Thursday, July 2, 2015

A Few Observations about Greece, Debt, and the Euro


New twists and turns in the current Greek disaster keep coming rapidly. Last Saturday (Friday in the U.S.), Prime Minister Alexis Tsipras announced a surprise referendum to take place next Sunday (July 5) on the latest offer by the troika for an extension of the “bailout.” The Greek parliament subsequently approved this referendum. The European Central Bank then announced that it capped the amount it will lend to Greek banks, which are faced with large withdrawals by understandably nervous depositors. This forced the Greek government to close the banks until at least next Monday and to limit Greeks to withdrawing 60 euros per day from ATMs. Tourists with foreign bank cards are not limited, and one assumes that Greeks who have foreign bank cards can get around the restriction. However, ATMs are running out of cash and the lines to use them are long. Then on Tuesday morning came the news that Tsipras had written a letter saying he is willing to accept the terms of the latest troika offer with some amendments. The Germans maintain though that there is nothing to negotiate until after the referendum, and Tsipras is still urging Greeks to vote no, that is, to say that they do not accept the troika’s offer.
There has obviously been a negotiating failure here on a scale that one rarely sees. The Greeks want to stay in the eurozone; most European governments want Greece to stay. (There may, though, be some disagreement between German Chancellor Angela Merkel and her finance minister, Wolfgang Schäuble.)  The apparent dislike and disdain of each side for the other, along with less than diplomatic public statements and differences on the underlying economics, has made agreement difficult, if not impossible. It is often remarked that the Europeans, when faced with problems, like to kick cans down the road; in the current situation, they have yet to find the right can to kick.
What is distressing is that the Europeans do not want to admit what is perfectly obvious; the Greeks cannot pay all of their debts.  It needs to be restructured and effectively partially forgiven (as would happen if there were a bankruptcy option for  countries similar to that available to corporations). It is not in anyone’s interest to perpetuate a situation where Greek creditors effectively advance new loans to pay off old ones, all the while strong arming Greece to follow economic policies that hinder economic growth. This hurts Greece and the creditors, since it weakens Greece’s ability to pay down its debt. The creditors need to admit that they will not be fully paid back.
The pressure being applied to Greece suggests that some of the Europeans want to cause the current Greek government to fall. What other reason would there be not to discuss how to restructure and partly forgive the outstanding debt? If the goal has been to punish Greece for its profligate ways, that certainly has been accomplished. The past, though, cannot be changed; the parties need to agree on what is the best for all of them going forward.
Also, what the current crisis demonstrates is the folly of the euro. (In 2011, I wrote about this.) Too many countries, with different economic situations, cultures politics, languages, legal systems and so on were allowed to join. There is no way that the current eurozone is an optimum currency area. Moreover, the necessary additional surrender of some sovereignty to a central government with respect to fiscal policy has not been accomplished. And Greece got admitted to the club by cooking the books, while the other members apparently looked the other way.
Catherine Rampell of the Washington Post wrote in a recent column about the euro:
“…Milton Friedman, among other Cassandras, explained why nearly two decades ago in an essay detailing the best (the United States) and worst (Europe) conditions under which to create a currency union. In Europe, where countries are divided by language, customs, regulatory regimes and fiscal policies, a common currency would inevitably prove disastrous, he wrote. Shocks hitting one country would heave themselves across the continent if individual countries could not easily adjust prices through their exchange rates.

“Rather than promoting political unity, Friedman argued, ‘the adoption of the Euro would have the opposite effect. It would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues.’”
Finally, the mishandling of this crisis by both sides may have some very bad political consequences. It raises questions about whether “the European project” can go forward. Not only is Greece an issue, but the UK is trying to negotiate what amounts to associate membership in the EU before their referendum on EU membership. The National Front in France is pleased with the developments, since it wants to take France out of the EU. The political ramifications in other “periphery” countries, such as Portugal, Spain, and Ireland, is uncertain and there may be growing doubts about Italy’s economic situation. It is not that difficult to imagine the movement towards an “ever closer union” shifting into reverse.

If the Greek situation continues to be handled badly, this may result in Greece moving closer diplomatically to Russia during a period that tensions are on the rise between Russia and the West. Also, Greece is one of the countries that migrants to Europe first go to; a less than cooperative and impoverished Greece would not help address this problem.
Finally, there should be concern about the internal political situation in Greece if its economy continues to deteriorate. The regime of the colonels ended in 1974 and Greece became democratic. That was forty-one years ago, which may seem like a long time, but many people are still alive who had direct experience of that regime. While a military coup would seem to be unlikely, it is unpredictable what will happen when countries are subject to depression for a long time or high inflation, or, worse, both at the same time.

Greece and GDP-Linked Bonds


It is perfectly obvious that at some point Greece’s creditors’ will have to admit that they will not be paid back in full. This morning there are reports that the IMF has highlighted this point.
One idea that the Greek Finance Minister Yanis Varoufakishas has floated is to replace some of Greece's existing bonds with GDP-linked bonds. The merit of this idea is that it is one possible way to make both Greece and its creditors understand that their interests are aligned. With this type of bond, the greater the Greek economy grows, the more the creditors would receive.
There are some obvious problems, though, that would have to be addressed. A GDP statistic that everyone could trust is essential; at this point, creditors may not be willing to trust a number the Greek government produces. Also, GDP numbers are also subject to revision as new data comes in. A decision would have to be made at what point a number is final for purposes of the bond. Also, there is probably not insignificant economic activity in Greece that is “off the books.” How to account for this in coming up with a GDP number is a question.
Consequently, we will probably not see a GDP-linked bond, at least not one marketed to private creditors. However, since much of Greek debt is owned by public sector entities, it may be an idea worth pursuing along with others. The European creditors of Greece have made a mistake in not wanting to discuss ways to restructure and partially forgive Greek debt, and the Greek negotiating tactics have seemed ill-advised. If Greece and the troika find a way eventually to talk seriously about how to deal with the Greek debt problem, GDP-linked bonds are not essential to a solution but are worth considering.
(Some of what I have to say here is informed by my work at Treasury designing Treasury’s inflation-indexed bonds.)

Tuesday, June 23, 2015

More on the AIG Case


I finally got around to reading U.S. Court of Claims Judge Thomas Wheeler’s opinion in the class action suit led by Maurice (Hank) Greenberg against the United States concerning the terms of the bailout of AIG. Nothing in it changes my opinion about Steven Pearlstein’s article in the Washington Post about this case, which I found to be incredibly biased for a news story.
I am no expert on the applicable law in this case, but Judge Wheeler’s opinion seems quite reasonable. In short, he held that the Federal Reserve exceeded its authority by demanding a controlling equity interest in AIG as condition for a loan that would keep AIG for filing for bankruptcy, but he found that AIG’s stockholders were not due any payment from the government for this action, since the alternative, bankruptcy, would have left them in a worst position economically. In a less noticed part of the opinion, the judge found that AIG’s reverse stock split in a ratio of twenty-to-one was done in order to keep AIG share price over $1.00 so as not to be delisted from the New York Stock Exchange. The judge found no evidence that it was done to avoid a stockholder vote on the government exchanging preferred stock for common stock. In other words, on this issue, the plaintiffs lost.
The judge’s descriptions of the events leading up to the AIG loan do not portray anyone in a very favorable light. In particular, one gets the impression that certain of the actors reveled in acting as the tough guys in the way they acted towards AIG. Left unexplained is why the terms of the AIG loan which involved the effective nationalization of AIG and a very high interest rate were so much tougher than what the government demanded of the banks. As I’ve indicated, the excuse that Pearlstein and Andrew Ross Sorkin proffer, i.e., the government did not regulate AIG, is questionable, since the Office of Thrift Supervision did have supervisory authority over AIG as a thrift holding company. Also the judge mentions, without much comment, that the Federal Reserve decided that AIG’s credit default swap counterparties would be paid the full amount they were owed, even though AIG was in financial distress but for the government backup. This seems to have been a way to help the banks.
As to the legal authority to take an equity interest in AIG, particularly telling is an email from a Davis Polk lawyer who was acting as the New York Fed’s outside counsel. In this email, the lawyer said that the government “is on thin ice and they know it. But who is going to challenge them on this ground?” Well, we know the answer to this question. How Mr. Greenburg feels about winning his case after paying a very expensive legal team led by David Boies but not receiving any payment in spite of this win is unclear, except that he is not satisfied. According to The Wall Street Journal, he plans to appeal Judge Wheeler’s decision on damages and an earlier decision to dismiss claims related to the “backdoor bailout” of banks by making them whole on the CDS contracts with AIG.
Also, of course, AIG is hardly blameless. The company took excessive risk by taking on the mortgage risk that the banks did not want to hold through credit default swaps. It is also true that the government actions led to AIG continuing in business.  Given the pressures of the time, the government officials were making the best decisions they could, and mistakes were inevitable. In retrospect, many think that the biggest mistake was letting Lehman Brothers fail. While Treasury and Federal Reserve officials claim that they did not have sufficient authority to save Lehman, this is not widely believed given their resourcefulness in other matters, including AIG.

Tuesday, June 16, 2015

Some Criticisms on the Reporting of the AIG Case in Today’s Washington Post and New York Times


I have not yet had time to read Judge Wheeler’s opinion in a Court of Claims case in which he decided that the Federal Reserve had exceeded its legal authority in obtaining an equity interest in AIG through a trust but did not award any payment to Starr International Company (effectively, as I understand it, Maurice Greenburg). Nevertheless, I am disappointed with two articles I read about this case this morning: one in the Washington Post and the other in the New York Times.
The Washington Post article is by Steven Pearlstein. While the article appears on the “Wonkblog” online, it is on page A3 of the print edition, i.e., it appears as a regular new article. Nevertheless, it is quite clear that Mr. Pearlstein is not writing as an objective reporter. It is obvious that he believes the judge’s decision is wrong. For example, he writes that the judge substituted “his judgement for that of the treasury secretary and the five-member Federal Reserve Board.” He also criticizes the judge for not noting “a key point. Although the government, as bank regulator, could control the behavior of the banks, without an ownership stake it would not have had control over an unregulated global insurance holding company to which it had just made the largest loan in recorded history.”

Pearlstein is wrong about the AIG’s regulatory status. AIG was a thrift holding company, then subject to the Office of Thrift Supervision (“OTS”) oversight and regulation. At the time of the financial crisis, this may have been overlooked because OTS was for the most part not taken that seriously as a regulator of thrift holding companies. Nevertheless, those managing the crisis may have been able to use OTS to control AIG’s behavior and other agencies could have lent staff to OTS with expertise. I do not know the limits of OTS’s holding company authority, but Pearlstein should have mentioned this possibility. . (In passing, I would note that some insurance companies bought small thrifts in order to be regulated by OTS as a thrift holding company. They did this in order to operate in the European Union without being subject to holding company regulation by an EU regulator. The EU accepted this, even though it was clear to many that OTS would not be doing much supervision.)
I am puzzled by Pearlstein’s exact status at the Washington Post. He was a regular columnist for the Post, but left a few years ago to become a professor at George Mason University, which is located in the Virginia suburbs of Washington, DC. While at George Mason (it is not clear whether he is still employed there, though he may be), he wrote occasional columns for the Post. Recently, I have seen news articles written by him, with a Washington Post email address after his name. If he is now writing news articles as a Post employee or contract worker, he and his editors should know the difference between writing an opinion column and a news article. I should not be able to read a straight news article about a court decision and know that the reporter disagrees with it.

Andrew Ross Sorkin in today’s New York Times has an article about the AIG decision where he ignores OTS, though what he writes is not inaccurate: “But the Fed did not have regulatory oversight of A.I.G., which is an insurance company, and therefore couldn’t maintain the same kind of control it did over the banks.” Sorkin also should have mentioned OTS.
I am not as critical of Sorkin as I am of Pearlstein, because the formatting of the article in the Times (jagged right margin) serves to indicate that this is an analytical piece reflecting the author’s views, not a straight news article. The line between what should go on the editorial pages of the Times and what analysis is appropriate for the news pages is very fuzzy. I have criticized Sorkin in the past for advocacy in an article he wrote about Antonio Weiss, which I thought should be better placed as an op-ed. I do not think, though, that he crossed any lines in today’s article, and attribute the OTS omission as an oversight.

Friday, June 5, 2015

Some Further Thoughts on Financial Regulation


As some of my previous posts have suggested, the ideal structure of financial institution and market regulation is maddeningly elusive. The U.S. structure was never well thought out and planned; it was created piecemeal in reaction to various historical financial developments, problems, and crises – most notably in the 1930s, 1970s, and more recently. Because of the way politics works and laws are enacted in the U.S., it is difficult to reform financial regulation absent a crisis, and even then reforms may fail to address some fundamental problems.

In the UK, by contrast, the government has been able to change the regulatory structure with less political difficulty given the nature of the political system (though, as the recent election there attests, the UK political system appears to be evolving in fundamental ways). For example, in 2000, the Labour Government headed by Tony Blair consolidated most financial regulation in the Financial Services Authority ("FSA"). In the aftermath of the financial crisis of 2008, the Conservative Government headed by David Cameron deemed the FSA to be a failure and in 2013 split the FSA into two entities, one for business conduct regulation and the other for prudential regulation and gave more authority to the Bank of England.

Sometimes, there is something to be gained by rearranging and consolidating or splitting (as the case may be) regulatory boxes. In the U.S., there is a good case to be made for merging the SEC and the CFTC and for having fewer bank regulators. The case for the former rests on the similarity of many of the market instruments the two agencies regulate; the case for the latter rests on forum shopping by banks. One could go further and pose the question whether insurance companies (life, casualty, and health) should be primarily regulated by the states given the important role these entities play in financial markets and also ask whether the regulation of pension funds is adequate.

One thing is clear. When Alan Greenspan was the Federal Reserve chairman, he liked to argue that multiple regulators would foster competition among regulators and that this would result in better regulation. Of course, that is an application of faith in the free market and competition in an area where it makes no sense. Greenspan’s not terribly well hidden agenda was that competition among regulators for entities to regulate would result in regulatory laxity, which he thought was desirable. Given the financial crisis of 2008, that is no longer a widely shared view.

The main problem with financial regulation is regulatory capture. While restructuring the agencies responsible for regulation may help, it does not solve this problem. When there are multiple regulators, there is a tendency for each agency to be an advocate for the entities it regulates and to fight any encroachment by other regulators. This can even extend to matters that are not strictly in the regulators’ jurisdiction. For example, some years ago there was a political fight over whether derivatives should be marked to market for accounting purposes, as the Financial Accounting Standards Board ("FASB") had proposed. (This simplifies FASB’s complex proposal but gets to what the dispute was about.) The bank regulators supported the banks in fighting the proposal, while the SEC supported it. The issues revolved around capital requirements and the stability of reported income. For broker-dealers regulated by the SEC this was not an issue, since SEC capital rules key off assets for which there is a market and are valued at market (or "fair value") prices. For banks, this had the potential to increase capital requirements if there were a decline in the value of certain of their derivatives holdings. Of course, the regulators could come up with a regulatory capital measurement that went contrary to FASB rules, but the regulators did not want to do that.

In the end, a version of the FASB rule was finalized. As for Treasury, the staff was divided. Those who worked on bank regulation argued against FASB; those who worked on securities regulation, which included me because of Treasury’s government securities market rule-making authority, sided with the SEC and FASB. Ultimately, Treasury political appointees sided with FASB. A provision was included that effectively stated that inflation-indexed bonds structured in the manner of Treasury’s inflation-indexed bonds did not have an embedded derivative that needed to be split out and marked to market. Whatever one thinks of the merits of that particular provision, it obviously was in Treasury’s interest for FASB to conclude this as the Treasury was trying to develop a market for the new security.

As for the SEC, the staff there seemed to be heavily influenced by the largest broker-dealers and held out Goldman Sachs as having excellent compliance programs. In some areas, Goldman no doubt has good compliance programs. But one wonders if the deference SEC staff paid to firms like Goldman led them to miss some of the practices that exacerbated the bursting of the housing bubble and the 2008 financial crisis.

Despite the foregoing, consolidating regulators does not necessarily solve the regulatory capture problem. It probably limits the types of entities that can do the capturing to the largest firms and exchanges, but these entities will find a way to both charm and pressure a regulator with broader responsibilities than the current one. After all, as the Carmen Segarra tapes suggest, the Federal Reserve Bank of New York ("FRBNY") will sometimes handle large and influential firms with a light touch (in this instance, Goldman Sachs), even though the FRBNY would seem to be powerful enough to be immune from influence and pressure.

There is no obvious answer on how to reform the regulatory system. Dodd-Frank made some improvements, but the ability to resist regulatory capture requires leadership and a change in the culture of the regulatory agencies. As regards leadership, it is not sufficient to have a gung-ho regulator who heads an agency for only a few years. The leadership must be sustained from administration to administration. Also, a gung-ho regulator may not always be for the best. It is not always the case that writing lots of regulations solves problems, especially if they are not well designed to solve identified problems. Moreover, regulators need to show good judgment, which was absent in the lead-up to the 2008 financial crisis. After all, the regulators had authority that they did not use, which might have at least lessened the severity of the crisis. Particularly egregious was Greenspan’s refusal to use the Fed’s authority to curtail what was happening with subprime mortgages.

Given the current state of our political system, it is hard to be optimistic about making significant improvements in regulation. Any administration which wants to improve regulatory oversight and appoints people to the agencies who share that view will get pushback from certain factions in Congress. The large financial entities know how to play the Washington game, including how to influence Congress and exploit rivalries and tensions among various government agencies. Currently, probably the best discipline on the financial sector is the memory of the 2008 crisis. However, as time passes, memories of that will fade and a new crop of ambitious people will be working at the firms with no personal memories of 2008 at all.

This does not mean that we should quit trying to improve financial regulation. While there will certainly be serious problems in financial markets – there always are – perhaps we can be able to mitigate them. The regulations we have and their application and enforcement are not worthless; they do a lot of good. They could, though, be better.

Friday, May 15, 2015

Paul Volcker: Financial Regulatory Reform and the Civil Service


In reaction to my comments on the Volcker Alliance recommendations on financial regulatory reform and the Treasury Department, a correspondent writes me to suggest that Volcker may have given up on his efforts of many years to improve the functioning of the civil service by limiting the number of political appointees and strengthening career senior government executives. In my correspondent’s view, Volcker may be recommending that Treasury play less of a role in financial regulation and the “independent” financial regulatory agencies, especially the Federal Reserve, because he has recognized that the civil service has not been reformed. Also, despite his famous frugality, Volcker appreciates that financial regulatory agencies can pay salaries higher than the regular civil service pay schedule, which is important for both recruitment and retention of staff. Most Treasury employees are paid according to the regular civil service pay schedule, with the notable exceptions of the staffs of the Office of Financial Research, which was created by the Dodd-Frank legislation, and of the Office of the Comptroller of the Currency.  
I think my correspondent is on to something. I do not think that the lack of civil service reform is the only reason for the recommendations of diminishing the role of the Treasury Department, but I think it is part of it. The other reason is that I think Volcker, as well as many others, admire the Federal Reserve as an institution and admire its staff. In fact, the Federal Reserve does have good staff, but, as I have indicated in previous posts, the Fed is not infallible and has its weaknesses, as do all government agencies (and all organizations, public or private).
As far as the civil service is concerned, Paul Volcker is right that it should be reformed and the proliferation of political appointees should be stopped and, even, reversed. Clearly, the President has the right to have his own team in place to formulate policies. However, there also needs to be a recognition that many activities of the federal government (for example, managing the public debt) continue from administration to administration and there is a benefit to having senior career people manage many programs and available to give operational and policy advice on request. The knowledge and experience gained from years of government service is invaluable to continuity and in assisting political appointees carry out their specific policy agendas.
Unfortunately, during my tenure at Treasury (and I am told since the end of World War II), the trend is for each incoming administration to name more political appointees and to place them further and further down in the bureaucracy. In my experience, some of these political appointees are excellent; some are mediocre; and some are outright terrible. I often tell people that the hardest part of my job at Treasury was not the substance of what I was working on but figuring out how to relate to each new boss who appeared on average about every two years.
This state of affairs is in general terrible for morale. Younger employees see the situation and come to the conclusion that after a reasonable period of government service they should probably look elsewhere for career advancement. Consequently, the government loses many of its best people.
Moreover, political appointees are not usually motivated to improve the organization they are working for temporarily; they are usually there to advance a particular agenda and to further their personal career goals – some view it as getting their “ticket punched.”  If political appointees go too far down in an organization – and they do at the Departmental Offices of the U.S. Treasury – then no one with responsibility for multiple offices is motivated in improving the organizations’ effectiveness. For example, there is no political appointee is likely to consider implementing programs for career Treasury employees encouraging them to work in multiple areas, including domestic and international, in order to develop senior officials with broad experience in different aspects of the Treasury’s responsibilities. Finally, a problem with having too many political appointees is that it may be more likely that some of them will do considerable damage that outlasts their tenure to the organization.   
As far as pay is concerned, the George H.W. Bush Administration in the wake of the savings and loan disaster decided that new legislation should enable the bank regulators to pay higher than normal government salaries in order to recruit good staff. After some years, legislation extending this pay preference to the SEC and the CFTC was enacted. While the motivation for this is understandable, the government pay issue should be one that is addressed globally, rather than piecemeal. Given the diverse functions and vast size of the government, it is a questionable system for most civil service employees to be paid according to the same rigid schedule overseen by a single government agency (OPM). A way should be devised to give more agencies more flexibility in determining how much they pay employees. (I know that that pay was an issue at Treasury, because when I was recruiting people I could offer them interesting work but could not match the pay of competing agencies.)

If Volcker has concluded that civil service reform, despite his best efforts, is not going to happen anytime soon, I think he is right. It usually takes a crisis for the government to change, and the problems in the civil service are slowly making things worse but are not creating a crisis. And when there is a crisis, such as in the financial sector, partial solutions can be applied, such as reorganizing some agencies and paying select government employees more money. Nevertheless, I am leery of giving more power to the Federal Reserve. I agree with much of what it has done in recent years, and I think both Ben Bernanke and Janet Yellen have been excellent in leading that organization. One does not, though, have to go back that far in history to find that the Fed has made major mistakes. Moreover, if ultimately, any particular Administration is going to be judged by how the economy performs, one should not continue a trend of giving more and more authority to agencies that the Administration does not control.

Thursday, May 7, 2015

More on the Volcker Alliance Financial Regulatory Proposals


In my previous post, I criticized the Volcker Alliance report, “Reshaping the Financial Regulatory System,” for essentially being the opening salvo in a turf fight between the Fed and the Treasury. Since I agree with the report authors that the financial regulatory system should be reformed, I was disappointed with some of their specific recommendations and the seeming underlying assumption that the Federal Reserve is the best regulatory agency around and should essentially be the lead agency except when there is a financial crisis and more political entities, such as Treasury need to get involved.
There are some other comments I have on the report’s recommendations that did not fit into the main theme of the previous post.

First, the report’s recommendation that the SEC and the CFTC be merged is one with which most disinterested observers have agreed for a long time. It has long been obvious that a mistake was made when the CFTC was created in the mid-1970s from its predecessor agency, the Commodity Exchange Authority, which was part of the Agriculture Department. The advent of futures on foreign currencies and subsequently other financial instruments, which were not covered by the Commodity Exchange Act (“CEA”) at that time, made some sort of change necessary. But rather than transferring authority for futures and “commodity” options to the SEC, the CEA was modified so that the definition of “commodity” encompassed potentially almost everything imaginable (with the amusing exception of onions), including securities and indices of all sorts, while leaving the definition of “futures contract” undefined. This first led to jurisdictional issues with the SEC, which were initially papered over with the Shad-Johnson Accord in December 1981 (named after the then chairmen of the SEC and the CFTC). I remember discussing the Shad-Johnson Accord with my boss at Treasury at the time. We concluded that it resolved some existing, troubling jurisdictional issues, but that it did not solve the jurisdictional problems due to the way the CEA could be interpreted and the overlapping interests of the two agencies. We were right. (Most significantly, the lack of definition of futures contracts led to a large public debate among the CFTC and other financial regulators about whether OTC swaps were covered by the CEA. This was never resolved and has been overtaken by various amendments to the statutes which the CFTC, the SEC, and the bank regulators administer. Another provision of the CEA, known as “the Treasury Amendment” led to a dispute between the Treasury and the CFTC about it jurisdiction over OTC foreign currency options. An aspect of that dispute went to the Supreme Court in a 1997 case in which Treasury was not a party. The CFTC lost, nine to zero.)
Given that most of the contracts the CFTC now regulates are financial, it has long made sense that the SEC and the CFTC be merged. For example, it makes no sense that stock index futures and options on stock index futures are regulated by the CFTC, while option on the same stock indices are regulated by the SEC. The political problem is that the CFTC falls under the jurisdiction of the Congressional agriculture committees, which do not want to cede their authority over the CFTC.

However, while the report is right in calling for a SEC/CFTC merger, the recommendation that some of the authority that now exists with these agencies should be transferred to a new regulator is more problematic. The report recommends that a new prudential supervisory authority (“PSA”) be “responsible for supervising broker-dealers, swap dealers, FCMs [futures commission merchants], and MMFs [money market mutual funds].” (p. 36) The new SEC-CFTC merged agency would have “the current rulemaking authority of the SEC and the CFTC with respect to matters of investor protection, the structure of securities and derivatives markets, and the integrity of those markets.” (p. 36) The report is silent about whether the SEC-CFTC agency would have any examination authority.
This structure looks like one asking for turf fights. Dividing the responsibility for the structure of markets, their integrity, and investor protection from responsibility for overseeing the principle market makers and conduit to the marketplaces is unlikely to work very well. One wonders why the authors of this report, after correctly identifying that merger of the SEC and the CFTC would improve the regulatory structure, then go on to weaken the combined agency and create other problems.

Another weakness of the report is the failure to address the insurance industry and the mortgage markets. The report specifically states that regulation of the insurance industry and the mortgage markets “are beyond the scope of [the] report.” (p. 5) Perhaps, the authors were perplexed about what to do in this area, because there has no decision about Fannie Mae and Freddie Mac and reforms to insurance regulation means taking on state regulatory agencies. Nevertheless, this is a significant weakness in the report since both the mortgage market and an insurance holding company were heavily involved in the 2008 financial crisis. The involvement of the mortgage market does not require any elucidation here. With respect to insurance, an affiliate of AIG took on more risk than it can handle from other financial institution through the use of credit default swaps. This turned out to be a major problem during the financial crisis. AIG was nominally regulated by the Office of Thrift Supervision (“OTS”) as a savings and loan holding company because it owned a savings and loan, but OTS did not (and probably did not have the capacity) to do much supervision of AIG. The Dodd-Frank legislation abolished OTS and merged it with the OCC. The savings and loan holding company responsibilities were transferred to the Fed. An insurance company could fall under some federal oversight under Dodd-Frank if it is deemed to be a systemically important financial institution even if it does not own a thrift institution, but, given the large role insurance companies play in the financial system, the report’s omission of any discussion or recommendations of how they should be regulated is significant.
Another important omission of the report is the lack of any discussion of the too-big-to-fail issue, which has arguably gotten worse after the financial crisis. The report also does not discuss whether the contention that the resolution procedures of Dodd-Frank would work, especially for large, complex, international financial institutions subject to the courts and differing legal systems of multiple jurisdictions.

Finally, fewer regulatory agencies, as this report recommends (though in a flawed manner), may mitigate the regulatory capture problem but will not eliminate it. For example, of all the regulatory agencies, the Fed is the most powerful and the most able to withstand both political and industry pressure, but the evidence suggests that it is not immune from regulatory capture. (The Carmen Segarra tapes are one example; the decision to pay AIG swap counterparties in full is possibly another.)  Paul Volcker is someone ideally situated to think about and make recommendations about what to do about regulatory capture. I hope he will.
As it is, though, the Volcker Alliance is going to have to do better to contribute meaningfully to consideration of changes in the U.S. financial regulatory structure. The current report is, unfortunately, disappointing.