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Home > Uncategorized > Hank Paulson’s Ideas for Financial Reform

Hank Paulson’s Ideas for Financial Reform

February 18, 2010

This is a guest post written by my friend Matt Crespi, a college classmate of mine who works at a prominent public finance consulting firm.

Tuesday’s New York Times (Tuesday, 2/16) featured an editorial by former Treasury Secretary Henry Paulson, discussing how to best manage financial regulatory reform.  Though thoughtful and well-argued, Paulson’s reasoning seems to come up short in a few critical areas.  Unfortunately, his piece seems to be a perfect example of how Washington policy makers, past and present, are better at attacking other ideas than creating and improving their own.

Paulson is right on the money when he alleges that certain regulations proposed by the Obama administration would not have prevented the massive collapses we saw at the height of the crisis.  Limits on trading activity wouldn’t necessarily have brought down Lehman’s leverage ratio or increased its liquidity.  He’s right on the money when he asserts that specific rules governing specific types of activities are of relatively little use.  If anything, he understates things.  Rules can be worked around.  For every cap in percentage, a fee can be added.  For every security regulated, a similar one can be constructed with clever legal work or alignment of derivatives.  For every narrow regulatory power granted, a vehicle can be created to operate outside of its jurisdiction.  And as markets evolve, even apt and appropriate rules can still reach obsolescence with alarming speed.

He proposes two things, but overlooks what many (including this author) consider incredibly compelling arguments.  It’s worth noting that these arguments don’t fall along political lines, and Mr. Paulson is commendable in his nonpartisan approach to the policy recommendations he outlined.  There was no right-wing rhetoric or industry talking points; only thoughtful explanation.

The first proposal is the creation of a “systemic risk regulator” whose job it would be to monitor these large risks and–with the power vested in it by the federal government–make companies cease systemically risky behavior.  It’s a great idea and, on the surface, might seem to be everything need.  If the system isn’t at risk, the government wouldn’t ever need to step in (almost by definition).  Crisis averted.  In fact, crises averted!  Forever!  In Mr. Paulson’s defense, he does acknowledge that a regulatory body won’t catch everything, but it’s up to a critical legislature (not to mention citizenry) to ask, “What evidence do we have to make us believe it would catch anything substantial at all?”

This seems to violate a common (and often correct) conservative argument: government isn’t as good as the private sector at innovation.  While historically that isn’t true in all cases, simple economics would predict the outcome of this tug-of-war.  In a battle of financial ingenuity, Team A pays their guys $500,000 a year, and Team B pays their guys $50,000 a year.  Who wins?  On the off chance that the latter group takes a round, what’s to stop the Team A from firing their PhDs and making the winners an offer most rational self-interested humans couldn’t refuse?  Nothing.  And it’s a lot harder for Team B to fire people and to adapt.  (If you’re playing along at home, give yourself points if you thought Team A was a large bank and Team B was the government.)

Stepping away from an admittedly oversimplified theoretical example, let’s move to the empirical.  Let’s apply Mr. Paulson’s own test (from the paragraph immediately preceding the one in which he suggested this idea): would such a proposal have helped prevent the fall of Lehman Brothers?  Or Washington Mutual?  AIG?  Fannie and Freddie?  Wachovia?  No, no, maybe, probably not, and no (or do your own count).  How can one be so certain?  Many existing regulatory bodies already had the ability to do something about it, and didn’t!  And multiple Treasury Secretaries, Henry Paulson included, could have certainly asked Congress for temporary powers to reign in the risk.

A good regulatory body is necessary, and having a group dedicated to identifying systemic risk is a step in the right direction.  But it’s not enough.  They need to be better armed if they’re to protect basically all of civilization from economic disaster.

Mr. Paulson’s second proposal is to give the government “resolution authority to impose an orderly liquidation on any failing financial institution.”  His analysis suggests that bankruptcy is an inappropriate and dangerous remedy for a failing but important financial institution, especially a complicated one inextricably linked to a large financial crisis.  He’s right, and his recommendation is targeted to directly attack that problem (which it does).  But it’s not enough.  Here, he overlooks a common (and often correct) liberal argument: too big to fail is, in and of itself, a systemic risk.  If some firms are too big to fail, the government’s on the hook to save them.  They have strong incentives to engage in risky behavior (heads they win, tails taxpayers lose), and the implicit future rescue gives an unfair subsidy to the largest players.  Big banks enjoy lower borrowing costs in markets whose participants know the federal government is likely to help them out in a pinch.  This is completely antithetical to smart policy goals in the realm of financial regulation, which should seek to level the playing field and incentivize good service to customers.  Gaming a system shouldn’t be more profitable than generating real value.

Mr. Paulson’s second recommendation is, simply put, a better band-aid.  It’s not a solution, and it certainly isn’t preventative.  Yes, it’s better than bankruptcy, but does it eliminate Too Big To Fail?  At best, it raises the threshold of “Too Big” slightly.  It actually WORSENS the problem of giving big banks special treatment; their lenders and shareholders would get more profitable dissolutions than a bankruptcy.  It’s a softer landing for the economy as a whole, but one that only kicks in after the fact.  The bank has already failed when the resolution authority is invoked, and it doesn’t alter incentive structures in any meaningful ways.  Banks can still play fast and loose with other peoples’ money, and while a bailout is better than Paulson’s soft landing, the executives making the decisions still get paid the same either way (and leave at the same time too).  To change behavior, incentives need to change.

Mr. Paulson proposes interesting and well thought out recommendations, ones worthy of consideration.  But his suggestions are only a few of the building blocks the United States will need for effective financial reform and economic stability.  Most plans that have been thrown out are worthless alone, but great ideas exist on both sides of the political aisle.  We need more discussion like this.  Americans are desperate for financial reform, yet don’t even know what it should look like.  Politicians need to understand that attacking someone else’s puzzle piece in favor of their own is going to get us nowhere.  We need more than a handful of ideas.  Maybe it’s time to start fitting the pieces together, and see what picture starts to emerge.

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