Bank Scandals and Bank Reform Eugene N. White Rutgers University Tangri Forum: Economic Issues in the National Election Rutgers University October 15, 2012

The 2012 Party Platforms Republican Party Democratic Party More transparency for the Fed, an annual audit New gold commission to determine if $ should be linked to gold to prevent inflation No more taxpayer-funded bank bailouts Dodd-Frank: “massive labyrinth of costly new regulations that discourage lending” FDIC insurance “must be preserved” but banks “should be well capitalized” Eliminate Fannie Mae and Freddie Mac, down size FHA Mortgage underwriting standards “to guard against opportunistic litigation” Democratic Party No comment about the Fed No change in monetary standard No more taxpayer-funded bank bailouts, TARP was est. by “last administration” End Too-Big to Fail. Implicit pro-Frank Dodd. “Hold Wall Street accountable, bringing new transparency to financial markets” Refocus financial industry on lending to small and medium firms Consumer Financial Protection Agency will protect public from deceptive and unfair lending BUT FIRST, SOME BACKGROUND…….

Financial Crisis of 2008 & Great Recession of 2007-2010 Recession began in late 2007 Accelerated by 2008 Panic: meltdown of MBS in shadow bank system [Baer, Lehman, AIG], lending collapse Worst post-World War II recession, sluggish recovery and high unemployment----why? housing collapse Fiscal Response: TARP & Fiscal Stimulus The Fed: push down FF rate, special programs to boost liquidity into particular markets (commercial paper), QE1, QE2, Operation Twist , now QE3 FDIC, Fed, OCC bank policy: tighten lending rules, raise capital requirements

Concerns Fiscal Policy, brief stimulus then stopped—too little or just ineffective Monetary Policy, halted panic, disagreement over QE1, QE2, QE3 and Op Twist: necessary or inflation potential + distortions? TARP: Oct 2008 authorize $700 B for purchase of assets and equity from troubled institutions Reduced to $475 B in 2011, actual $431 B disbursed $245 B to banks--$169 B repaid & $51 B from AIG Auto companies $34 B Bailout of Fannie Mae/Freddie Mac—up to $200B from Treasury in preferred stock, use $190 B and pay $46 B in dividends to U.S. government

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 Title I: Financial Stability—two new agencies to monitor system risk and respond to threats Title II: Orderly Liquidation Authority, enable liquidation of large financial institutions—eliminate TBTF Title III: New Powers to OCC, FDIC & Fed and permanent increase in DI to $250,000 Title IV: Regulation of Advisors to Hedge Funds Title V: Federal Insurance Office—give federal government regulatory authority over insurance Title VI: Improvements to Regulation:“Volcker Rule” Title VII: Wall Street Transparency and Accountability: regulates credit default swaps/derivatives---limits OTC

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 Title VIII: Payment, Clearing and Settlement Supervision Title IX: Investor Protection: powers for SEC and GAO Title X: Bureau of Consumer Financial Protection Title XI: FRS: new position of Vice Chair for Supervision Title XII: Improving Access to Mainstream Financial Institutions—credit to low/moderate income households Title XIII: Pay It Back Act: Cuts TARP to $475 Billion and repayments reduce deficit Title XIV: Mortgage Reform and Anti-Predatory Lending Title XV: Miscellaneous [Rules governing “blood diamonds” from Congo

One Summary of Dodd-Frank

Although, the rules aren’t quite finalized…

A Simplified Diagram, pre- Frank Dodd

One PA banker’s plea to his federal bank regulator on bank capital “Just tell me what the rules are and I’ll manage the capital. But, tell me now.”

Continuing Financial Scandals Are they related? Bernie Madoff---a pure Ponzi scheme, complete fraud, a rarity The “Whale Trade” at JP Morgan Chase---relatively unsupervised trader makes huge failed bets—costs billions. Failed chain of command to manage risk-taking. MF Global: John Corzine promised to ramp up firm---moved from forward contracts for customers to taking risky propriety trades, cover losses with funds from customers’ “protected” accounts Each one a specific failure—which combined contributed to the crisis

Can you make banking safe? Should you make banking safe?

Can you make banking safe? Should you make banking safe? Regulations on bank lending, trading and capital to constrain risk-taking Bank supervisors at Fed, OCC and FDIC act to police. BUT there are incentives that thwart safety Deposit insurance and Too-Big-To-Fail create moral hazard---socialization of risk, expanded at every crisis, Deposit Insurance $100,000$250,000. MMMFs Entrenched management---directors weakly controlled by shareholders (may only vote advisory on executive compensation, difficult to nominate outside directors) RESULT: next crisis biggermore rules worse incentives

Was is Reasonable to Expect? If try to make banking perfectly safe so that no depositor or creditor ever sustains a loss, create vast moral hazard from socialization of risk. Ironic: smaller losses requires taking some losses to improve incentives to reduce risk-taking Does the political stomach to swallow this and fight off special interests?

The 2012 Party Platforms Republican Party Democratic Party More transparency for the Fed, an annual audit New gold commission to determine if $ should be linked to gold to prevent inflation No more taxpayer-funded bank bailouts Dodd-Frank: “massive labyrinth of costly new regulations that discourage lending” FDIC insurance “must be preserved” but banks “should be well capitalized” Eliminate Fannie Mae and Freddie Mac, down size FHA Mortgage underwriting standards “to guard against opportunistic litigation” Democratic Party No comment about the Fed No change in monetary standard No more taxpayer-funded bank bailouts, End Too-Big to Fail. TARP was est. by “last administration” Implicit pro-Frank Dodd. “Hold Wall Street accountable, bringing new transparency to financial markets” Refocus financial industry on lending to small and medium firms Consumer Financial Protection Agency will protect public from deceptive and unfair lending