What We're Reading: Financial Regulatory Reform, October 24

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Wednesday, October 24, 2012

BPC's Financial Regulatory Reform Initiative will regularly highlight news articles, papers, and other important work which illuminate current and new thinking within financial regulation. We circulate these articles to provide a full view of cutting edge ideas, reactions and positions. The views expressed in these articles do not necessarily represent the views of the initiative, its co-chairs, task force members, or the Bipartisan Policy Center.

Compiled by Aaron Klein and Shaun Kern

Letter From International Finance Ministries to the CFTC on Cross Border Swaps

By finance authorities from the European Union, U.K., France, and Japan

“For all its past faults, the derivatives market has allowed financial counterparties across the globe to come together to conduct more effective risk management and, as a result, support economic development. Done properly this should be of benefit to all. At a time of highly fragile economic growth, we believe that it is critical to avoid taking steps that risk a withdrawal from global financial markets into inevitably less efficient regional or national markets. We of course recognise and understand the need for US and other regulators to satisfy themselves on the adequacy of regulation in other jurisdictions. But we would urge you before finalising any rules, or enforcing any deadlines, to take the time to ensure that US rulemaking works not just domestically but also globally.” For the full letter, click here.

House Financial Services Committee Majority Staff Analysis “Too Big to Fail”

By majority staff for Chairman Bachus (R-AL) and Vice-Chairman Hensarling (R-TX)

“But if we judge the Dodd-Frank Act on whether it ‘ends too big to fail’ and whether it ‘ends bailouts,’ we have no choice but to conclude that the Dodd Frank Act is a failure. The largest financial institutions in America remain ‘too big to fail’; in fact, they are even bigger now than they were at the height of the crisis. And the Dodd-Frank Act most certainly did not end bailouts; instead, it institutionalized them and made them permanent in the form of the ‘Orderly Liquidation Authority’ set forth in Title II of the Act.” Read more here.

House Financial Services Committee Minority Staff Analysis of “Too Big to Fail”

By minority staff for Ranking Member Barney Frank (D-MA)

“The Wall Street Reform and Consumer Protection Act addresses the TBTF [too big to fail] problem at its roots by protecting the financial system without protecting the existence of any individual financial firm. It accomplishes this result through two basic means – first, by providing a set of tools to ensure that large, complex financial firms and the financial system in which they operate are more stable and transparent, and that regulators can supervise the financial system and its constituent parts more effectively; and second, by ensuring that a failing financial firm can fail in a fashion that minimizes risks to the financial system without any ultimate cost to taxpayers.” Read more here.

The Origins of the Financial Crisis

By Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson

“A key point in understanding this system-wide failure of risk assessment is that each link of the securitization chain is plagued by asymmetric information – that is, one party has better information than the other. In such cases, one side is usually careful in doing business with the other and makes every effort to accurately assess the risk of the other side with the information it is given. However, this sort of due diligence that is to be expected from markets with asymmetric information was essentially absent in recent years of mortgage securitization… The buyers of these instruments had every incentive to understand the risk of the underlying assets. What explains their failure to do so?

"One part of the reason is that these investors — like everyone else — were caught up in a bubble mentality that enveloped the entire system. Others saw the large profits from subprime-mortgage related assets and wanted to get in on the action. In addition, the sheer complexity and opacity of the securitized financial system meant that many people simply did not have the information or capacity to make their own judgment on the securities they held, instead relying on rating agencies and complex but flawed computer models.” Read more here.

Testimony of the Honorable Phillip Swagel before the Committee on Banking, Housing, and Urban Affairs Subcommittee on Financial Institutions and Consumer Protection, U.S. Senate.

By Phillip Swagel

“The key element for addressing too big to fail is that bondholders take losses. This is likely to be the case, given that the ability to do this is clear in the legislation. In contrast to the resolution of WAMU by the FDIC in the fall of 2008, the imposition of (possibly substantial) losses will not be a surprise to bondholders and therefore should not cause massive spillover effects that adversely impact the ability of other firms to fail. The key is that Title II makes clear that bondholders will take losses.” Read more here.

The Dog and the Frisbee: A paper presented at the Federal Reserve’s 2012 Jackson Hole symposium

By Andrew Haldane

“Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation… Yet despite this complexity, catching a frisbee is remarkably common… It is a task that an average dog can master. Indeed some, such as border collies, are better at frisbee-catching than humans… So what is the secret of the dog’s success? The answer, as in many other areas of complex decision-making, is simple. Or rather, it is to keep it simple. Catching a crisis, like catching a frisbee, is difficult. Doing so requires the regulator to weigh a complex array of financial and psychological factors, among them innovation and risk appetite… Yet despite this complexity, efforts to catch the crisis frisbee have continued to escalate… Ever-larger litters have not, however, obviously improved watchdogs’ frisbee-catching abilities… So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity… In financial regulation, less may be more.” Read more here.