Tuesday, July 6, 2010

Ho-hum, the Financial Reform Bill is Going to be Passed

Perhaps the most benign statement about the passage of the United States financial reform bill passed by the House of Representatives last week and whose passage is pending in the Senate comes from Richard Bove, banking analyst at Rochdale Securities: The bill, he states, “doesn’t seem to be terribly onerous.” (See “JPMorgan Brushes Aside Bill Concerns,” http://www.ft.com/cms/s/0/24bcbc8c-8858-11df-aade-00144feabdc0.html.)

In terms of the regulation of swaps, especially credit default swaps, “The once-feared swap provision has become toothless.”

The recent debate in Congress over the financial reform bill: A lot of “sound and fury signifying nothing.”

This legislation, the most comprehensive reform of the financial system since the 1930s, seems be passing into the history books with very little fanfare.

Sure, the financial institutions “huffed and puffed” and spent tons of money to fight Congress “every inch of the way.” But, what else did you expect. Perhaps you need to read a good economics book on “Game Theory”.

And, now?

Can’t you hear the executives at the big banks say, under their breath, “Well, the bill is passed, now we need to get back to business. Sure we spent a lot of money that could have gone elsewhere, but that is now history. In terms of where we are going to focus in the future, we just continue doing what we have been doing, finding the best way to do business and to make money. The bill, itself, will cause some inconvenience in some areas, hurt the smaller institutions more than the larger ones, but will not basically change what we are going to be doing.”

The article cited above states it all. JPMorgan acquired a large energy and metals trader last week. How will the financial reform bill impact this deal? After all, “Commodities are among a handful of derivatives still targeted…” by the bill.

The author of the article writes: “Blythe Masters, head of commodities at JPMorgan, said the bank already traded most energy through an affiliate and the law would ‘not substantially’ affect business.”

I have been arguing for months that the large banks had already moved beyond the reach of the regulations being discussed in Congress and that anything enacted by the legislators would be DOA, “dead on arrival.” The large banks started to reform and restructure themselves soon after the fall of 2008 when the financial crisis was at its peak! By the spring of 2009 these banks were well on the way to the future.

Congress, on the other hand, was mired in the past.

JPMorgan, to my mind, is one of the organizations leading us into the future. See, for example, my blog post “Follow the Dimon,” (http://seekingalpha.com/article/212236-follow-the-dimon). But, there are many others that are also out there pushing finance into the future.

Similar discussion are taking place in all areas of the finance field. Just this morning, the Wall Street Journal contained the article “What’s a ‘Prop’ Trader Now?” relating to the proprietary trading that many of the largest financial institutions engage in. (See, http://online.wsj.com/article/SB10001424052748703620604575349161970563670.html?mod=ITP_moneyandinvesting_0&mg=com-wsj.) The article addresses issues like, “What are ‘Prop’ traders?” and “How are banks redefining ‘Prop’ traders?” and “Where are ‘Prop’ traders located within the organization?”

The answers to these questions will help the larger financial institutions “churn out” billions of dollars in profits. Thus, the banks are willing to spend millions of dollars in hiring “the best and the brightest” lawyers and financial experts to come up with the answers. Congress is just not capable of matching the resources available to these publically-traded firms and so will lag behind what is going on in the private sector. To me, the information “gap” between the public sector and the private sector has never been larger.

The problem is that Congress is attempting to achieve “outcomes”. They want to keep banks from becoming “too big to fail” and to keep banks from taking on too much risk. Historically, we see that laws and regulations that seek “outcomes” are bound to fail because, specifying “outcomes” tells those being regulated what they have to “get around”, what they have to “evade.”

In this Age of Information, it has become exceedingly easy to “get around” laws and regulations and “evade” the restrictions imposed by the legislators and regulators. (See the series of posts I began on January 25, 2010, “Financial Regulation in the Information Age”: http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.)

Laws and regulations work better when they are aimed at processes, the way that the regulated firms do business. These kinds of rules and regulations have to do with information flow (corporate disclosure and transparency), how trades are made, how trades are constructed, margin requirements, and so forth. One can see successful examples of “process” oversight in the creation of the Financial Futures Market and the Options Market in the latter part of the 20th century.

A proposal for overseeing the assumption of risk by financial institutions has been put forward by Oliver Hart, an economics professor at Harvard, and Luigi Zingales, an economics professor at the University of Chicago, in the Spring 2010 copy of National Affairs, titled “Curbing Risk on Wall Street,” (http://www.nationalaffairs.com/publications/detail/curbing-risk-on-wall-street). I have threatened several times to present a critique of this proposal in one of my posts. Hopefully, I will accomplish this soon for the Hart/Zingales proposal, I believe, offers a lot for people to consider.

So, the world goes on. The financial reform package will be passed. Banking and finance will continue to thrive. Big banks will get bigger and there will be fewer and fewer small banks. Hedge funds and venture capital funds will, in general, continue to do what they do well. And, sometime in the future there will be another financial crisis.

Things are not different.

End note: for a “good read” check the lead article in the business section of the New York Times on Sunday about Ken Rogoff and Carman Reinhart and their book “This Time Is Different”: http://www.nytimes.com/2010/07/04/business/economy/04econ.html?_r=1&scp=1&sq=ken%20rogoff%20and%20carmen%20reinhart&st=cse.

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