Wednesday, November 4, 2009

On Financial Reform

There are now efforts on the Hill to do something about the financial system. While some bemoan the fact this has not happened yet, my guess is the administration simply put health care reform first on the agenda for whatever reasons.

So -- what do we do about the financial system?

Let's start with two observations.

The first is the financial system stands at the middle of the economy. Often times the phrase "financial intermediary" is used to describe a bank or other financial player. These companies take individual finances like small savings accounts and pool them into larger amounts of money that then go to finance large projects. Hence, they act as intermediaries. In addition, the Federal Reserve effects the economy through these institutions. These actions by the Federal Reserve fundamentally impact the direction of the economy. Because of the unique roll these institutions play in the economy they must be looked at differently. At a minimum, these institutions must be functioning at a basic level in order for the US economy to work.

Secondly, there are different types of intermediaries that are largely classified by the type of risk they undertake. As an example, take an investment bank which is

A financial intermediary that performs a variety of services. This includes underwriting, acting as an intermediary between an issuer of securities and the investing public, facilitating mergers and other corporate reorganizations, and also acting as a broker for institutional clients.

and compare that to a standard bank which "borrows short and lends long" meaning they take in deposits, pool them and make loans with the pooled money. Notice these institutions still perform financial intermediation, but perform the roles in far different manner.

The second Glass Steagall (which was repealed with the Gramm Leech Bliley Act in 1999) prevented different financial intermediaries from participating in certain other types of financial intermediation. For example, a commercial bank -- which lent money to corporations/larger borrowers -- couldn't own a brokerage company/investment bank. The reason is these types of financial companies had very different risk profiles. While the commercial bank did take on risk it was usually far less than an investment bank's risk. Hence, by preventing certain types of companies with a certain risk profile from owning another company with another risk profile, the legislation essentially prevented risk from being centered in one or more institutions -- more commonly referred to as "too big to fail".

Here's an example. Sometime over the last few years Bank of America -- a bank -- purchased Merrill Lynch -- an investment bank. This could not have happened under the old Glass Steagall act but can happen now. Also note the different financial services each offers. Bank of America takes in deposits and makes loans whereas Merrill Lynch is a brokerage company the buys and sells securities along with other, riskier investment banking operations.

The primary benefit of Glass Steagall is separation/segregation of risk. The act essentially prevents risk from being concentrated in a small group of institutions at the center of the economy. However, there is a drawback -- and it is a large drawback. It prevents "one stop shopping" for financial services. For example, large company X needs a variety of financial services such as general corporate banking and investment banking. By preventing consolidation, the Glass Steagall act does not allow larger companies to consolidate operations, thereby lowering costs through economies of scale.

Let's return to the Bank of America/Merrill Lynch example. By combining services, Bank of America can now service a larger group of clients (individuals to companies) and perform a far wider swath of services (banking and investment banking). While this does combine risk it also allows the company to increase its customer base and lower cost through economies of scale.

Many have blamed the repeal of Glass Steagall as a primary driver of the financial meltdown that started in 2007. Hence putting it back in place should be part of financial reform. The repeal of Glass Steagall was clearly a factor. But suppose that instead of occurring in a lax (or non-existent) regulatory environment, regulators had been far tougher on larger institutions. For example, suppose simple mortgage under-writing standards were more stringent (like actually requiring a meaningful down payment for a house). Would that have prevented the melt-down from occurring? There is no answer for that. However, the point is there is more than one way to look at financial reform.