Institute for Financial Transparency

Shining a light on the opaque corners of finance


The Financial Choice Act isn’t all bad

The GOP has begun the process of gutting the Dodd-Frank Act and its over-reliance on financial regulators.  The Financial Choice Act is now wending its way through the legislative process in the House of Representatives.

I must confess I expected to dislike the Financial Choice Act more than I dislike the Dodd-Frank Act.  Much to my surprise, there are actually a lot of very good ideas in the Financial Choice Act for what to change in the Dodd-Frank Act.

The Financial Choice Act takes direct aim at the over-reliance on regulators and their enforcement of complex financial regulations.  It notes,

By introducing an almost mind-numbing level of complexity into the calculation of bank capital, Basel has succeeded in making the largest banks almost entirely opaque to their investors, creditors, and regulators.

Having worked on the pre-cursor to the original Basel capital regulations, I can tell you the bankers championed these regulations because they allowed the bankers to hide how much risk they were taking behind a veil of opacity.  So it was nice to see the GOP wanted to remove the veil.

The Act then took on how the Fed operates as a lender of last resort.  It restricts the Fed lending

to those instances that meet the specific criteria of Bagehot’s Dictum, named after the noted British financial journalist Walter Bagehot, which stipulates that a central bank should lend freely in a financial crisis, but only to solvent borrowers, against good collateral, and at penalty rates.

I agree with the principle behind what the GOP is trying to achieve here.  I disagree with restricting lending to “solvent” borrowers.  Because of deposit insurance, the Fed should lend to “viable” borrowers who may or may not be solvent at the time the loan is made.

Clearly, the Fed should lend at penalty rates.  As I discussed in Transparency Games, by not lending at penalty rates during the financial crisis, the Fed gave the bankers a gift in excess of $12 billion of the taxpayers’ money.

The Act requires the Fed to establish a method for determining what collateral it will lend against.  To show this collateral is “good”, the Fed must have a

method for obtaining independent appraisals of the collateral.

The only way the collateral can be independently appraised where the result of the appraisal can be trusted is if the collateral provides transparency.  Therefore, the Fed should require the collateral carry a label from the Transparency Label Initiative indicating all the necessary disclosure is made so the Fed could know what it “owns” and an independent appraisal of the collateral could in fact value the collateral.

As the financial crisis accelerated in 2008/2009, banks submitted opaque securities as collateral.  The very same opaque securities that the market could not value as the lack of disclosure prevented this assessment.

The Financial Choice Act also looks at the decision to increase the Fed’s role in financial regulation.

At the most basic level, it’s hard to see how the expansion of the scope of the Federal Reserve’s authority to cover any large financial institution makes sense. The Federal Reserve was not able to prevent disaster at the firms it was already charged with overseeing. What reason is there to think it will do a better job at regulating a wider universe of firms?

More concretely, the Federal Reserve had regulators in place inside of Lehman Brothers following the collapse of Bear Stearns. These in-house regulators did not realize that Lehman’s management was rebuking market demands for reduced risk and covering up its rebuke with accounting sleight- of-hand. When Lehman actually came looking for a bailout, officials were reportedly surprised at how bad things were in the firm.  A similar situation unfolded at Merrill Lynch.  The regulators proved inadequate to the task.

Given the Fed has shown itself unfit for the purpose of bank supervision, I prefer a simpler solution than the Act proposes.  I want to break up the Fed and send all of its supervision and regulation responsibilities to the FDIC.  This will reinforce market discipline on the banks as the FDIC’s central mission is to protect the deposit insurance fund.

Finally, the Financial Choice Act wants to do away with the Office of Financial Research.  I agree with the GOP’s reasoning:

By driving regulators towards a homogenized assessment of financial system threats, the OFR contributes to a “one-world view” of risk that has had such disastrous consequences in Basel and other regulatory contexts. Eliminating the OFR would actually improve risk management by encouraging diverse perceptions of risk and risk management strategies.