Financial Reform – What Are We Getting?


How can we assess the bank reform legislation? Why not start with the reasons the Western banking system collapsed, and from there, deduce what reforms would be needed to avoid a similar meltdown in the future?

The Western banks collapsed because they were trading assets (packages of mortgage-backed securities) that nobody could value. Recognize that most mortgages were and still are paying on time. It was not being able to value the packages that caused the problems.

Why the problems in valuation? Because by the time the mortgages had been sold off and packaged, nobody had any idea of which ones were safe and which ones were risky. So when the real estate cycle turned down and foreclosures rose (as they always do in a real estate downturn), people started to ask questions about these packages. Ratings? Forget them: they have always been a joke. So suddenly the traders panicked and refused to trade any more of them. Suddenly, the balance sheets of banks and other holders of these securities had a black hole – there was no market for mortgage-backed securities. That led to the bank meltdown and the global recession that followed[1].

Recognize that if only investment banks, hedge funds and private equity companies had been involved, the problems would have been less severe. But this meltdown threatened depository institutions. If a run on the banks had started, who knows where it would have ended.

What do I conclude from this? That another banking meltdown could occur if banks:

  • are allowed to trade with their own capital and
  • are allowed to sell off their loans.

I proposed a simple solution: restrict FDIC insurance to banks that don’t trade and don’t sell off their loans[2].

I also don’t believe more regulation will work because the financial world is too complex for regulators to understand[3].

Below, I briefly summarize these arguments and look at how my arguments are faring in the financial reform bill about to be made law.

No More Trading

Depository institutions should be allowed to trade – too risky. It was trading that led to the bank collapse when there was suddenly no market for asset-backed securities. I was heartened when I received the following e-mail from my Congressman Barney Frank:

I am a supporter of the proposal by Paul Volcker, which the President embraced, to ban proprietary trading by banks.  In fact, before Mr. Volcker got the President’s support, I backed an amendment in the committee that I chair that specifically empowers the regulators to ban proprietary trading by depository institutions, and since the Obama administration has clearly indicated support for that, the effect of that specifically empowers the regulators to ban proprietary trading by depository institutions, and since the Obama administration has clearly indicated support for that, the effect of that amendment – which passed over Republican objections – would be to allow that ban to go into effect as soon as the bill is passed.

Managing Their Own Loans

In earlier times, banks made money if they could lend out most of their depositors’ funds for a higher interest revenue stream than all their services to depositors cost them. In bankers’ parlance, they made money on the spread (the interest rate on loans minus the interest rate paid depositors). Banks knew their survival depended on a positive “spread”, so they watched their loans to individuals (including mortgages) and business very carefully.

My father was a banker, and I estimate that a third of his staff’s time was spent “working” with those they lent money to. Everything changed when banks started selling off their loans. Instead of lending to low risk individuals and firms and worrying about how their borrowers were doing, banks focused on generating commissions by selling off their mortgages and other loans. This constituted a fundamental change in incentive structures – from worrying about the soundness of their loans to writing as many loans as they possibly could for commissions. My view is that as long as banks are allowed to sell off their loans, they will be working to earn commissions and not to make sound loans.

Congressman Frank’s comment on this topic:

As to managing their own loans, I do not think that securitization should be banned entirely because I do think that properly done, it increases our ability to make loans.  But I have objected to the ability of banks to do 100% securitization, so I did sponsor an amendment that was successful in our legislation that mandates the regulators to impose a risk retention on any lender – bank or non-bank.  It will be 5% in most cases, although it can go to 10% for risky loans, but I think that will be sufficient to restrain some of the bad lending because we will be insisting that that 5% loss, if there is any, come off the top.  In addition, we have put some very specific restrictions on mortgage loans to make it impossible for them to do the kind of subprime lending that they did in the past.

At least Frank recognized the danger, but I believe he is confused on the “our ability to make loans” point. Note that allowing banks to sell off their loans does not increase the liquidity of the system: there has to be a buyer for every loan a bank sells off so there is no change in liquidity overall. But the secondary market does give banks the chance to make more loans. But do we want this? When loans made to earn a sales commission, many will not be good loans.


Consider what bank regulators now face in trying to assess the financial well-being of depositary institutions. Go to the Citigroup 2009 Annual Report, page 195 of the pdf. From there, scroll forward to page 237.

The bank regulator is expected to be able to judge the soundness of Citi’s cash flow and derivative hedges, the fair value assumptions, including the changes in the Level 3 fair value category. This is all nonsense. The regulators are not up to the task. They can’t do it.  And new regulations will only make their jobs more problematic

Legislative Results

1. Trading

Still allowed up to 3% of Tier 1 capital. And banks will be allowed to hold on to their swaps-dealing units. Depressing. But here is the killer: the agreed-upon provision calls for federal financial regulators to study the measure, and then issue rules implementing it based on the results of that study. The financial lobbyists will be all over the financial regulators.

And The Huffington Post reported:

Senate negotiators also announced they were carving out a class of financial institutions from the restrictions. The most immediate beneficiaries are State Street Corp., the nation’s 19th-largest bank with $153 billion in assets, and BNY Mellon, the nation’s 13th-largest bank with $221 billion in assets. The exemptions were granted to secure the support of Brown, the Senator from Massachusetts.

2. Banks Managing Their Own Loans

Forget it. Gone. All the bill includes is a requirement that banks must verify that borrowers are able to repay the loans that they issue. And lenders would pay penalties for irresponsible lending. The same incentive structure remains in place: make sales commission money by writing as many mortgages as they can and sell them off.

The legislation also states that mortgage lenders are barred from receiving incentives to push people into high-priced loans. Question: Does this matter when they have an incentive (sales commission) to write as many loans as they can, good or bad?


The legislation calls for the creation of a 10-member Financial Services Oversight Council including the Treasury Secretary, the Federal Reserve chairman, a presidential appointee with insurance expertise, and the heads of regulatory agencies. The council would have wide powers to determine which financial institutions must meet tougher regulations and would have a say in some new consumer financial protection regulations. It also would have the power to break up large financial firms if they pose a grave threat.

Call me cynical, but this “watchdog” does nothing to calm my fears.


We had to do something, and this is better than nothing. There are more hurdles the financial service must jump through before causing another Western banking collapse resulting in a global recession. But the two critical elements to avoid a major banking collapse – banks can’t trade and must manage their own loans – are missing.

The Aftermath

 I lived in Washington for 20 years, and there are enough openings in this legislation for the financial lobbyists to get us back to where we were in early 2008. Binyamin Appelbaum wrote a good article in the New York Times on what will happen next.

Appelbaum points out that there is a lot more work to do:

…Brett P. Barragate, a partner in the financial institutions practice at the law firm Jones Day, estimated that Congress had fixed in place no more than 25 percent of the details of that vast expansion….

 Interest groups have been preparing for months. When the Consumer Bankers Association convened its annual meeting in early June, there was still plenty of time to lobby Congress. But the group’s president, Richard Hunt, told his board that the group should shift its focus to the rule-making process. The board voted to increase the group’s budget and staff. “Now we hope to have a good give and take with the regulators on the best interests of the consumer and the industry,” said Mr. Hunt….

 One clear consequence is a surge in the demand for lawyers with expertise in financial regulation, particularly those who have worked for regulatory agencies. Most of the major trade groups are hiring lawyers. The major banks say they are employing more, too.

Open Secrets reports that the finance industry spent $477 million lobbying in 2008. That number will increase.

[1] For more detail on this, see –

[2] For detail on this, see

[3] This point is made in detail in –

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of
This entry was posted in Global Economics, Global Finance. Bookmark the permalink.