Wednesday, September 30, 2009

Very important article in this week's New Yorker by John Cassidy

About finance reform...

"Our system failed in basic fundamental ways," Treasury Secretary Timothy Geithner acknowledged earlier this year. "To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game."

Despite this radical statement of intent, serious doubts remain over whether the Obama Administration’s proposed regulatory overhaul goes far enough in dealing with the problem of rational irrationality. Much of what the Administration has proposed is welcome. It would force issuers of mortgage securities to keep some of the bonds on their own books, and it would impose new capital requirements on any financial firm "whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed." None of these terms have been defined explicitly, however, and it isn’t clear what the new rules will mean for big hedge funds, private-equity firms, and the finance arms of industrial companies. If there is any wiggle room, excessive risk-taking and other damaging behavior will simply migrate to the unregulated sector.

A proposed central clearinghouse for derivatives transactions is another good idea that perhaps doesn’t go far enough. The clearinghouse plan applies only to "standardized" derivatives. Firms like JPMorgan Chase and Morgan Stanley would still be allowed to trade “customized” derivatives with limited public disclosure and no central clearing mechanism. Given the creativity of the Wall Street financial engineers, it wouldn’t take them long to exploit this loophole.

The Administration has also proposed setting up a Consumer Financial Protection Agency, to guard individuals against predatory behavior on the part of banks and other financial firms, but its remit won't extend to vetting complex securities—like those notorious collateralized debt obligations—that Wall Street firms trade among themselves. Limiting the development of those securities would stifle innovation, the financial industry contends. But that's precisely the point. "The goal is not to have the most advanced financial system, but a financial system that is reasonably advanced but robust," Viral V. Acharya and Matthew Richardson, two economists at N.Y.U.'s Stern School of Business, wrote in a recent paper. “That’s no different from what we seek in other areas of human activity. We don’t use the most advanced aircraft to move millions of people around the world. We use reasonably advanced aircrafts whose designs have proved to be reliable."