The Best Policy

The ABCs of Reform

How Washington blew its chance to bring real change to Wall Street.

What went wrong with reregulation?
        Click image to expand.
What went wrong with reregulation?

Even acknowledging the truism that making laws is like making sausage, often leading any observer toward becoming a vegetarian, if not a vegan, some legislation stands out as especially unpleasant. With that in mind, what conclusions can we draw about the financial reregulation bill now making its way through Congress?

First, the bill does virtually nothing to confront the single greatest structural problem we face: the continued growth of too big to fail, or TBTF, institutions. Indeed, over the course of the crisis we have gone in the wrong direction, with the banking industry now more concentrated than it was several years ago. There is no reason to believe that this trend will change or that the federal guarantees of TBTF institutions will be withdrawn.

Second, the bill by and large reinvests regulators with the same discretion they had—and failed to use—before the crisis. The theory underlying the bill is simple: “Trust us—next time we will do better.” Indeed, in virtually every case, the very same people are still in the positions they had before the cataclysm. Isn’t it comforting to know that the systemic risk council—that critical group that is supposed to be akin to the canary in the mine, warning of impending danger—will be led by the same people (Timothy Geithner and Ben Bernanke) who failed or refused to see the omens of this crisis as it swept through the economy?

Third, those few ideas that promise structural reform and did make it into the bill—namely, the so-called Volcker Rule and changes in derivatives practices—are horrendously watered-down and compromised. And they derived their support from outside the White House, as the alignment between Geithner and Larry Summers vigorously opposed these ideas until the political pressures became unbearable.

Fourth, the New York Federal Reserve Bank, the governmental institution perhaps most at fault for failing to take any of the actions that might have prevented the banking crisis, escaped unscathed. The New York Fed simply beat back the many well-reasoned calls for reform.

The end result is an almost perfect illustration of not just how legislation is made but how politics works. Proponents of the bill continue to talk in grandiose terms of reform, but the actual terms of the bill provide continuity in both power and structure.

I have examined the governing structure of the New York Fed and, in particular, the impact of that structure on its decisions over the course of the bailouts. Since then, a scathing inspector general report and good investigative journalism have validated the view that the New York Fed—and its then-president, current Treasury Secretary Timothy Geithner—failed utterly to negotiate effectively for the public. (Geithner’s multiple and contradictory explanations get less credible every day.)

Most folks don’t appreciate that the New York Fed is literally owned and governed by its member banks. Indeed, the member banks choose six of the nine members of its board. Additionally, most people don’t appreciate that Geithner was chosen to be president of the New York Fed, a position he held from November 2003 till January 2009, by a committee including the current or former chairs of AIG, Goldman Sachs, Chase Manhattan, and Lehman Bros.

Given the horrific record of the New York Fed and a desire to bring its decisions back into alignment with the public’s policy objectives, not the banks’ policy objectives, Sen. Chris Dodd suggested that the president of the United States choose the president of the New York Fed, subject to confirmation by the Senate. That’s the system, after all, for members of the Cabinet, Supreme Court justices, and the chairman of the entire Federal Reserve System. Fearing that they would lose control of this critical position, the banks cried “Politics!” Apparently, having the president choose the president of the New York Fed would “politicize” any decisions made by the New York Fed. Yet having the banks choose their own regulator and lender was wise policy.

In traditional Washington fashion, under the current reregulation bill, there is a “compromise” that permits the illusion of reform but leaves the status quo intact. The bill does not call for the president of the United States to choose the president of the New York Fed. Instead, it leaves the selection of the president of the New York Fed to its “B” and “C” directors. The role of the “A” directors is eliminated.

What do these alphabetized categories mean, you may ask. A good question. There are nine members of the New York Fed’s board: three A directors, three B directors, and three C directors. The A directors are chosen by the banks to represent the banks. So eliminating them from the process sounds pretty good. The B and C directors are supposed to represent the public. And who chooses them, you ask? Another good question. The C directors are chosen by the Federal Reserve Board of Governors. And the B directors are chosen by … the banks. That’s right: The banks choose directors to represent the public.

Still, just because they’re chosen by the banks, doesn’t mean the B directors cannot perform a valuable public service. All this begs the question: Who are the B directors? They are, currently, the chief executive of GE, the largest beneficiary of the fed guarantee of commercial paper; the chief executive of one of the largest pharmaceutical companies in the world; and the chief executive of one of the largest insurance companies in the world. Typical public voices? Of course not.

I am not criticizing these gentlemen as individuals. Indeed, I consider several of them friends. But it is absurd to view them as public voices that can bring a Main Street rather than a Wall Street perspective to the choice of the most important regulator in the financial system. Indeed, the B directors are no different in perspective than the A directors, who are chosen by the banks to represent the banks.

Among the class C directors, by the way, is the president of the Partnership for New York City, a coalition of businesses whose primary mission is to bring a business perspective to policy issues. Who are the co-chairman of the partnership? Lloyd Blankfein, the chairman and chief executive of Goldman Sachs, and Rupert Murdoch, the chairman and chief executive of News Corp.

So of the six directors who will choose the president of the New York Fed—and this is the only structural reform to the Fed in the bill—four are pure Wall Street voices. Is this reform? Of course not.

And when you examine any of the so-called reforms, the same reality emerges. Virtually nothing has changed. Oh, the atmospherics are different, perhaps, and maybe a momentary lesson has been learned. But there is a reason bank stocks rose the day the final agreements on the financial regulatory bill were announced. The smart money knew which side had won.

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