Obama and Leverage

| Mon Jun. 15, 2009 1:52 AM EDT

The Wall Street Journal describes the financial industry regulatory reform that Barack Obama is expected to unveil this week:

The plan stops short of the complete consolidation of power that some lawmakers have advocated. For example, it will allow several agencies to continue supervising banks. It also won't place specific limits on the size or scope of financial institutions, but it will make it much harder for large companies to be so overleveraged that they threaten the broader economy.

....The plan calls on the Fed to oversee financial institutions, products, or practices that could pose a systemic risk to the economy. It will create a "council" of regulators to monitor this area as well. Government officials believe this arrangement will forestall companies from growing large and overleveraged without substantial federal supervision, as happened, for example, in the case of giant insurer American International Group Inc.

The Fed will likely have the power to set capital and liquidity requirements for the U.S.'s largest financial companies and scour the books of a wide range of firms. It is unclear what enforcement powers the central bank will have; that likely will be a point of contention as lawmakers debate the issue.

I'm OK without complete consolidation.  Box drawing exercises often just ignite turf battles without really accomplishing much.  I'm also OK with not trying to limit the size of financial institutions.  I'm semi-persuaded that it might be a good idea to do this, but I also suspect that it's fanciful to think that it could work.  The limits would have to be draconian, compliance would have to be almost perfect worldwide, counterparty connections would have to be monitored as rigorously as size, and companies would almost certainly be able to figure out ways to evade the regulations.  This seems like a tide that's nearly impossible to hold back.

But leverage — that's critical.  For the past two decades we've not only ignored increasing leverage in every nook and cranny of the financial world, we've made it worse.  LTCM blew up in 1998 because of astronomical leverage and afterward Alan Greenspan produced a report saying we should "encourage" financial institutions to limit their leverage.  Result: nothing.  In fact, things got worse.  Basel II followed Basel I and loosened capital adequacy requirements.  In 2004 the SEC allowed big Wall Street investment banks to increase their leverage ratios.  Off balance sheet leverage skyrocketed with no pushback from anyone.  At the consumer level, zero down mortgages became common.  The shadow banking system went almost entirely unregulated.  All this plus a tsunami of cheap money made disaster almost inevitable.

If Obama's plan truly addresses leverage — everywhere and in all its guises — and if he can persuade the rest of the world to follow suit, he will have really accomplished something.  It's not the only thing we need to do, but it's the most important.  When we get the details of his proposals to regulate leverage, that alone will tell us most of what we need to know about whether he's really serious about taking on Wall Street.

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