Banking Reform Comes Through the Back Door

“A Humbling Transformation”

After many high profile failures to reform banking, thwarted by the power of the banking lobby, including efforts to break up banks “too big to fail,” it now seems that a simple and obvious rule has made a significant difference. The Federal Reserve ruled that they simply had to keep more cash on hand to cover potential losses.

For many years, including those leading up to the credit bubble and the 2008 crash, banks ingeniously tried to increase the leverage of their assets. They took liabilities such as mortgage debt and repackaged them as bonds, simultaneously removing them from the negative side of their balance sheets and creating new products to sell, in effect, adding new assets.

Assisted by the ratings agencies that did not fully grasp the slight of hand involved and gave the bonds “Triple A” ratings, those bonds proved wildly popular with investors. That is, until the collapse of the housing industry exposed the fact that the bonds were not actually assets, but based on debt, bad debt. Subsequently, the Fed ruled that the banks had to keep more cash on hand, real cash, not speculative cash.

The banks’ efforts to thwart this new rule were ineffective because the logic behind it was so obvious. Clearly, banks had to remain solvent to protect those who entrusted their money to them, and they had failed at that, forcing the government to bail them out. Then the role of the mortgage-backed securities in our economic collapse was obvious when tens of thousands of home-owners defaulted on mortgages that the banks and mortgage companies who sold them knew they had little chance of paying off. The bonds then proved virtually worthless.

This common sense step has led to what The New York Times has called “a humbling transformation” in the banking industry. The banks had gotten used to huge profits as a result of their freedom to speculate.

This new rule, obvious in the light of what happened, has led to what
the New York Times has called “a humbling transformation”
in the banking industry. Now with their hands tied, unable to
speculate as freely as before, “Bonuses are shrinking. Revenue growth
has stalled. Entire business lines are being cut.”

As Timothy Geithner, the former Treasury secretary, put it: “We have substantially reduced the amount of risk they can take.” Less risk, less profit – but less risk to us all.

There is something relieving to see common sense, once again, at work in the financial industry. We have gotten used to thinking only Nobel laureates could understand it, which has had the effect of making us all vulnerable to fraud. Perhaps there can be an influx of common sense in other ways as well: cutting taxes reduces revenue, does not increase it; eliminating estate taxes does not benefit the poor, who have no estates; moving our businesses off shore only benefits shareholders, not job holders, while forcing government to raise revenue elsewhere.

The Times quoted a bank analyst: “You are hard-wiring a change into the banking industry. . . . When we look back 10 years from now, we are going to say the biggest impact was from capital rules.”