Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz professor of entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”
In an important speech on Feb. 21, Kara Stein, a commissioner at the Securities and Exchange Commission since August 2013, laid out a powerful vision for how regulation should operate in the United States. She put much more focus on reducing unacceptable systemic risks and on cooperation between the S.E.C. and other relevant agencies.
At the moment, some of her colleagues at the S.E.C. seem to lack sufficient drive in terms of deciding on crucial regulatory issues and pushing forward on them. Let’s hope the S.E.C. chairwoman, Mary Jo White, will agree with Ms. Stein that the pace of carrying out reforms needs to accelerate — and that important potential loopholes in the regulatory system need to be closed.
As Ms. Stein emphasizes, the S.E.C. has become more forceful on enforcement in the last couple of years, and the organization should get appropriate credit for this change. The lack of sufficient enforcement before 2007 and immediately after the crisis of 2007-8 remains a stain on the reputation of the S.E.C. and, frankly, created a credibility gap that needs now to be overcome. (To be clear, I am not happy with enforcement in the financial arena more broadly, but I would put more emphasis on failings at the Department of Justice.)
The S.E.C. is also an important writer of rules. And it is on this dimension that Ms. Stein stresses that there is unfortunately insufficient progress to report.
The Dodd-Frank Act requires that the S.E.C. work, through writing or amending, on more than 100 rules. A significant amount of this work remains to be done, including on money market funds and on the ability of shareholders to claw back compensation from executives who run their companies onto the rocks.
The problem is not so much the amount of work as a tendency to fall back into the bad old habits that prevailed before 2007 — this (and what follows below) is my assessment, not what Ms. Stein says.
The Financial Stability Oversight Council was created in order to help regulators work together effectively. It has helped on a few issues, including nudging things forward on
money market mutual funds, but over all its effectiveness has been disappointing. Part of the problem may be lack of full cooperation from the S.E.C. and some other regulators. Fighting to protect turf is not good
for the health of the overall financial system.
The Federal Deposit Insurance Corporation is pushing hard for meaningful change — for example, see my recent assessment of the work being done by its vice chairman, Thomas Hoenig. The Federal Reserve System is more uneven, but some people at the top want to carry out real change. For example, the F.D.I.C. and the Fed are now putting more emphasis on the leverage ratio — the total amount of assets that a financial company has, relative to its shareholder equity, without making any “risk-weighting” adjustments. This is a sensible step in the right direction.
But the S.E.C. needs to get on the same page, in part because that agency regulates broker-dealers, which trade securities and are a significant part of some large banks. Broker-dealers can easily increase borrowing (that is, take on more debt), which increases leverage of the overall bank and the risks to the system. Where is Ms. White on the core set of issues surrounding the regulation of capital and reasonable limits on leverage?
At the moment we just do not know. (There are five S.E.C. commissioners, but Ms. White is widely regarded as holding the decisive vote on important issues.)
A further fascinating example is provided now by collateralized loan obligations. Large, complex financial institutions — known as L.C.F.I. to officials, and as too-big-to-fail banks to the rest of us — are trying to argue that they should be allowed to invest in these financial instruments just as they were allowed to hold other kinds of securitized instruments (with multiple tranches) before the financial crisis.
These issues are complex, but Adam Levitin of Georgetown University has kindly provided a very good primer on the issues in recent congressional testimony.
Insured banks and other regulated financial institutions have an incentive to hold assets in such a way as to limit the amount of equity they are required to use in their funding. Again, this is about bankers wanting to raise leverage, as this increases their return on equity — and compensation — when things go well. When things go badly, of course, it’s a major problem, but — the people running too-big-to-fail banks hope — for someone else. (Anat Admati and Martin Hellwig’s book, “The Bankers’ New Clothes,” is the must-read text on the core incentive issue.)
An effective way for big banks to become more leveraged before 2007 was to set up an “off-balance sheet” entity that was allowed to be thinly capitalized because any losses supposedly could not become a responsibility of the bank. But banks have repeatedly provided support to — and therefore incurred the losses due to — legally separate funds. As Professor Levitin points out on Page 11 of his testimony, “We have seen it happen repeatedly with credit card securitizations,” and it also happened in a number of prominent cases in 2007 and 2008, including two “nominally independent, external hedge funds” that were bailed out by Bear Stearns.
Working with other regulators, the S.E.C. must guard against collateralized loan obligations’ becoming the next big loophole in capital requirements and in the Volcker Rule (which prohibits banks from taking this kind of dangerous risk).
More broadly, as Mr. Levitin put it, “The S.E.C. needs to take its systemic stability mandate just as seriously as it does its investor protection mandate.” If Ms. White listens to Ms. Stein, the S.E.C. will head in that direction.