Financial crisis

Meet our new regulatory structure, almost as bad as the old one.

By David Andrew Singer

Last week, the administration of U.S. President Barack Obama released a wide-ranging plan to reform the regulation of financial institutions and markets. Pundits and economists, pleased by the attempt to control "too big to fail" institutions and systemic risk, met the plan with guarded caution.

Harsher criticism would have been warranted. The proposal falls short, as it fails to address a crucial problem: the United States' fragmented, and thus broken, financial regulatory structure. Indeed, rather than emulating the world's best regulatory systems -- which are streamlined and unitary, like Canada's -- the United States has simply dusted off its current Balkanized system and tried to pass it off as new. American companies and investors deserve better.

Of course, Obama's proposal includes many sensible reforms. For example, all nationally chartered banks would be supervised by a new national bank supervisor, rather than multiple agencies. Financial holding companies would be subject to strict capital and other prudential standards, thereby closing the loophole that AIG, Bear Stearns, and other institutions exploited for enormous financial gain (but which ultimately led to their downfall). And hedge funds and other private pools of capital would have to register with the Securities and Exchange Commission (SEC) and open themselves to monitoring.

However, as the biggest regulatory overhaul since the Great Depression, the proposal leaves much to be desired. It would abolish just one regulatory agency -- the Office of Thrift Supervision (OTS). Accountability for financial stability, whether of individual firms or the entire system, would continue to be spread thinly across the Federal Reserve, Treasury Department, and an alphabet soup of bank, securities, and insurance regulators.

The national bank supervisor would not have jurisdiction over thousands of state-chartered banks, which could still choose to be regulated by either the Federal Deposit Insurance Corporation (FDIC) or the Fed. Fifty separate state regulators would still oversee insurance companies, with only a new token Office of National Insurance to "coordinate" their disparate regulatory regimes. The Commodity Futures Trading Commission and the SEC would remain institutionally separate, despite the clear overlap in their jurisdictions. Complex financial institutions such as Bank of America would continue to face a multitude of masters, including the new national bank supervisor, the Fed, and the SEC.

This regulatory hodgepodge inevitably creates loopholes to be exploited. In the past, banks and other financial institutions have been able to to play regulators off one another. For instance, in 2007 OTS actually courted Countrywide Financial away from another agency by offering more-flexible oversight. There's too little in the Obama proposal that promises to stop such malfeasance.

Another troubling part of Obama's proposal is the creation of a Financial Services Oversight Council to "identify emerging systemic risks and improve interagency cooperation." In place of regulatory consolidation, the new council would give the full gamut of regulators a seat at the table and no doubt invite the very turf wars and blame shifting that contributed to the financial crisis. The need for such a council reflects the underlying fragmentation that should be rectified -- and not by committee.

The United States has much to learn from other rich countries -- Australia, Canada, Finland, and South Korea, for instance -- that have simplified their regulatory structures. Financial institutions in these places, from the largest holding company all the way down to the smallest subsidiary, have a single regulator. Requirements are clearer and better enforced as a result.

Moreover, central banks in these countries are focused solely on keeping prices stable and monitoring systemic risks. The Fed currently has a dizzying array of responsibilities, from administering the White House's distressed-asset programs to determining if a company is overleveraged. It is difficult to imagine it will succeed, particularly with other Balkanized agencies muddying the waters.

The time has come for the United States to rationalize its regulatory structure by simplifying it. The rest of the world is waiting.

David Andrew Singer is assistant professor of political science at the Massachusetts Institute of Technology. He is the author of Regulating Capital: Setting Standards for the International Financial System.

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Governments across Europe are about to slash their defense budgets -- but they need to ensure they cut correctly.

By Tomas Valasek

The economic crisis has wracked government budgets across Europe, as revenues have fallen and spending on stimulus and bailouts has soared. Already, there are signs that defense spending across the continent will suffer. Finance ministers will be looking for ways to reduce deficit and debt, and military budgets are a tempting target.

Such budget cuts will have some salutary effects: Defense establishments, with their resistance to civilian oversight and emphasis on continuity, tend to get bloated in times of relative plenty. It often takes a crisis to force meaningful reforms. But cuts also threaten to sap the effectiveness of European fighting forces and leave parts of the world exposed to insecurity.

The easiest portion of the budget to cut is operations. But it's also the most important portion. Withdrawing soldiers from faraway places plays well at home and requires no layoffs, but it means fewer troops in some of the world's most imperiled regions. Poland announced in April that it would withdraw from all U.N. peacekeeping operations. While the Poles may be no less safe, fragile countries such as Chad and Lebanon still need foreign troops to keep the peace.

Rather than withdrawing from conflict zones, European countries and agencies should stop sending overlapping missions to the same trouble spots. Both the EU and NATO sent missions to Sudan in 2007, and three different forces are currently fighting piracy off the coast of Somalia. Better to roll those operations into one; the current duplication wastes taxpayer money.

As defense ministries slash their budgets, their instinct will be to cut multinational weapons programs and make any purchases domestically so as to protect jobs at home. But that carries risks. Many truly necessary systems, such as transport airplanes, are so expensive and complex that they are best funded and shared between countries.

Granted, many past collaborative programs have been disastrous, such as the seven-nation plan to develop the A400M military transport aircraft. A modern-day Spruce Goose, the plane cannot fly because its engines, made by a four-nation European consortium, lack the proper certification; the plane is also said to be too heavy.

But the trouble with the A400M lies not in the collaborative nature of the program. The plane is a failure because its designers have been more concerned with securing production jobs than with obtaining a good product. In return for investing in the aircraft, they have demanded that a commensurate number of production jobs go to their country. As a result, bits of the plane are being built all over Europe -- and not necessarily in the countries most qualified to do the job.

European governments must be smarter. They should accept that it makes more sense to order the needed parts from the plant with the most relevant technical expertise. The governments also need to be more ready to buy off-the-shelf components, rather than try to generate jobs by manufacturing parts from scratch.

The impact of the budget cuts -- particularly the reductions in personnel and equipment -- also threaten to turn some European militaries into showcase forces, incapable of deploying abroad and thus irrelevant to most EU and NATO operations. It makes little sense, for example, for all but very few allies to keep tanks unless they are upgraded to be able to operate in faraway places such as Afghanistan and unless the governments have access to aircraft big enough to transport the tanks. As an excellent new study commissioned by the Nordic governments concluded, "small and medium-sized countries lose their ability to maintain a credible defence" when certain units shrink too much.

There are two ways to avoid such outcomes while cutting budgets. Some of the key equipment that makes modern warfare possible -- such as planes providing air-to-ground surveillance or military transport -- needs to be jointly owned. NATO operates a common fleet of aircraft that coordinates air traffic, and the alliance plans to buy transport airplanes for its members to use. This arrangement allows militaries of smaller and poorer European states, like the new allies in Eastern Europe, to take part in complex operations in distant places.

But that alone will not generate enough savings. Indeed, the time has come for European governments to consider abandoning parts of their national forces and infrastructure and to form joint units with their neighbors. Modern militaries do virtually all their fighting abroad and in coalition with others. If they lack the money to equip and deploy their soldiers overseas, they need to consider radical cost-saving measures. More governments should do as Belgium, the Netherlands, and Luxembourg did -- they merged parts of their air forces -- or emulate the Nordic countries, which are considering joining their amphibious units.

Most European governments have, in the past, found it too difficult to part with the cherished symbol of national sovereignty that is a proper army or an air force. But the practical value of such military services in Europe is often negligible. As the recession deepens, defense ministers across Europe should see the crisis as an opportunity to combine certain units and programs across countries. This will save money, which could be put to use properly training and equipping forces for EU and NATO operations.

Tomas Valasek is director of foreign policy and defense at the Centre for European Reform in London. A version of this article first appeared as a post on the Centre for European Reform blog.

Photo: Flickr user Jerome K

The Obama administration is sending mixed messages about bad banks.

By James Kwak 

One of my backgrounds is in marketing. A key goal in marketing is to identify your one main message and communicate it as clearly and consistently as possible. The Obama team did this masterfully during the presidential campaign. Unfortunately, it is having less success doing this when it comes to the crisis in the financial sector.

The core problem is that people lack confidence in the long-term strength of some of the largest U.S. banks. The stress tests whose results will be announced on Thursday, May 7, (and are leaking out daily) make sense as a regulatory measure: By forecasting how banks will be affected by a severe recession, the tests should indicate which banks are healthy, which need more capital, and which (if any) are hopelessly insolvent and should be closed. If people think that the tests are sufficiently rigorous, then they should have confidence in the banks that survive.

However, administration officials are torn between two alternative messages. On one hand, they fear that revealing negative information about major banks could cause a panic, so the first message is that the financial system is doing just fine, thank you. Treasury Secretary Timothy Geithner said on April 21, "the vast majority of banks have more capital than they need to be considered well capitalized by their regulators." A New York Times article in April was even blunter: "Regulators say all 19 banks undergoing the exams will pass them."

On the other hand, no one will believe the results of a test that all banks are able to pass. So the second message is that the administration is taking the problems in the financial sector seriously and not coddling the banks.

The result is a message that goes something like this: "Some banks have health issues, but those issues can be resolved through proper diet and exercise" (additional capital). This is the message that is leaking out with the test results (Bank of America needs $34 billion, Wells Fargo $15 billion, Citigroup $10 billion). Ideally, the numbers should be big enough to be credible, but small enough to avoid panic.

The positive reaction of bank stock prices to these leaks implies that the administration has achieved its first objective of not causing a panic. However, achieving the second objective of showing seriousness will be more difficult because ultimately it requires actually fixing the banks' balance sheet problems. On this front, the outcome is less clear.

First, the results of the stress tests are being negotiated between the banks and the government. One theme of the financial crisis is that as the banks have become more dependent on the government, the government has also become more dependent on the banks -- to not blow up and damage the economy. If the final capital requirements are the product of negotiation, rather than rigorous, objective analysis, they are less likely to be believed.

Second, the banks will have the option of meeting their capital shortfalls simply by converting the government's existing preferred stock investments into common stock -- an accounting trick that provides no new cash to the bank.

Ultimately, the success of the tests will depend on how much information the administration provides. If the results enable investors to make independent judgments about banks' health and the banks are able to raise the required capital from the private sector, then that will go a long way toward restoring confidence in the system. If the stress tests remain a black box and we simply have to trust that they accurately reflect the banks' condition, then we will go right back to where we started. Undoubtedly, some of the brightest minds in Washington are struggling with that marketing question right now.

James Kwak is a student at Yale Law School and coauthor of the economics blog The Baseline Scenario.

Photo: Justin Sullivan/Getty Images

The EU wants to cut deficits. What is it thinking?

By Desmond Lachman

One has to be struck by the oddity and poor timing of the European Union's call on Greece, Ireland, and Spain to begin reducing their budget deficits. At the very time that the International Monetary Fund is counseling countries to engage in aggressive fiscal stimulus to fight the worst postwar global recession, the European Union is pushing for belt-tightening. And it is doing so for those euro-zone countries that are hardest hit by the global economic crisis.

Greece, Ireland, and Spain are all neck-deep in recessions of epic proportions that will soon raise unemployment to the highest levels in the past 70 years. In Ireland and Spain, the bubbles bursting in the housing market make the United States' own predicament look benign. All three countries also must cope with a global collapse in trade and tourism.

Under usual circumstances, a country experiencing a recession of this proportion would sharply reduce its interest rates and allow for a sharp depreciation of its currency. However, stuck within the euro zone, Greece, Ireland, and Spain have to live with interest rates set by an overly cautious European Central Bank (ECB) and a euro whose relatively high price on world currency markets renders their economies grossly uncompetitive. At the very least, these countries should be allowed a reprieve from having to fight widening budget deficits even as their economies weaken.

History is littered with examples of fixed-exchange-rate countries that have tried and failed to balance their budgets in deep recessions by raising taxes and cutting expenditures. In counseling budget tightening for Greece, Ireland, and Spain this week, the European Union seems blithely oblivious to this experience. Policymakers in these countries need only look as far as the Baltic countries to see that economic collapse is being exacerbated by hair-shirt budget tightening.

Rather than counseling budget austerity for Greece, Ireland, and Spain, the European Union would be better advised to push for aggressive fiscal stimulus in Germany, Europe's major economy. Or how about a decidedly more expansionary monetary policy from the ECB? The German government itself now concedes that, with present policies, the German economy will contract a staggering 6 percent in 2009 before recovering only marginally in 2010. Absent more vigorous growth in that country, it is difficult to see how Greece, Ireland, and Spain can extricate themselves from deep recessions -- even if they ignore the European Union's advice. This time, the real deficit to watch out for is that of common sense.

Desmond Lachman is resident fellow at the American Enterprise Institute.

Photo: SAMUEL KUBANI/AFP/Getty Images

The International Monetary Fund now has $750 billion to lend to needy nations during the Great Recession. But will the additional capacity hurt the IMF's mission? 

By Martin Edwards

Two years ago, global economic consensus held that the International Monetary Fund -- the lender of last resort for ill-managed countries with a desperate, immediate need to borrow -- was dying or dead. Its bungling of the Asian financial crisis in 1997 harmed its reputation; the availability of foreign capital made it obsolete.

But global economic consensus now holds that the IMF will play an integral part in alleviating today's crisis. The "Great Recession" has created a strong demand for its lending, and the G-20 countries tripled its resources to $750 billion at their latest conference. Once a black sheep, the IMF overnight became the world's economic shepherd.

Yet the reforms undertaken to expand the IMF dramatically alter its modus operandi and fundamental purpose. They might even make the fund less effective over time.

At the latest G-20 conference, the IMF announced two major changes in response to the global economic crisis: It eased the conditions on its standard loans and created a new lending facility for approved countries. Standard IMF loans now have negotiable installment schedules and easier conditional restrictions. Countries were once required to make big changes -- rewriting their tax codes, for instance -- in order to receive loans. Now, the fund is much less aggressive in cleaning up governments' acts. Second, the IMF created the "Flexible Credit Line" (FCL) program to provide loans to countries with strong macroeconomic fundamentals. FCL loans have essentially no conditions whatsoever -- and Poland, Mexico, and Colombia have already received them.

Thus, the IMF has greatly expanded and turned itself into a provider of loans to prevent crises, not just alleviate them. The amount pledged to fund borrowers is now twice as much as was committed at the height of both the Asian crisis in 1998 and the Latin American crisis in 2002. That is all well and good for the Polands and Colombias of the world. Their IMF loans will surely help them avoid economic catastrophe. But it isn't necessarily good for either the developing countries that may be worst hit by the crisis, or for the IMF itself.

Indeed, with its much-heralded unveiling of the FCL, the IMF placated G-20 countries unwilling to provide loans to struggling countries themselves. Industrialized countries, such as the United States, pledged to lend directly to the fund to meet the $750 billion goal. But middle-income emerging countries, like Brazil, Russia, India, and China, proposed to provide resources in the form of purchases of IMF-issued bonds, rather than permanent lines of credit. These new resources will help the fund better meet the challenges of the economic crisis in the short term. In the long term, however, they mean that Brazil, Russia, India, and China will have a greater procedural voice within the fund. The golden days of the IMF being autonomous and distant from the desires of developing countries has surely reached an end.

Second, the fund's easing of conditionalities stemmed from a perceived need to reduce the stigma associated with seeking a loan from the IMF. But many countries value these conditions and tolerate the stigma. In a weak state, politicians might not want to take vital steps that will be electorally costly, such as cutting government spending or raising taxes. The fund plays a valuable role as a scapegoat, providing political cover for policymakers and ensuring changes are made. Making conditionality "cheaper" by reducing the stigma, then, may net the IMF more loans as states with weak commitment seek fund programs, but it is not likely to produce the reforms many of these countries urgently need.

These developments should temper our enthusiasm about the reemergence of the IMF. A more responsive fund is not necessarily a better one. Having a degree of autonomy from member states allows international organizations to be influential. The conditionality reforms, combined with the likely exchange of bond purchases for more voting power, by diminishing this autonomy, may make the fund's new prominence brief indeed.

Martin Edwards is assistant professor at the John C. Whitehead School of Diplomacy and International Relations at Seton Hall University and the author most recently of "The International Monetary Fund, Conditionality, and the World Economic Crisis: New Beginning or False Dawn?" (pdf).

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