The Limited Potential of New Financial Regulations


Congress, along with the more than 2,500 financial sector lobbyists, is preparing new legislation which they hope will prevent any further financial meltdowns. Unfortunately, the lobbyists’ interests will keep a good bill from emerging. But what would a good bill include, and just as importantly, not include?

Accurate Representations

Selling a financial product should be no different than selling a lawnmower or an electrical appliance. The seller should provide accurate information to the buyer. Goldman recently did not, and that why the SEC has indicted it for fraud. For most consumer products, the Federal Trade Commission is in charge of regulating sellers. The SEC does it for some financial sellers. But with the rapid expansion of financial sellers (see my recent article), this issue needs to be looked again closely and updated. So far, the SEC does a pretty good job on publicly traded stocks, bonds, and mutual funds. But how about ETFs, hedge funds, private equity companies, etc.? Clearly, new approaches to limited buyer protection are needed.

But the absence of buyer protection did not bring the markets down. For what did, we must look elsewhere.

What Do We Want Government Protection For?

In designing new regulations, this is the key question. It is often overlooked. Certainly, the financial lobbyists do not want to address it. The answer is simple: we want to protect bank deposits. That is why we have FDIC insurance. Do we care if one investment bank or another goes belly up? We do, but only insofar as that would threaten the financial soundness of depository institutions. But why would the failure, say, of Goldman, affect depository institutions? Because banks trade financial instruments, and many of Goldman’s IOUs’ are held by depositary institutions.

The financial freeze occurred because a real estate downturn caused the market in mortgage-backed securities to collapse. Depository institutions by and sell such securities, and bank regulators try to put a value on them in hopes they can keep bank deposits safe. In fact, financial wizards are regularly brought together by the Bank for International Settlements to come up with better standards for bank regulators. We have had Basel I (applied in the US and Europe) and Basel II (applied in most of Europe but not the US), and neither worked: the banking system collapsed after they were put in use.

New regulations for today’s sophisticated financial instruments are doomed to fail. Once one is banned/regulated, another will take its place.

Consider what bank regulators now face in trying to assess the financial well-being of depositary institutions. Go to the Citigroup 2009 Annual Report, and scroll forward starting on p. 195 to p. 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.


What is making the financial reports of depository institutions so complex? Their trading activities. What caused these institutions to collapse in late 2008? Their trading activities.

In 1933, Congress passed the Glass-Steagall Act. It established the FDIC to insure bank deposits. It also required banks to get rid of their trading activities: buying and selling stocks was considered too dangerous for depositary institutions.

Anyone who dispassionately reviews the 2008 banking collapse has to agree with the mandates of the 1933 legislation. Depositary institutions, insured by the FDIC, should not be allowed to engage in significant trading activities.

Loan Management

It used to be quite simple: banks tried to attract depositors by providing:

  • various services for checking accounts and
  • interest on savings accounts.

Banks made money if they could lend out most of their depositors’ money 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. There are still a few banks of this type as we will see below.

But back in the ‘thirties, the Federal regulators worried that banks could not keep the “spread” positive. That is, they feared that banks would not make enough interest on their loans to cover the interest and the other costs of service to depositors. So they decided to create a secondary market for bank loans. Their reasoning was that with the secondary markets, banks would not have to worry about getting the spread right. Instead, they could sell off their mortgages and make money on sales commissions.

In short, fee income replaced spread income. But this change had one very important unintended consequence: it eliminated bank concern over the quality of borrowers. All that mattered was to have a buyer of loans in the secondary market. This move spawned mortgage companies, organizations with no money of their own to lend out, organizations totally dependent on secondary markets to underwrite the mortgages they wrote.

Today, the lenders don’t have to care about the creditworthiness of the borrowers – just write the loan up so we can get our sales commission.

A Bank Comparison

Let’s compare the activities of a small bank with those of a large bank:

  • The Lenox National Bank is located in Lenox, MA. It has 63 stockholders. It makes loans and holds them until they are paid off. President Paul Merlino said they have not had a foreclosure in years. He said the Federal regulators urged him to consider taking TARP funds. He had no interest.
  • Citicorp is a big bank. It does everything mentioned above – trading in securities, buying, repackaging, and sometimes insuring asset-backed securities it sells off, along with creating new financial instruments and trading them. Citi has had a lot of trading problems. As a result, it has borrowed $45 billion in TARP funds and an additional $277 billion in loan guarantees.

My Proposal

The American taxpayer ultimately pays for the insurance services the FDIC provides. As depositors, we want our money to be safe. We understand that to be profitable, banks have to make a little more on its loans than it pays us for deposits. That is fine. But we have absolutely no interest on the other activities of the big banks – selling loans, repackaging them, selling them again, guaranteeing them, and trading.

My proposal is that FDIC insurance should only be given to banks that:

  • manage their own loans;
  • do not engage in trading activities.

In short, I am proposing we go back to the situation as it was in the ‘thirties: banking has to be safe; all peripheral activities such as trading and selling off loans should be spun off.

What are the chances my proposal will be adopted? No good. Why? Because the trading activities of the big banks justify paying their senior executives outrageous amounts. Without trading, banking would again become something that modestly-paid accountants with green eye shades could manage.

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of
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