Interveiw with Rob Johnson and Sony Kapoor on 'Too Complex to Fail'
Too complex to regulate? by Andrea Orr, Economic Policy Institute
http://www.epi.org/analysis_and_opinion/entry/too_complex_to_regulate/
Lawmakers seeking to prevent a repeat of the greatest financial meltdown since the Great Depression are considering ways to impose tighter regulations on big investment banks, where trading of credit default swaps and other derivatives reached unsustainable levels, helping bring the economy to the brink of disaster in 2008. Although they are commonly described as a form of insurance against defaults on home mortgages, the credit default swaps sold by A.I.G. and other firms became so widespread and complex over the past decade that it became almost impossible for the banks themselves, let alone outside regulators, to sort out the real value of these popular investments or assess the risk.
The rise in trading of derivatives — sophisticated financial instruments whose value is derived from something else such as home mortgages — also underscores how far so many banks have strayed from what should be their main mission of providing lending to individuals and small businesses to help support growth in the general economy. Critics note that derivatives trading escalated to a rapid back-and-forth exchange of paper certificates where the value often had little connection to real economic activity.
If “Too Big to Fail” and “Too Connected to Fail” have become the slogans justifying the repeated government bailouts of some major banks and insurers such as A.I.G., these firms’ continued resistance to tighter government restrictions might be summed up as “Too Complex to Regulate.”
That complexity is neither necessary nor useful, argue Robert Johnson, an EPI board member who previously served as managing director of Soros Fund Management as well as chief economist for the Senate Banking and Budget Committees; and Sony Kapoor, a former investment banker who now heads the international think tank Re-Define (Rethinking Development, Finance, and Environment). In recent interviews, Johnson and Kapoor discuss how Wall Street uses extreme complexity as a shield to pad its profits and keep regulators guessing, and why banks need to return to the sort of activities that serve people on Main Street.
Q. The trading of derivatives and credit default swaps, which are at the core of the current economic instability, are often presented as something that is too complex for the average person to understand. Why?
Johnson: They (the banks) make things hard to understand so they cannot be easily copied, which enables them to charge a higher profit margin. Complexity in and of itself doesn’t help them avoid regulation, but their declaration of instruments such as credit default swaps as stock when they are actually insurance contracts was a misnaming designed to avoid regulation.
Kapoor: Wall Street has a very strong incentive to make things as complex as possible. Complexity is used as a tool to fool regulators and to avoid tax. You set up new subsidiaries, you make new products that haven’t been addressed by regulations. Regulators are very hard-pressed to get any information.
Q. It’s been pretty well documented how the rise of credit default swaps contributed to the demise of some major investment banks. How have they contributed to the pain much of the rest of the country is feeling in the form of lost jobs, lost homes, and general economic instability?
Kapoor: Risk taking is essential to the creation of jobs and economic prosperity, but risks need to be taken by those who understand them and have the capacity to bear them. But in pursuit of profits, the banks ended up sending the risks to nontransparent corners of the market, and to less sophisticated actors who did not understand the risk, and to entities such as pension funds that did not have the capacity to bear it.
Johnson: There were two problems. First, the credit default swaps were commonly treated as income, rather than as the equivalent of an insurance policy, which might have to be repaid. And two, they were allowed to be written on third-party risks. It was as if I were allowed to bet on whether someone else’s house was going to burn down, which is not the way insurance usually works.
Q. At its peak, the size of the credit default swap market was $45 trillion. How did it get so big?
Johnson: It got so big because there were no transactional costs and no regulation. It was a completely unregulated market.
Q. What were the warning signs that should have been heeded?
Kapoor: When you have banks earning a 25% return on equity in an economy growing at only 3 or 4%, that is not just a warning bell, but a clanging fire alarm. Everybody rationally knew it was not sustainable in the long run but as long as the music was playing, the banks were going to keep dancing. It was not in their interest to stop, which is another reason you need regulation.
Johnson: Complexity was also a problem. When you shock a system, complexity makes it difficult to assess the counter parties. The other big institutions are also highly leveraged and you can’t assess whether they are solvent or insolvent. They become un-analyzable. They don’t even know themselves. When you have a situation where several big institutions are intertwined with each other and some are insolvent, there is a cascading effect that can make them all insolvent.
Q. What are your thoughts on the proposals put forth in the Obama administration to step up regulation?
Johnson: I think it is a step in the right direction, but it is probably not sufficient. The proposals for regulating over-the-counter derivatives favor the finance industry too much. I understand they are also considering a form of the Consumer Product Safety Commission to oversee derivatives trading, which would be a move in the right direction.
Kapoor: A lot of people are saying, let’s save the system first and then regulate. But in my understanding, these two issues are inseparable. Crisis came about because of a total breakdown of trust. That issue of trust cannot be resolved by going back to business as usual.
Q. The history of Wall Street seems to be a series of financial scandals, followed by calls for stricter regulation, and then a scandal of a different sort arising a few years later. Given the complexity on Wall Street, and bankers’ strong interest in avoiding regulation, can we realistically expect anything to change for the better? What is needed to accomplish meaningful regulatory reform?
Johnson: I would say that if you look at A Short History of Euphoria (John Kenneth Galbraith), it makes the point that financial markets are treated like they are rational, and yet the history of markets is one of boom and bust and crash. Many people prescribe remedies without accurately diagnosing the animal. Understanding that markets do not behave rationally makes you realize that they need much greater regulation. They need much greater capital set-asides.
Big banks should be like public utilities, where they perform a stable function. Casinos and hedge funds ought to be separate from the banks. In recent years, the banks used deposit insurance to get funds for their casinos. Society has been subsidizing the funding of these institutions and their volatile, risky activities.
Kapoor: Subsequent to each crisis, the regulatory reforms that have happened have addressed the particular cause of that crisis. None have addressed the fundamental instabilities that lie at the heart of finance. It is remarkable not how much it crashes, but how little it crashes.
We need to increase competitiveness and reduce barriers to entry in the finance system so that we have more institutions that are not too big to fail. We need a principle of diversity that prevents insurance firms, hedge funds, banks, and Japanese housewives from engaging in all the same investing activities. We also need reforms to bring about simplicity since the financial system left to itself will make more and more complex products designed to maximize profits and minimize regulation. And we need more fairness: a system which in good times pays its fair share of taxes, so that in bad times, it doesn’t take the economy down with it and make taxpayers, workers, and investors pay.
Finally, we need an accountable financial system where it is not good enough to say to politicians, to labor unions, and to Main Street that this is too complex and if you touch it, it will explode. No one touched it, and it exploded anyway. If it is too complex to understand, it is too complex for stability.
Too complex to regulate
As a former Citibank Vice President (retired)in New York, I totally agree with Robert Johnson and Sony Kapoor. As described by Simon Johnson, New York banks form an olligopoly that is so powerfull that the new regulations to be made public by the US Treasury will consist mostly of cosmetic changes leaving the banks free to continue as usual. The present crisis will therefore be followed by a new, more severe crisis in 3 to 5 years. A complete redefinition of the banking regulation body will then be unavoidable and will most likely result in a thougher world for the banks.
A friend of mine and I have decided to form a small group in France to push for reforms that make sense and could avoid this forthcoming mayhem.
Jean-Luc Basle
Instability and the Macroeconomic System
The subjet being discussed is really only the tip of the iceberg, what remains hidden is even more significant and serious. In fact our macroeconomic system has a built-in instability and the business cycles which are felt by it are the result. Not all of these cycles are from the same cause but there is one particularly significant one that seems to occur regularly every 18 years or so, that is due to the land-value (partly real-estate, since most people do not separate the two concepts) inflation "bubbles", which are the basic cause of our present economic woes.
Even without governmental encouragement to speculate in land-values, this process is an on-going thing. Who does not wish to benefit from an expanding community where tax-payers money is being continuously invested in the infra-structure of the community. Thus land values tend to rise and home owners to benefit from the changing values of the land under their homes. Thse values have steadily risen since the last crisis and already there are signs of a new cycle beginning to start up. The trouble is that speculation in land tends to hold it out of use with the result that the competition for the available land further inflates its price and reduces it availability for use.
The building trade is not the only kind of productive process affected. So too are many associated others and the resulting unemployment is all too obvious. Prices are simply too high to encourage demand and this effect is always with us. It is unstable until the failure of sufficient speculators and banks who help them, results in a significant fall in prices and a new cycle will then begin.
Most people blame the government and the banks whose combined policy over recent years is to allow and encourage this booming speculative matter, because it looks like a good thing for all (a sort of free lunch). Unfortunately it cannot go on for ever and when the costs of investment become so high that no more speculation in land is worthwhile, then the growth process breaks down. There is a need to tread carefully here, bank failures are regarded as catastrophic but when the losses are compared to earner's failures and the large numbers whose empolyment has been halted for many years and are debt-ridden, homeless, and poor to a growing degree and we can identify this reason, then it is time for the government to act; even if it necessitates losses by the banks in order to help those who are too poor to help themselves.
The answer is to stop land value speculation and to slowly reduce its cost so that people can afford to house themselves and to work again with the entepreneuers whose limititation due to high cost of leasing land is a basic part of the monopolistic land owning problem and its unavailability. One cannot simply blame the banks nor limit their amount of investment in mortgages, whether these are classed as good or bad kinds. The trouble is more basic and with the system of land tenure.
Land prices should be allowed to fall in a natural manner, when when their values are gradually taxed. (Land Value taxation may take 5 years to fully implement, meanwhile the specuators and banks have a chance to take their money elsewhere.) With land value taxation the resulting income to the public purse will allow for reductions in income tax giving the consumer more ability to spend and increasing the level of demand. The cheaper land will be more freely available. This will help reduce competitive production costs, allowing further demand to be expressed in a greater need for labor and significant reductions in the poverty level. The investment in the local infra-structure will be better used when population and industrial densities have grown due to the cheaper land being more fully used. Land value taxes are almost impossible to hide from since the owner of all of the sites and their comparative values are public knowledge and no exceptions in tax payment are justified. This tax cost less to collect than present income tax due to the many loop-holes that provise the background for a full-time battle between the payers and the collectors
Thus from all viewpoints the terrific (and often unrecognized) pressure which speculation in land values exerts on the national economy and in the bipolar trend of our society will be lifted. It wil be done in a way that is not subject to corruption nor privitation of the national bounty arrising from the land. The cause of the unstable pricing of land will cease and the nation be able to live with a more certain future expectation of a "levelled playing field".
Land value taxation was first proposed by Henry George, famous American economist, more than 130 years ago in his seminal book "Progress and Poverty" which sold more than 4 million copies, but which the landed interests at the time were able to oppose. We are still suffering from this ommission to see the light.
Your submission - "Too complex to regulate"
Very much would like to continue this discussion. You may recall we worked together prior to the shift and changes at Citibank. Great to reconnect and get an update from you!
Margaret A. Gomez
response intended for Jean Luc Basle - re: "Too complex to reg.
Response is intended for Jean Luc Basle.