Photograph by Bloomberg — Getty Images
By James M. Stone
May 8, 2016

Giant banks, opaque hedge funds, and incomprehensibly leveraged trading in derivatives are the dominant features of the financial landscape. None of these are valuable for the country’s growth, its wealth distribution, or its commercial economy–and none are in any way necessary. All three sources of excess and instability are results of past policy mistakes in Washington whose implications no one saw coming. The banks, hedge funds, and the derivatives business should be contracted to a tiny fraction of their current scale and influence.

Courtesy of Houghton Mifflin Harcourt

People listened intently when the President took to the airwaves to talk about the financial crisis. He conveyed a reassuring message. He talked about how he would “clean up thoroughly unwholesome conditions in the field of investment.” He assembled a team of intellectuals, wily former traders, and savvy political hands to design a financial sector reform of unprecedented scale. A new regime was brilliantly constructed around the explicit principles of constrained leverage and enhanced disclosure.

Franklin D. Roosevelt and his team got it right. The program of financial regulation that they established helped to assure this country roughly half a century of strong, stable, and trustworthy financial markets, supporting the greatest period of national economic growth in the history of the world.

Supporting growth in tangible forms of commerce and expediting real economic activity is the role of the financial markets. Financial markets do not, in themselves, produce goods or–except in the zero-sum game of capturing profits from other lands–generate much growth in national income or wealth. They are, however, essential lubricants in a free-market economic system. Without its banks, its financial instrument markets, and well-informed investors, capitalism would grind to a halt. What FDR and his team were dealing with, though, was not an absence or shortage of those institutions’ services, but excesses and abuses in their operation. The right amount of oil in a machine allows it to work smoothly. Too much can destroy it. During the 1920s financial markets had gotten out of hand. The moment of truth arrived in October of 1929, with the crash of the stock market and, soon thereafter, the start of the Great Depression. The worst drop in the market indices since then occurred in 2008 and 2009, and for many of the same reasons. The lessons of 1929 were learned and absorbed into public policy. This cannot be equally said of the lessons from the crash that came 80 years later, several of which were exactly the same lessons.

Financial sector regulation dominated years of my life. At the U.S. Commodity Futures Trading Commission, I tried hard to persuade others in power that overly leveraged derivatives and lack of disclosure represented a threat to our economic stability. My efforts were not successful, and as I look back, that should have come as less of a surprise. Here was a green, unknown regulator armed with more opinion than evidence who was unable to garner grass-roots, academic, or press support. On the opposition side were a mighty river of campaign contributions, a growing aristocracy of influential financiers, and a transformative revolution brewing against government regulation. This was not the Roosevelt era.

My thesis for the financial sector has three major elements. We should initiate policies to reduce the scale and risk profile of our banks. We should regulate hedge funds as mutual funds under the Investment Company Act, stressing the ageless principles of transparency through maximum disclosure and tolerable levels of risk for pools of client money. And we should reduce decisively and dramatically the leverage of derivatives markets.

There are tools readily available for all these objectives. The best way to limit the scale of banks is for the Federal Reserve to impose progressively steeper capital requirements. The next most promising route would be for the FDIC to modify its insurance charges to reflect systemic risk. If the regulators can leave behind the notion that these charges should reflect artificially modeled risk levels, and can instead be used to shape the risk profile of the financial economy as a whole, the rest will be straightforward. This approach would give shareholders the incentive to downsize the banks in whatever manner their private interests prescribed. A market-driven approach to downsizing would be preferable in my view to restrictions on the activities of insured banking institutions, although activity restrictions are a great deal better than nothing.

The best hedge fund regulatory tool has been available all along. All that needs to be done is to end the availability of the exemptions from mutual fund treatment for any fund management controlling assets over a designated size limit.

The best device for curbing derivatives leverage is a meaningful reserve requirement. Banks are free to put us all at risk in derivatives trading without creating any offsetting cushion. Every derivatives transaction involves some risk. Whenever a new position is taken, there should be a mandatory accompanying reserve. This would increase protection for the public and the banks, while simultaneously blunting the appeal of oversized trading volumes. If, for example, the minimum charge were 0.1% of the position value, an open position of $100 trillion in derivatives would require $100 billion in reserves, an amount inaccessible enough to render that trading scale a bad memory. The reserves on gross position sizes ought to be mandated by the Federal Reserve. The FDIC should calculate its insurance premiums based on the risks imposed by banks’ gross positions. Charges to match the risk created would bring trading volumes back to sensible size–all with a minimum of new regulations and no need to outlaw useful commercial practices. A gross position reserve requirement would simply acknowledge that all derivatives positions impose some element of risk on the holders and the public.

Nothing I have suggested is industrial policy or red tape. It is not bringing Washington into a private arena where it doesn’t belong. The government, through existing law and regulation, provision of deposit insurance, and the implied guarantees of a history of bailouts, is deep in the field already. It just isn’t doing the job as effectively as it should. Whatever you hear from banking and political sources to the contrary, you will know that the goal has not been accomplished until the banks are smaller and less leveraged, the hedge funds have evolved into mutual funds, and the entire financial services sector retreats to its proper role as a lubricant to the real commercial economy–safe, healthy, and enjoying the single-digit share of the nation’s profits it has rightfully deserved all along.

Adapted from FIVE EASY THESES: Commonsense Solutions to America’s Greatest Economic Challenges by James M. Stone. Copyright 2016 by James M. Stone. Published by Houghton Mifflin Harcourt.

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