Can We Avoid Another Cataclysmic Meltdown Of The Global Financial System?

Chapter 10 The Revolving Door

Chapter 10 discusses the money culture and the revolving door between Wall Street and Washington and why it it has been so hard to turn back the tide of growing financialization and avoid another economic meltdown.

Financial Industry Lobbying: Passage of The Dodd-Frank Loophole 

Discussed at the beginning of this chapter is a loophole that was added to the Dodd-Frank financial reform legislation in 2014. As explained, the Dodd-Frank legislation initially contained  provisions to force Too-Big-To-Fail banks, to move their riskiest and most profitable trading activities to new entities outside of their parent bank. This restriction was designed to prevent Too-Big-To Fail (“TBTF”) banks  from using government guarantees and taxpayer-funded bailouts to recover losses that they may incur, when hedging default swaps, commodities and derivatives.

This 85 line loophole amended the Dodd Frank legislation when the US House of Representatives inserted this restriction into 1,600 page spending bill in 2014. It wasn’t an accident, as it took millions of dollars of lobbying effort by Citigroup and others in the financial industry. In essence it enabled TBTF banks to continue trading in these risky securities and re-exposed taxpayers to TBTF banks’ potential trading losses. This amendment illustrates how hard it is to achieve any lasting reforms to  the financial system, and how powerful interests are able undo legislation they do not like.

Revising of The Volker Rule

The Volker Rule that was passed, banned TBTF banks from holding on to billions of dollars in private equity and hedge fund investments.  In December 2014, the Federal Reserve and other regulators watered down this ban, when they incorporated an exception called “portfolio hedging” that allowed TBTF banks  to engage in risky trades as long as they were “in the interest of protecting risky assets”, rather that making profits from newly obtained private equity and hedge fund investments. Again, extensive lobbying from the financial industry resulted in this relaxation of legislation that the financial industry did not like.

The Power of the Financial Lobby

Financial institutions have a history of fighting against further restrictive legislation and regulation. It has been reported that over the last several years, the  financial industry been extremely active in looking out for its interests, and that $1.4 billion had been spent by the financial lobby during the 2013-14 election cycle alone. Another $39.7 million was also spent lobbying congress in the run-up  to the Dodd-Frank loophole’s passing, and PACs of four biggest financial institutions that control ~90% of the “swaps market”, (Goldman Sachs, Bank of America, Citigroup and J.P. Morgan), gave  2.6 times more money to members of Congress for creation of the Dodd-Frank loophole. It has also been estimated that the financial industry spent $498 million in lobbying in 2014, ($10 million more than the “Big Health” industry), and that in the 2013-14 election cycle, it “shelled out” twice as much as any other single industry. A determined lot indeed!.

Direct Pressure From Financial Industry Leaders

The financial industry’s influence in Washington  extends beyond formal lobbying and campaign contributions. It is a well known fact that top officials of major banks and other financial institutions, as well as their trade groups and their lawyers, regularly consort with members of federal agencies that regulate them. Often these meetings take place to influence legislation or to seek relief from specific regulation. The meetings are also frequent and involve representatives from the Treasury Department, the Federal Reserve, the Commodities Futures Trading  Commission, the Securities Exchange Commission, and/or the Federal Deposit Insurance  Corporation.

For example, when Dodd Frank reforms were being made, Goldman Sachs  paid  eighty-three visits to regulators to discuss  changes in rules regulating derivatives. Likewise,  when the Volker Rule was being enacted in July through October, 2011, 93 percent of  federal agency contacts that were made, were from members financial institutions, their trade groups and their lawyers.

The Wall Street-Washington Revolving Door

Federal agency regulators and administration officials are often offered  jobs with the banks and other financial institutions they oversee. They are often asked to return to government service in the same  agencies after they had obtained industry experience. In some cases, this Wall Street friendly back-and-forth happens several times in one’s career. Ms. Faroohar then observed that the friendliness between the regulators and the regulated has tended to produce a “finance-centric” world view, and this mindset is responsible for not questioning the  status quo. The academic community calls this phenomenon, “cognative capture”.

Blaming The Treasury Department

The Treasury Department has been singled out by Ms. Faroohar as being the most friendly toward former financial industry talent. She singled out a number of individuals that have gone through this revolving door and have held top positions in the big banks and became top regulators. She blames Treasury Department officials for the way the financial crisis was handled. She opines that many of these Treasury Department officials  were the same former Wall Street executives that backed the repeal of Glass-Steagall Act, that allowed tax code changes favoring performance pay, that blocked derivative regulation, and that allowed exemptions from public scrutiny of derivative trading. She also indicated that there were others who should also be blamed for our dysfunctional financial system, and that some experts even blame Ronald Reagan, pointing to the fact that under his administration, large share buybacks were made legal and antitrust enforcement was relaxed.

The TARP Bailout of AIG

Ms. Faroohar presents another example of  this Wall Street-Washington nexus , pointing to the way the former New York Federal Reserve chief, Timothy Geithner orchestrated the Troubled Asset Relief Program (“TARP”) during the financial melt-down of 2008. As explained, TARP was used in the bail-out of AIG, and  it was the first time US taxpayers were put on-the-line for the full cost and full risk of saving a failing company. Geithner rationalized  that because AIG had been a key player in the derivatives system and had become insolvent, their insolvency threatened to pull down Goldman and Chase, two solvent mega-banks. To his credit, Geithner tried to obtain bail-out funds from Chase and Goldman, but was turned down, as they claimed that they could not afford the systemic effect of an AIG collapse and they were struggling too. And having saved AIG with taxpayers money, Geithner had demonstrated his finance-centric  view of the economy, where banks are the dog, not the tail. He also defended this rescue by saying that “the markets loved it”. Shortly thereafter Geithner was rewarded for his “financentricity” , as he was allowed to enter the revolving door, and emerge as President of Warburg Pincus a prominent Wall Street private equity firm.

Political Origins of Banking-A Brief History

This chapter also covers the political origins of banking and how we ended up with our present dysfunctional financial system. It is presumed that the purpose  of presenting such a history is to help gain insights as  to what worked in the past and stimulate ideas on how to fix today’s dysfunctions.

In the 18^th century, banking in the US was comprised of a large number of  small banks designed to operate in regional markets and serve rural interests. These small banks were subject to different sets of regulations promulgated in the states and counties they serviced. Shortly thereafter, the United States won its independence, Alexander Hamilton and  other Federalists advocated for establishing a national banking  system designed to serve large urban areas and support a single currency. The first such bank was chartered in New York,  to facilitate international trade, to issue and sell Government backed bonds, and to finance larger projects. Unfortunately, at that point in time, there was no cohesive national system of branch banking and risks could not be efficiently spread around the banking system.

Prior to the stock market crash of 1929  US banking had become a low leverage, high liquidity business. It was also built on relationships established between bankers and  their customers. Like banks in Great Britain, U.S. banks were subject to a much stricter legal framework. Banks typically held more than 25% of their assets in cash and maintained liquid assets designed to cover  50% of their liabilities at any time. Currently, big banks are only providing 10% coverage.  And prior to 1929, banks used a partnership structure where partners bore unlimited liability and were personally accountable for losing money or taking on too much risk. This structure acted as a constraint on banks pursuing financialization strategies.  In addition,  this unlimited liability structure tended to balance out the interests of shareholders and bank managers, as well as the interests of borrowers and of society as a whole.

The stock market crash of 1929 and the great depression changed all that. In its aftermath hundreds of small local and regional banks which had been undercapitalized, failed. Legislation was then enacted to concentrate a national banking system around one central bank, “The Federal Reserve”,  which was to become the national lender of last resort. In addition,  laws were enacted to establish a new system of deposit insurance and to limit the liability of bank officials. This led to the incorporation of many of the country’s investment banks, which allowed them to grow into the TBTF mega-banks we have today. This evolution was gradual, taking place over the last 100 years.  As explained in this chapter, it has led to an imbalance in the US banking system between returns that are privatized and risks that are “socialized”. As documented throughout this book, banking’s focus has changed from “relationship banking” into one of trading based on “securitization”. The casino-like nature of increased financialization of banking has led to the criticism that bankers’ own interests are now out of line with interests of other stakeholders,  and with the rest of society.

Enforcement of Bank Laws and Regulation

Mentioned briefly in this chapter is  the failure of the justice system to meaningfully punish individuals in the financial industry when laws are broken. Singled out as an exception, are the 1,000 bankers that were jailed for the role they played in creating the savings and loan crisis  the 1980s. Also mentioned are the handful of executives that got jail time for their role in creating  Enron debacle  in the 1990s. Ms. Foroohar then mentioned The Sarbanes-Oxley Act, as a piece of legislation that has already been enacted that could be used to punish individuals for violating laws and regulations pertaining to the financial industry. She  also blames the Washington-Wall Street nexus for the dysfunction and the lack of prosecutor activity as relates to 2008 crisis. She then cites the fact that from 2012 to 2014, the financial industry has been fined $139 billion, (for everything from money laundering to collusion, to lack of disclosure, to foreclosure abuses, to interest rate fixing, and to insider trading), but she admits that these fines have had little impact on the industry. She also believes that the lack of enforcement can be blamed on government’s own involvement with  the financial industry, on weak regulatory oversight, on untimely deregulation, and on buck passing through monetary policy. She concludes that these failings have contributed to  making government regulators and other officials “willfully blind” to the problems that led to this crisis. Strong words!

A Final Observation

Ms. Foroohar  argues that the  federal government  decision to bail out the financial system following this crisis, may not have been necessary. She concurs with the government’s assessment that the  pain and suffering that such a financial system collapse would have caused the real economy  was  not worth it. But  she also points out that these “cognatively captured” public officials did not use all the levers they had available at the time bailouts  were being made and they missed an opportunity to put pressure on the financial industry to  reign in its high risk trading activities.