Tags: CDOs, Chris Dodd, Credit-Default Swap, Economic Recovery, Financial Reform, Tobin Tax, Too Big to Fail, Volcker Plan, Wall Street

Financial Reform: Three Ways to Fix Wall Street

By , Money Morning •

The financial-reform bill introduced by U.S. Sen. Christopher J. Dodd, D-CT, seems likely to pass both houses without all that much alteration.

And that should immediately raise our suspicions. After all, the U.S. financial-services business has a very effective lobby, so if there isn't huge opposition to the legislation, it probably won't achieve all that much.

It won't fix Wall Street.

But there's another issue here: It's also not clear to me that we know just what we want the financial-reform initiative to achieve. By that, I mean: What banking-sector reforms would we implement in an ideal world, to reduce the danger from the sector while preserving the essentials of a free market?

Sen. Dodd's bill focuses on a number of changes, none of which seem likely to provide a solution to the financial sector's most-serious problems. It includes elements of the "Volcker Plan," which aimed to prevent banks with deposit guarantees from doing "proprietary trading."

But the legislation gives regulators the power to impose regulations - which will presumably allow the banking lobbyists to ensure nothing effective is done. It provides an orderly liquidation mechanism for failing big banks, which doesn't solve the "too big to fail" problem, but still may alleviate it, depending on the final details. It provides for a consumer financial protection agency, but gives control to the U.S. Federal Reserve, which suggests the agency will be ineffective.

Finally, Dodd's bill provides investors with some ability to denounce excessive pay packages, but without full control.

In other words, the financial-services-sector reform bill suffers from the opposite problems that weaken the recently enacted healthcare-reform legislation. Far from shaking up the system completely and transferring huge power to the state, the financial-services legislation is likely to achieve very little, and not solve the problems it is supposed to address. Also, unlike the healthcare plan, I predict it will pass fairly easily with bipartisan support.

The bottom line, unfortunately, is that the bill will not solve the problems of Wall Street. That is a pity; there are a number of legislative actions that would go a long way to do so - by and large, those are the ones that have met with hysterical opposition from Wall Street's lobbyists.

First and foremost, we need a "Tobin tax" - a small tax on transactions, at some tiny percentage of their value. Much of Wall Street's income these days is gained by "fast trading," where investment banks place electronic-trading terminals in the stock exchange and take advantage of ultra-rapid information about order flows. Sorry, but that's insider trading, just as it would be if they traded on insider knowledge of next quarter's earnings. It's pure rent extraction - Wall Street is sucking value out of the system, about $20 billion a year in total - without providing anything of value in return.

You can't make it illegal, because market-makers have always used their order-flow knowledge as part of their business, but you can tax it enough to make it unprofitable. The margins on this business are tiny, so a tax of 5 cents per share on equities and equivalent amounts on bonds and derivatives should be ample, and 1 cent would probably be enough. It needs to be enforced across all major domiciles, though, to keep the business from just migrating.

An additional advantage of a Tobin tax would be to tilt the playing field back away from trading and towards value-added businesses. Wall Street institutions hate the idea - more than any other tax - because they can't pass it on to their customers. The tax would simply reduce the unearned profits Wall Street extracts from those clients.

Second, we need a provision that enforces proper risk management. The "Value at Risk" (VAR) system and its derivatives don't work, because they rest on incorrect assumptions about price movements. Moreover, these systems can be "gamed" by traders who invent new securities - such as collateralized debt obligations (CDOs) and credit default swaps (CDS) - which appear benign under the VAR system, but actually carry huge, unrecognized risks.

As my forthcoming book "Alchemists of Loss" (jointly written with Professor Kevin Dowd) points out, there are litmus tests that can identify these pathological products and flag their excessive risks. Regulators need to insist that the banks use those tests, and then adjust their risks accordingly. The result would be to force very low trading limits on CDOs and CDS, putting those economy-killers out of business.

Third, we need a "too-big-to-fail" regimen - but with real teeth. The simplest form of this is, once again, a tax - this time on agglomerations of assets that exceed about 2.5% of gross domestic product (GDP), or about $400 billion.

If that tax were set at 0.1% per annum, it would become more economic for the behemoths to spin off some of their operations and slim down to a reasonable size.

As of Dec. 31, there were four "traditional" commercial banks with assets in excess of $1 trillion. Following those four, in order, were:

  • Goldman Sachs Group Inc. (NYSE: GS) at $849 billion.
  • Morgan Stanley (NYSE: MS) at $771 billion.
  • And then a huge gap before the next two houses, U.S. Bancorp (NYSE: USB) and PNC Financial Services (NYSE: PNC), both under $300 billion. We need to slim the behemoths down to a size where a bankruptcy won't take the entire financial system down with it.

That collection of three quite simple changes would revolutionize the system, though ideally tighter monetary policy and limitations on deposit insurance (which would reduce the encouragement it gives to speculate with taxpayers money) would be added to complete the package.

Don't hold your breath hoping that these three provisions will become reality, however: Whether they are Republican or Democrat, the Wall Street lobbyist army has far too much political control for that to happen.

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