaul to credit-rating agencies is needed?
Many regulators, politicians and even bankers lay a lot of blame at their feet. Credit-rating firms were charged with judging the quality of corporate, municipal and other kinds of debt. As gatekeepers, they are supposed to be independent from the companies whose debt they rate. Yet, critics say, as the growth in the debt linked to residential mortgages exploded, credit rating firms' standards fell by the wayside as they competed with each other for business.
Most credit-rating firms are paid by underwriters issuing the same debt they rate, and critics say they had an incentive to give the debt products favorable ratings to win future business.
As late as April 5, 2007, one analyst at a major rating firm said their ratings model didn't capture 'half' of a deal's risk, but that 'it could be structured by cows and we would rate it,' according to an SEC report looking into the problems.
The concern: Investors, including banks, bought billions of dollars of packaged debt, some of it highly rated and some risky. Though some investors were unaware of the extent of riskier debt, many thought the safest components would protect them. They didn't. When the housing market collapsed, so did those loans, sparking a series of losses still shaking the system.
6. How frail is the banking system now?
Pretty frail. The stock prices of many banks have plunged, which makes raising capital more expensive. Private investors are skittish about pouring money into the banking system, fearful of being wiped out by any possible future government rescue.
There isn't really a segment of the industry that is performing particularly well. Some were hit by subprime loans, most others by the larger drag of the recession. Many big banks have had a hard time digesting acquisitions and underestimated how much capital they would need to survive. Multiple regional banks have high concentrations in risky assets or geographic areas, such as Florida, Arizona, and Ohio. Many small banks are suffering from high exposures to commercial real-estate loans.
7. How big is 'too big to fail?'
For commercial banks, it appears the answer is $100 billion in assets. The Obama administration said last month it would run 'stress tests' on the 19 banks that have more than $100 billion to determine how much additional capital these companies would need to continue lending. The tests are designed to see how the banks would perform under various dire scenarios for the economy, such as unemployment rising above 10%.
Banks aren't the only companies that have received government assistance. The government has committed more than $100 billion to prevent the collapse of AIG. The Fed and Treasury still see its collapse as something to be avoided at all costs.
8. Is Wall Street still needed?
Yes -- or something akin to it is. Wall Street has historically played an important role in greasing the wheels of the financial system by routing capital to those who might best use it. Wall Street banks also traditionally took riskier bets than standard commerical banks that are backed by consumers' deposits. Now both kinds of banks have been burned by taking on too much risk, and what remains of Wall Street is shrinking as it weans itself from relying on borrowed money. Both now may be unwilling to assume new risks, or may be prevented by the new rules from doing so.
In the future, traditional investment banks may be smaller and more specialized such as a mergers-and-acquisition advisory business or a brokerage firm.
9. Will Congress over-regulate?
The answer depends on where you sit. As long as taxpayers are funding the bailout of large financial institutions, there will be political pressure to find scalps and change how the financial system operates. Congress and the Obama administration already have signaled that virtually all financial institutions and financial products will be regulated.
Some influential members of Congress have historically sought to balance markets and regulation. That may go by the wayside with a Democrat-controlled Congress and a pent-up populist anger at Wall Street. In a recent WSJ/NBC News poll, the highest-ranked peeve, named by 35% of those polled, was bank executives taking large bonuses while receiving taxpayer funds.
Banks and businesses, which for years have successfully fought off attempts to beef up the rules, will face an uphill battle avoiding them.
10. What happens if Washington doesn't make big changes?
The banking industry posted huge losses in the fourth quarter, and banks are having a hard time raising private capital, because of investors' worries that they might wiped out if banks get nationalized. This could continue indefinitely if policy makers don't clarify how they plan to supervise the banking industry.
In the U.S., changes are high on the agenda, and bankers have conceded that they are necessary to help restore confidence to financial markets. European governments are pushing for regulatory overhauls too. Still, if any U.S. moves have a global component, that will make them much more complicated to broker.
5. How much overhaul to credit-rating agencies is needed?
Many regulators, politicians and even bankers lay a lot of blame at their feet. Credit-rating firms were charged with judging the quality of corporate, municipal and other kinds of debt. As gatekeepers, they are supposed to be independent from the companies whose debt they rate. Yet, critics say, as the growth in the debt linked to residential mortgages exploded, credit rating firms' standards fell by the wayside as they competed with each other for business.
Most credit-rating firms are paid by underwriters issuing the same debt they rate, and critics say they had an incentive to give the debt products favorable ratings to win future business.
As late as April 5, 2007, one analyst at a major rating firm said their ratings model didn't capture 'half' of a deal's risk, but that 'it could be structured by cows and we would rate it,' according to an SEC report looking into the problems.
The concern: Investors, including banks, bought billions of dollars of packaged debt, some of it highly rated and some risky. Though some investors were unaware of the extent of riskier debt, many thought the safest components would protect them. They didn't. When the housing market collapsed, so did those loans, sparking a series of losses still shaking the system.
6. How frail is the banking system now?
Pretty frail. The stock prices of many banks have plunged, which makes raising capital more expensive. Private investors are skittish about pouring money into the banking system, fearful of being wiped out by any possible future government rescue.
There isn't really a segment of the industry that is performing particularly well. Some were hit by subprime loans, most others by the larger drag of the recession. Many big banks have had a hard time digesting acquisitions and underestimated how much capital they would need to survive. Multiple regional banks have high concentrations in risky assets or geographic areas, such as Florida, Arizona, and Ohio. Many small banks are suffering from high exposures to commercial real-estate loans.
7. How big is 'too big to fail?'
For commercial banks, it appears the answer is $100 billion in assets. The Obama administration said last month it would run 'stress tests' on the 19 banks that have more than $100 billion to determine how much additional capital these companies would need to continue lending. The tests are designed to see how the banks would perform under various dire scenarios for the economy, such as unemployment rising above 10%.
Banks aren't the only companies that have received government assistance. The government has committed more than $100 billion to prevent the collapse of AIG. The Fed and Treasury still see its collapse as something to be avoided at all costs.
8. Is Wall Street still needed?
Yes -- or something akin to it is. Wall Street has historically played an important role in greasing the wheels of the financial system by routing capital to those who might best use it. Wall Street banks also traditionally took riskier bets than standard commerical banks that are backed by consumers' deposits. Now both kinds of banks have been burned by taking on too much risk, and what remains of Wall Street is shrinking as it weans itself from relying on borrowed money. Both now may be unwilling to assume new risks, or may be prevented by the new rules from doing so.
In the future, traditional investment banks may be smaller and more specialized such as a mergers-and-acquisition advisory business or a brokerage firm.
9. Will Congress over-regulate?
The answer depends on where you sit. As long as taxpayers are funding the bailout of large financial institutions, there will be political pressure to find scalps and change how the financial system operates. Congress and the Obama administration already have signaled that virtually all financial institutions and financial products will be regulated.
Some influential members of Congress have historically sought to balance markets and regulation. That may go by the wayside with a Democrat-controlled Congress and a pent-up populist anger at Wall Street. In a recent WSJ/NBC News poll, the highest-ranked peeve, named by 35% of those polled, was bank executives taking large bonuses while receiving taxpayer funds.
Banks and businesses, which for years have successfully fought off attempts to beef up the rules, will face an uphill battle avoiding them.
10. What happens if Washington doesn't make big changes?
The banking industry posted huge losses in the fourth quarter, and banks are having a hard time raising private capital, because of investors' worries that they might wiped out if banks get nationalized. This could continue indefinitely if policy makers don't clarify how they plan to supervise the banking industry.
In the U.S., changes are high on the agenda, and bankers have conceded that they are necessary to help restore confidence to financial markets. European governments are pushing for regulatory overhauls too. Still, if any U.S. moves have a global component, that will make them much more complicated to broker. |
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