Mike Konczal

Roosevelt Institute Fellow

Recent Posts by Mike Konczal

  • Two Contradictory Arguments That Dodd-Frank is Crony Capitalism

    Dec 17, 2014Mike Konczal

    I’m pretty convinced that the term “crony capitalism,” as deployed by the right, is useless as a political or analytical tool. I keep a close eye on how conservatives talk about financial reform, and according to the right, Dodd-Frank is crony capitalism. Oh noes! But what does that mean, and how can we stop it? Here’s a fascinating case in point: two AEI scholars with different publications argue that we need to stop Dodd-Frank from enabling crony capitalism, and then proceed to describe two opposite, mutually exclusive sets of problems and solutions.

    First, a good test question: The Federal Reserve recently required that the largest firms have a greater capital surcharge than had been originally proposed. Is that cronyism?

    Here’s one story, from James Pethokoukis in ”Fighting the Crony Capitalist Alliance”: “our highly concentrated and interconnected, Too Big to Fail financial system [...] gives a competitive edge to megabanks.” How is that? Regulators create incentives for big banks to take on risks “such as investing in mortgage-backed securities and complex derivatives.” Banks are the size they are, and do the activities that they do, because of the actions of regulators.

    So how do we combat this problem? According to Pethokoukis, we should “substantially raise the capital requirements for Too Big To Fail banks” to limit risk. Even more, “such capital requirements might well nudge the biggest banks into shrinking themselves or breaking up.”

    Here’s another story, from Tim Carney’s “Anti-Cronyism Agenda for the 114th Congress”: Dodd-Frank is cronyism because “[e]xcessive regulation is often the most effective crony capitalism.” What’s worse is that Dodd-Frank designates the biggest firms as Systemically Important Financial Institutions (SIFIs), meaning that they pose a systemic risk to the economy. Those firms are put under more regulation, but it’s obviously a cover for a permanent set of protections.

    So what should we do? According to Carney’s agenda, Congress should “open banking up to more competition by repealing regulations that give large incumbent banks advantages over smaller ones.” Well, which regulations are those? “Congress should repeal its authority to designate large financial firms as SIFIs.”

    Note that though these are from the same institution and carry the same banner of fighting “cronyism,” these agendas are the exact opposite of each other. For Pethokoukis, the important goal is identifying the largest and riskiest institutions and putting aggressive regulations on them, with capital requirements set high enough that they could fundamentally shrink those banks. For Carney, it’s important that we do not identify any firm as too large that it is risky for the economy, and thus increase their capital requirements, since doing so just encourages cronyism -- indeed, it is the logical conclusion of cronyism. Don’t regulate the largest firms with more attention or care; just don’t do anything to them.

    In the Pethokoukis version, the financial sector poses a real threat to the stability of the economy, and as such special efforts should be made to prevent failure and handle failure when it does occur. His answer is, essentially, to do more. In the Carney version, there’s no real danger outside the government’s interference, or at least not a danger that is worth a policy solution. His answer is to do nothing, except repeal what regulation already exists.

    And, crucially, for Pethokoukis, the recent increase in capital surcharges for SIFIs are a good idea; for Carney, they enshrine the problem by working through the SIFI framework, and are a bad idea. How can a policy agenda be built around such a “cronyism” framework?

    There are other problems with “cronyism” as described here. Pethokoukis blames cronyism for the concentration in the financial sector in the last few decades. However the previous argument had been that the size and geographic restrictions that prevented this concentration before the 1990s are the real cronyism. Dodd-Frank blocks a single financial firm from having liabilities in excess of 10 percent of all liabilities, benefitting smaller firms at the expense of larger ones. Is that cronyism or the opposite? Cronyism can’t just be “things turned out in a terrible way when left to the markets.”

    As Rich Yeselson notes in a fantastic essay on New Left historians in the recent issue of Democracy, the Gabriel Kolko-inspired stories about how regulations evolves (stories that influence Carney) are monomaniacally mono-causal. So just quoting CEOs’ statements to the press about Dodd-Frank constitutes analysis, as the regulations must obviously flow from elite desires through their captured lackeys in the state.

    But Dodd-Frank is more complicated than that - look at the effort to stop the CFPB from starting, or the epic battles both between and within regulators, the state and consumers over derivatives. Carney’s top-down inescapable vision of how reform works leaves no room for the contingency of actual efforts to fix a broken system. In turn, this leaves us with no way to actually critique what Dodd-Frank does. Worse, it conflates fighting “cronyism” with an agenda of laissez-faire economics, liberty of contract, and hard money, sneaking in a three-legged stool of reactionary thought through our concerns about fairness.

    Actual cronyism is a real problem, but I’ve seen no evidence that it adds up to a systemic criticism of our economy as a whole. Instead, we need a language of accountability, benefit and power in how markets are structured. Without this, we’ll have no working compass for reform.

    Follow or contact the Rortybomb blog:
     
      

     

    I’m pretty convinced that the term “crony capitalism,” as deployed by the right, is useless as a political or analytical tool. I keep a close eye on how conservatives talk about financial reform, and according to the right, Dodd-Frank is crony capitalism. Oh noes! But what does that mean, and how can we stop it? Here’s a fascinating case in point: two AEI scholars with different publications argue that we need to stop Dodd-Frank from enabling crony capitalism, and then proceed to describe two opposite, mutually exclusive sets of problems and solutions.

    First, a good test question: The Federal Reserve recently required that the largest firms have a greater capital surcharge than had been originally proposed. Is that cronyism?

    Here’s one story, from James Pethokoukis in ”Fighting the Crony Capitalist Alliance”: “our highly concentrated and interconnected, Too Big to Fail financial system [...] gives a competitive edge to megabanks.” How is that? Regulators create incentives for big banks to take on risks “such as investing in mortgage-backed securities and complex derivatives.” Banks are the size they are, and do the activities that they do, because of the actions of regulators.

    So how do we combat this problem? According to Pethokoukis, we should “substantially raise the capital requirements for Too Big To Fail banks” to limit risk. Even more, “such capital requirements might well nudge the biggest banks into shrinking themselves or breaking up.”

    Here’s another story, from Tim Carney’s “Anti-Cronyism Agenda for the 114th Congress”: Dodd-Frank is cronyism because “[e]xcessive regulation is often the most effective crony capitalism.” What’s worse is that Dodd-Frank designates the biggest firms as Systemically Important Financial Institutions (SIFIs), meaning that they pose a systemic risk to the economy. Those firms are put under more regulation, but it’s obviously a cover for a permanent set of protections.

    So what should we do? According to Carney’s agenda, Congress should “open banking up to more competition by repealing regulations that give large incumbent banks advantages over smaller ones.” Well, which regulations are those? “Congress should repeal its authority to designate large financial firms as SIFIs.”

    Note that though these are from the same institution and carry the same banner of fighting “cronyism,” these agendas are the exact opposite of each other. For Pethokoukis, the important goal is identifying the largest and riskiest institutions and putting aggressive regulations on them, with capital requirements set high enough that they could fundamentally shrink those banks. For Carney, it’s important that we do not identify any firm as too large that it is risky for the economy, and thus increase their capital requirements, since doing so just encourages cronyism -- indeed, it is the logical conclusion of cronyism. Don’t regulate the largest firms with more attention or care; just don’t do anything to them.

    In the Pethokoukis version, the financial sector poses a real threat to the stability of the economy, and as such special efforts should be made to prevent failure and handle failure when it does occur. His answer is, essentially, to do more. In the Carney version, there’s no real danger outside the government’s interference, or at least not a danger that is worth a policy solution. His answer is to do nothing, except repeal what regulation already exists.

    And, crucially, for Pethokoukis, the recent increase in capital surcharges for SIFIs are a good idea; for Carney, they enshrine the problem by working through the SIFI framework, and are a bad idea. How can a policy agenda be built around such a “cronyism” framework?

    There are other problems with “cronyism” as described here. Pethokoukis blames cronyism for the concentration in the financial sector in the last few decades. However the previous argument had been that the size and geographic restrictions that prevented this concentration before the 1990s are the real cronyism. Dodd-Frank blocks a single financial firm from having liabilities in excess of 10 percent of all liabilities, benefitting smaller firms at the expense of larger ones. Is that cronyism or the opposite? Cronyism can’t just be “things turned out in a terrible way when left to the markets.”

    As Rich Yeselson notes in a fantastic essay on New Left historians in the recent issue of Democracy, the Gabriel Kolko-inspired stories about how regulations evolves (stories that influence Carney) are monomaniacally mono-causal. So just quoting CEOs’ statements to the press about Dodd-Frank constitutes analysis, as the regulations must obviously flow from elite desires through their captured lackeys in the state.

    But Dodd-Frank is more complicated than that - look at the effort to stop the CFPB from starting, or the epic battles both between and within regulators, the state and consumers over derivatives. Carney’s top-down inescapable vision of how reform works leaves no room for the contingency of actual efforts to fix a broken system. In turn, this leaves us with no way to actually critique what Dodd-Frank does. Worse, it conflates fighting “cronyism” with an agenda of laissez-faire economics, liberty of contract, and hard money, sneaking in a three-legged stool of reactionary thought through our concerns about fairness.

    Actual cronyism is a real problem, but I’ve seen no evidence that it adds up to a systemic criticism of our economy as a whole. Instead, we need a language of accountability, benefit and power in how markets are structured. Without this, we’ll have no working compass for reform.

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  • New Score: Socialize Uber

    Dec 17, 2014Mike Konczal

    I have a new Score column at The Nation: Socialize Uber. It's about Uber and other sharing economy companies as worker cooperatives. Normally I eyeroll when people talk about cooperatives as an economic solution, but I think there's compelling stuff here. Given that the workers already own all the capital in the form of their cars, why aren’t they collecting all the profits? I'm particularly interested in the comparisons to the Populist movement in this new economy, as back then workers also were amazed by new technologies but also wanted fairness on the terms they could access them.

    We've also revamped how the Score looks, particularly the online part of it, so I hope you check it out. There's some commentary already from Will Wilkinson and Brian Dominick. It's definitely a moment where people are thinking about this, as columns from Nathan Schneider and Trebor Scholz also came out at the same time making similar arguments about worker cooperatives.

    Sure Pricing

    Uber is also in the news because they turned on surge pricing during a terrorist hostage situation in Sydney, Australia. This has gotten people talking about surge pricing. I don't mind surge pricing, but the moralizing way journalists talk about it is really off-putting. Matt Bruenig has a good response to an example of this by Olivia Nuzzi ("How does the world owe you a private car, priced as you deem acceptable, that didn't exist five years ago? [...] you might consider meandering over to a country with a different economic system").

    To expand on Matt, there's two reasons why people might want to avoid surge pricing that virtually never get discussed.

    One is that people care about fairness. As Arin Dube wrote about the minimum wage, "the economists Colin F. Camerer and Ernst Fehr have documented in numerous experimental studies that the preference for fairness in transactions is strong: individuals are often willing to sacrifice their own payoffs to punish those who are seen as acting unfairly, and such punishments activate reward-related neural circuits." This is why you see high support for the minimum wage among people who otherwise support right-wing economic ideas, as we just saw in the 2014 elections.

    People care about fairness; it's in their utility function if you prefer. It's a funny economic argument where markets are meant to serve what people want, and producers are meant to meet those needs at the lowest possible cost, but if people want fairness built into the cost model then it's all sneering all the time. It's almost as if the moment is about conditioning people to serve market needs, rather than markets to serve people needs. If people demanded a cola beveridge that, say, was less sweet, would we get Daily Beast articles about "how dare you, the world doesn't owe you a less sweet cola, move to North Korea if you want to see your market demands turn into products." And there's a long history of using moral persuasion to try and limit price-gouging - check out Little House on the Prairie.

    But the first issue becomes more relevant with a second concern, however, and that's the increasingly negative view of Uber's tactics. People don't have perfect information, and it's reasonable that they might want to pool the risk that they'll be targeted for price discrimination. The obvious comparison here was that early moment Amazon turned out to be charging higher prices based on your browsing history, which it promptly shut down after public outcry. (Why don't you meander over to a different country if you don't want Amazon data-mining your browser to rip you off?)

    Why were people offended? Because in that case the price discimination just transfered the surplus from the customers to the producers - there wasn't any allocative effect. And the same worry can carry over to surge pricing.

    Without perfect information, customers don't really know if they are getting price surged based on supply-and-demand fundamentals or on their own individual characteristics. Imagine if the algorithm increased the liklihood of price surging based on people's past willingness to select price surging. Or because a neighborhood is more like to accept price surging. I assume we'd be mad, right? That wouldn't have an allocative effect - it would just be ripping off those people because the code can tell they'd be willing to pay more.

    Are they doing this now, or will they do this in the future? Normally trust is what would help mitigate both these worries, but with stories about "God mode" and their take-no-prisoners approach to everything, trust is in increasingly low supply.

    Follow or contact the Rortybomb blog:
     
      

     

    I have a new Score column at The Nation: Socialize Uber. It's about Uber and other sharing economy companies as worker cooperatives. Normally I eyeroll when people talk about cooperatives as an economic solution, but I think there's compelling stuff here. Given that the workers already own all the capital in the form of their cars, why aren’t they collecting all the profits? I'm particularly interested in the comparisons to the Populist movement in this new economy, as back then workers also were amazed by new technologies but also wanted fairness on the terms they could access them.

    We've also revamped how the Score looks, particularly the online part of it, so I hope you check it out. There's some commentary already from Will Wilkinson and Brian Dominick. It's definitely a moment where people are thinking about this, as columns from Nathan Schneider and Trebor Scholz also came out at the same time making similar arguments about worker cooperatives.

    Sure Pricing

    Uber is also in the news because they turned on surge pricing during a terrorist hostage situation in Sydney, Australia. This has gotten people talking about surge pricing. I don't mind surge pricing, but the moralizing way journalists talk about it is really off-putting. Matt Bruenig has a good response to an example of this by Olivia Nuzzi ("How does the world owe you a private car, priced as you deem acceptable, that didn't exist five years ago? [...] you might consider meandering over to a country with a different economic system").

    To expand on Matt, there's two reasons why people might want to avoid surge pricing that virtually never get discussed.

    One is that people care about fairness. As Arin Dube wrote about the minimum wage, "the economists Colin F. Camerer and Ernst Fehr have documented in numerous experimental studies that the preference for fairness in transactions is strong: individuals are often willing to sacrifice their own payoffs to punish those who are seen as acting unfairly, and such punishments activate reward-related neural circuits." This is why you see high support for the minimum wage among people who otherwise support right-wing economic ideas, as we just saw in the 2014 elections.

    People care about fairness; it's in their utility function if you prefer. It's a funny economic argument where markets are meant to serve what people want, and producers are meant to meet those needs at the lowest possible cost, but if people want fairness built into the cost model then it's all sneering all the time. It's almost as if the moment is about conditioning people to serve market needs, rather than markets to serve people needs. If people demanded a cola beveridge that, say, was less sweet, would we get Daily Beast articles about "how dare you, the world doesn't owe you a less sweet cola, move to North Korea if you want to see your market demands turn into products." And there's a long history of using moral persuasion to try and limit price-gouging - check out Little House on the Prairie.

    But the first issue becomes more relevant with a second concern, however, and that's the increasingly negative view of Uber's tactics. People don't have perfect information, and it's reasonable that they might want to pool the risk that they'll be targeted for price discrimination. The obvious comparison here was that early moment Amazon turned out to be charging higher prices based on your browsing history, which it promptly shut down after public outcry. (Why don't you meander over to a different country if you don't want Amazon data-mining your browser to rip you off?)

    Why were people offended? Because in that case the price discimination just transfered the surplus from the customers to the producers - there wasn't any allocative effect. And the same worry can carry over to surge pricing.

    Without perfect information, customers don't really know if they are getting price surged based on supply-and-demand fundamentals or on their own individual characteristics. Imagine if the algorithm increased the liklihood of price surging based on people's past willingness to select price surging. Or because a neighborhood is more like to accept price surging. I assume we'd be mad, right? That wouldn't have an allocative effect - it would just be ripping off those people because the code can tell they'd be willing to pay more.

    Are they doing this now, or will they do this in the future? Normally trust is what would help mitigate both these worries, but with stories about "God mode" and their take-no-prisoners approach to everything, trust is in increasingly low supply.

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  • The Bipartisan Policy Center Gets It Wrong: The Lincoln Amendment is Critical to Financial Reform

    Dec 11, 2014Mike KonczalAlexis GoldsteinCaitlin Kline

    A wide variety of people, ranging from Senators Elizabeth Warren and David Vitter to Representative Maxine Waters and FDIC’s Thomas Hoenig, are trying to stop a last-minute attempt to remove an important piece of financial reform. They are all speaking up against a move to repeal the Lincoln Amendment using language written by Citigroup in the year-end budget process.

    Given the wide variety of people against it, it’s interesting how few people are for it. One of the few institutions that has defended it is the Bipartisan Policy Center (BPC), whose Financial Regulatory Reform Initiative released a statement saying:

    “The Consolidated and Further Continuing Appropriations Act is consistent with BPC’s recommendations to repeal the Lincoln Amendment and to substantially increase funding for the SEC and CFTC.”

    These recommendations they cite date back to a 2013 paper, “Better Path Forward on the Volcker Rule and the Lincoln Amendment,” that included arguments against pushing out swaps.

    What’s their case, and does it hold up under scrutiny? We argue it does not. It misreads the purpose and scope of the Volcker Rule, disregards their own analysis on how financial reform should proceed, misses recent developments in the derivatives market, and ignores the issue of what an implicit government support means for exotic derivatives.

    As a reminder, the Lincoln Amendment pushing out swaps (which we’ll refer to as 716) insists that the largest banks hold their exotic, customized, and non-cleared derivatives outside of their FDIC-insured entities in separately capitalized subsidiaries. 716 exempted most standardized derivatives, including interest rate and foreign exchange swaps, as well as cleared credit default swaps (CDS). This provision only applies to the odd and dangerous stuff.

    So what are BPC's arguments?

    716 and Volcker Accomplish Different Goals

    Their core argument is that 716 is redundant, and therefore unnecessary, because of the Volcker Rule.  As they put it,“[L]ike the Volcker Rule, the Lincoln Amendment was intended to separate certain securities-related activities from traditional banking activities.” BPC further argues that with a “proper implementation of the Volcker Rule… the rationale for the Lincoln Amendment may no longer apply.”

    This is not the case. The Volcker Rule is about risky activities, and focuses on eliminating the gambling risks associated with proprietary trading and exposure to certain types of investment funds. 716, on the other hand, is about risky products, and aims to reduce risk to the Deposit Insurance Fund (DIF) by utilizing separately capitalized entities for the riskiest derivatives.

    While there is some overlap between the two, there are significant gaps. For instance, exemptions in the Volcker Rule allow some of the riskiest trades to be done within FDIC-insured entities -- things like making markets in bespoke, exotic, uncleared credit default swaps. Indeed, walking away from the financial crisis with an attitude that uncleared credit default swaps are no big issue is quite troubling. This puts the Deposit Insurance Fund at risk. 

    716 complements Volcker by forcing the riskiest and most non-vanilla derivatives and CDS into a separately capitalized entity, something Volcker doesn’t do by itself. This helps protect the DIF in case a firm gets into trouble market-making bespoke trades that can’t be perfectly hedged – a Volcker-compliant activity. 

    The Final Volcker Rule Isn’t Fully Implemented

    Shockingly, BPC is violating its own analysis with this recommendation. In the 2013 paper, BPC “recommends a wait-and-see approach regarding the Lincoln Amendment until more experience can be gained from the Volcker Rule.” Only then, if the full implementation of the Volcker Rule is working well, could the Lincoln Amendment “be repealed without any negative effect.”

    It is disturbing that the BPC supports this removal of the Lincoln Amendment before the Volcker Rule is fully implemented in mid-2015, and even before we've had time to see how it impacts the financial markets. It’s not even clear how they are judging whether the Volcker Rule is working the way they want, given that the data and metrics they rely on so heavily have only just begun to be reported to regulators, and are non-public.

    Shoving a bank-written addition into a budget bill, not unlike the CFMA of 2000 which helped create the crisis, is the exact opposite of a “wait-and-see approach.”

    Pushout Doesn’t Harm Bank Resolution

    Another argument made against 716 was that it would complicate the ability of regulators to deal with a bank failure. BPC points out that regulators are empowered to grant a temporary stay to derivatives, preventing derivative creditors from grabbing collateral while others wait two days, as they did with Lehman Brothers. (Under bankruptcy, derivatives are exempt from this temporary stay, which can complicate and accelerate bankruptcy.)

    Part of the argument is true: Dodd-Frank did grant the FDIC new powers under the Orderly Liquidation Authority, which allows them to force a 24-hour stay on derivatives (overriding the exemption), but this only applies to banks under FDIC purview.

    BPC argued that the largest banks should be allowed to keep derivatives inside the FDIC accounts, so that they could utilize the FDIC’s OLA power. BPC writes that the 716 “subsidiaries would not enjoy the temporary stay on the unwinding of contracts that applies to banks under FDIC resolution procedures. Rapid termination of such contracts in the event of a bank failure would have a disruptive impact on financial markets."

    But this argument is much less valid than it was when it was written, precisely because regulators are anticipating this problem. Eighteen of the major banks and the International Swaps and Derivatives Association (ISDA) agreed in October that they’d contractually apply temporary stays to derivatives. With wide agreement among the banks to apply temporary stays anyway, the proper course of action is to work through this process of standardizing derivatives for automatic stays across the financial sector, rather than trying to use taxpayer funds to backstop them.

    Apart from the BPC arguments, we wish to raise an additional point:  

    Should Policy Allow Firms to Capitalize on Market-Perceived Subsidies?

    Keeping derivatives in FDIC-insured entities lowers their costs: creditors charge lower rates, as FDIC accounts are seen as having the backing of the federal government. And these FDIC accounts typically have higher credit ratings, which is why, in 2011, Bank of America moved derivatives from its Merrill Lynch subsidiary, which had just suffered a downgrade, into its FDIC-insured subsidiary, much to the chagrin of the FDIC.

    As Peter Eavis writes in The New York Times, this directly helps Citigroup, who lobbied for and wrote the change, as they own a lot of CDS: “With some $3 trillion of exposure, the bank is one of biggest default swap dealers in the United States. Those swaps right now live inside an entity called Citibank N.A. that enjoys federal deposit insurance. Nearly $2 trillion of those swaps are based on companies or other entities with a junk credit rating.”

    And as Eavis points out, it’s very likely that a huge portion of Citigroup’s CDS are uncleared, as very few CDS overall are cleared: “Only about 10 percent of such swaps are centrally cleared, according to official surveys.”

    Banks keeping derivatives in the FDIC accounts lower their cost of doing business, due to the market perception of an implicit government support. It should not be the role of policy to artificially lower the cost of bank borrowing, and as such we find the case for removing the Lincoln Amendment to be unconvincing.

    Mike Konczal is a Fellow at the Roosevelt Institute.

    Alexis Goldstein is a former Wall Street professional, who now serves as the Communications Director at Other98.org.

    Caitlin Kline is a derivatives specialist at Better Markets.

    Follow or contact the Rortybomb blog:
     
      

     

    A wide variety of people, ranging from Senators Elizabeth Warren and David Vitter to Representative Maxine Waters and FDIC’s Thomas Hoenig, are trying to stop a last-minute attempt to remove an important piece of financial reform. They are all speaking up against a move to repeal the Lincoln Amendment using language written by Citigroup in the year-end budget process.

    Given the wide variety of people against it, it’s interesting how few people are for it. One of the few institutions that has defended it is the Bipartisan Policy Center (BPC), whose Financial Regulatory Reform Initiative released a statement saying:

    “The Consolidated and Further Continuing Appropriations Act is consistent with BPC’s recommendations to repeal the Lincoln Amendment and to substantially increase funding for the SEC and CFTC.”

    These recommendations they cite date back to a 2013 paper, “Better Path Forward on the Volcker Rule and the Lincoln Amendment,” that included arguments against pushing out swaps.

    What’s their case, and does it hold up under scrutiny? We argue it does not. It misreads the purpose and scope of the Volcker Rule, disregards their own analysis on how financial reform should proceed, misses recent developments in the derivatives market, and ignores the issue of what an implicit government support means for exotic derivatives.

    As a reminder, the Lincoln Amendment pushing out swaps (which we’ll refer to as 716) insists that the largest banks hold their exotic, customized, and non-cleared derivatives outside of their FDIC-insured entities in separately capitalized subsidiaries. 716 exempted most standardized derivatives, including interest rate and foreign exchange swaps, as well as cleared credit default swaps (CDS). This provision only applies to the odd and dangerous stuff.

    So what are BPC's arguments?

    716 and Volcker Accomplish Different Goals

    Their core argument is that 716 is redundant, and therefore unnecessary, because of the Volcker Rule.  As they put it,“[L]ike the Volcker Rule, the Lincoln Amendment was intended to separate certain securities-related activities from traditional banking activities.” BPC further argues that with a “proper implementation of the Volcker Rule… the rationale for the Lincoln Amendment may no longer apply.”

    This is not the case. The Volcker Rule is about risky activities, and focuses on eliminating the gambling risks associated with proprietary trading and exposure to certain types of investment funds. 716, on the other hand, is about risky products, and aims to reduce risk to the Deposit Insurance Fund (DIF) by utilizing separately capitalized entities for the riskiest derivatives.

    While there is some overlap between the two, there are significant gaps. For instance, exemptions in the Volcker Rule allow some of the riskiest trades to be done within FDIC-insured entities -- things like making markets in bespoke, exotic, uncleared credit default swaps. Indeed, walking away from the financial crisis with an attitude that uncleared credit default swaps are no big issue is quite troubling. This puts the Deposit Insurance Fund at risk. 

    716 complements Volcker by forcing the riskiest and most non-vanilla derivatives and CDS into a separately capitalized entity, something Volcker doesn’t do by itself. This helps protect the DIF in case a firm gets into trouble market-making bespoke trades that can’t be perfectly hedged – a Volcker-compliant activity. 

    The Final Volcker Rule Isn’t Fully Implemented

    Shockingly, BPC is violating its own analysis with this recommendation. In the 2013 paper, BPC “recommends a wait-and-see approach regarding the Lincoln Amendment until more experience can be gained from the Volcker Rule.” Only then, if the full implementation of the Volcker Rule is working well, could the Lincoln Amendment “be repealed without any negative effect.”

    It is disturbing that the BPC supports this removal of the Lincoln Amendment before the Volcker Rule is fully implemented in mid-2015, and even before we've had time to see how it impacts the financial markets. It’s not even clear how they are judging whether the Volcker Rule is working the way they want, given that the data and metrics they rely on so heavily have only just begun to be reported to regulators, and are non-public.

    Shoving a bank-written addition into a budget bill, not unlike the CFMA of 2000 which helped create the crisis, is the exact opposite of a “wait-and-see approach.”

    Pushout Doesn’t Harm Bank Resolution

    Another argument made against 716 was that it would complicate the ability of regulators to deal with a bank failure. BPC points out that regulators are empowered to grant a temporary stay to derivatives, preventing derivative creditors from grabbing collateral while others wait two days, as they did with Lehman Brothers. (Under bankruptcy, derivatives are exempt from this temporary stay, which can complicate and accelerate bankruptcy.)

    Part of the argument is true: Dodd-Frank did grant the FDIC new powers under the Orderly Liquidation Authority, which allows them to force a 24-hour stay on derivatives (overriding the exemption), but this only applies to banks under FDIC purview.

    BPC argued that the largest banks should be allowed to keep derivatives inside the FDIC accounts, so that they could utilize the FDIC’s OLA power. BPC writes that the 716 “subsidiaries would not enjoy the temporary stay on the unwinding of contracts that applies to banks under FDIC resolution procedures. Rapid termination of such contracts in the event of a bank failure would have a disruptive impact on financial markets."

    But this argument is much less valid than it was when it was written, precisely because regulators are anticipating this problem. Eighteen of the major banks and the International Swaps and Derivatives Association (ISDA) agreed in October that they’d contractually apply temporary stays to derivatives. With wide agreement among the banks to apply temporary stays anyway, the proper course of action is to work through this process of standardizing derivatives for automatic stays across the financial sector, rather than trying to use taxpayer funds to backstop them.

    Apart from the BPC arguments, we wish to raise an additional point:  

    Should Policy Allow Firms to Capitalize on Market-Perceived Subsidies?

    Keeping derivatives in FDIC-insured entities lowers their costs: creditors charge lower rates, as FDIC accounts are seen as having the backing of the federal government. And these FDIC accounts typically have higher credit ratings, which is why, in 2011, Bank of America moved derivatives from its Merrill Lynch subsidiary, which had just suffered a downgrade, into its FDIC-insured subsidiary, much to the chagrin of the FDIC.

    As Peter Eavis writes in The New York Times, this directly helps Citigroup, who lobbied for and wrote the change, as they own a lot of CDS: “With some $3 trillion of exposure, the bank is one of biggest default swap dealers in the United States. Those swaps right now live inside an entity called Citibank N.A. that enjoys federal deposit insurance. Nearly $2 trillion of those swaps are based on companies or other entities with a junk credit rating.”

    And as Eavis points out, it’s very likely that a huge portion of Citigroup’s CDS are uncleared, as very few CDS overall are cleared: “Only about 10 percent of such swaps are centrally cleared, according to official surveys.”

    Banks keeping derivatives in the FDIC accounts lower their cost of doing business, due to the market perception of an implicit government support. It should not be the role of policy to artificially lower the cost of bank borrowing, and as such we find the case for removing the Lincoln Amendment to be unconvincing.

    Mike Konczal is a Fellow at the Roosevelt Institute.

    Alexis Goldstein is a former Wall Street professional, who now serves as the Communications Director at Other98.org.

    Caitlin Kline is a derivatives specialist at Better Markets.

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  • The Financial Regulation Congress Is Quietly Trying to Destroy in the Budget

    Dec 10, 2014Mike Konczal

    There are concerns that the budget bill under debate in Congress will eliminate Section 716 of Dodd-Frank, using language previously drafted by Citigroup. So what is this all about?

    Section 716 of Dodd-Frank says that institutions that receive federal insurance through FDIC and the Federal Reserve can’t be dealers in the specialized derivatives market. Banks must instead “push out” these dealers into separate subsidiaries with their own capital that don’t benefit from the government backstop. They can still trade in many standardized derivatives and hedge their own risks, however. This was done because having banks act as exotic swap dealers put taxpayers at risk in the event of a sudden collapse. That’s it.

    Why would you want a regulation like this? The first is that it acts as a complement to the Volcker Rule. As Americans for Financial Reform notes, the Volcker Rule allows banks to make markets in derivatives. What 716 does is regulate the most exotic and custom derivatives, like the custom credit default swaps that generated the financial crisis of 2008. These derivatives are the most difficult part for the Volcker Rule to manage, so 716 adds a crucial second layer of protection.

    A second reason is 716 will also prevent exotic derivatives from being subsidized by the government’s safety net. As the Roosevelt Institute’s Rob Johnson notes, removing this language would “extend guarantees to complex derivatives within banks, which in turn will subsidize and encourage their overuse.” We should be finding a balance for the derivatives market, not expanding it.

    The third reason is for the sake of financial stability. The major banks have been unable to produce credible living wills describing how they can go through bankruptcy without tearing down the system. There is no world in which these banks will be closer to achieving this crucial goal by cramming themselves full of even more exotic types of derivatives.

    Pushing out these risky derivatives enables the financial sector to focus more on its core job. As Roosevelt’s Chief Economist Joseph Stiglitz wrote in favor of 716, “[b]y quarantining highly risky swaps trading from banking altogether, federally insured deposits (and our basic payments mechanism) will not be put at risk by toxic swaps transactions. Moreover, banks will be forced to behave like banks, focusing on extending credit in a manner that builds economic strength as opposed to fostering worldwide economic instability.”

    Stiglitz reiterated this point today, saying “Section 716 facilitates the ability of markets to provide the kind of discipline without which a market economy cannot effectively function. I was concerned in 2010 that Congress would weaken 716, but what is proposed now is worse than anything contemplated back then.”

    Now many on Wall Street would argue that this rule is unnecessary. However, their arguments are not persuasive.

    They might argue that many people opposed this bill at the time it was proposed, and indeed it was the source of great controversy. But what they overlook is that there was already a wave of compromise on this provision during the drafting Dodd-Frank. 716 focuses mainly on a subset of risky and exotic derivatives. Under the final law, banks can still hold most types of standardized and common derivatives, like ones for interest rates. This is the vast majority of the market. Banks can also hold derivatives that they use to mitigate their own risk. There was significant debate in 2010 over how this regulation should play out, and the final language reflects this compromise.

    They might also argue that the financial sector is taking care of this issue on its own. But instead of being moved out, derivatives are being moved into backstopped banks. As the former FDIC chairperson Sheila Bair notes, the “trend has been to move this activity from the investment banking affiliates, which do not use insured deposits, into the banks where the activity can be funded with cheap, FDIC backed deposits. Section 716 would at least keep certain credit default swaps outside of insured banks.”

    The question of how we should regulate derivatives and the financial markets more broadly has not been settled. There’s still an ongoing debate over how derivatives will be regulated across borders. And as noted, banks are still unable to produce credible living wills to survive a bankruptcy court. It’s for reasons like this that a wide variety of people who didn’t support the initial language of 716 now oppose removing 716: Timothy GeithnerJack LewSheila BairBarney Frank, and more.

    We should be strengthening, not weakening, financial reform. And removing this piece of the law will not benefit this project.

    Follow or contact the Rortybomb blog:
     
      

     

    There are concerns that the budget bill under debate in Congress will eliminate Section 716 of Dodd-Frank, using language previously drafted by Citigroup. So what is this all about?

    Section 716 of Dodd-Frank says that institutions that receive federal insurance through FDIC and the Federal Reserve can’t be dealers in the specialized derivatives market. Banks must instead “push out” these dealers into separate subsidiaries with their own capital that don’t benefit from the government backstop. They can still trade in many standardized derivatives and hedge their own risks, however. This was done because having banks act as exotic swap dealers put taxpayers at risk in the event of a sudden collapse. That’s it.

    Why would you want a regulation like this? The first is that it acts as a complement to the Volcker Rule. As Americans for Financial Reform notes, the Volcker Rule allows banks to make markets in derivatives. What 716 does is regulate the most exotic and custom derivatives, like the custom credit default swaps that generated the financial crisis of 2008. These derivatives are the most difficult part for the Volcker Rule to manage, so 716 adds a crucial second layer of protection.

    A second reason is 716 will also prevent exotic derivatives from being subsidized by the government’s safety net. As the Roosevelt Institute’s Rob Johnson notes, removing this language would “extend guarantees to complex derivatives within banks, which in turn will subsidize and encourage their overuse.” We should be finding a balance for the derivatives market, not expanding it.

    The third reason is for the sake of financial stability. The major banks have been unable to produce credible living wills describing how they can go through bankruptcy without tearing down the system. There is no world in which these banks will be closer to achieving this crucial goal by cramming themselves full of even more exotic types of derivatives.

    Pushing out these risky derivatives enables the financial sector to focus more on its core job. As Roosevelt’s Chief Economist Joseph Stiglitz wrote in favor of 716, “[b]y quarantining highly risky swaps trading from banking altogether, federally insured deposits (and our basic payments mechanism) will not be put at risk by toxic swaps transactions. Moreover, banks will be forced to behave like banks, focusing on extending credit in a manner that builds economic strength as opposed to fostering worldwide economic instability.”

    Stiglitz reiterated this point today, saying “Section 716 facilitates the ability of markets to provide the kind of discipline without which a market economy cannot effectively function. I was concerned in 2010 that Congress would weaken 716, but what is proposed now is worse than anything contemplated back then.”

    Now many on Wall Street would argue that this rule is unnecessary. However, their arguments are not persuasive.

    They might argue that many people opposed this bill at the time it was proposed, and indeed it was the source of great controversy. But what they overlook is that there was already a wave of compromise on this provision during the drafting Dodd-Frank. 716 focuses mainly on a subset of risky and exotic derivatives. Under the final law, banks can still hold most types of standardized and common derivatives, like ones for interest rates. This is the vast majority of the market. Banks can also hold derivatives that they use to mitigate their own risk. There was significant debate in 2010 over how this regulation should play out, and the final language reflects this compromise.

    They might also argue that the financial sector is taking care of this issue on its own. But instead of being moved out, derivatives are being moved into backstopped banks. As the former FDIC chairperson Sheila Bair notes, the “trend has been to move this activity from the investment banking affiliates, which do not use insured deposits, into the banks where the activity can be funded with cheap, FDIC backed deposits. Section 716 would at least keep certain credit default swaps outside of insured banks.”

    The question of how we should regulate derivatives and the financial markets more broadly has not been settled. There’s still an ongoing debate over how derivatives will be regulated across borders. And as noted, banks are still unable to produce credible living wills to survive a bankruptcy court. It’s for reasons like this that a wide variety of people who didn’t support the initial language of 716 now oppose removing 716: Timothy GeithnerJack LewSheila BairBarney Frank, and more.

    We should be strengthening, not weakening, financial reform. And removing this piece of the law will not benefit this project.

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  • Monetary Policy Event with Paul Krugman and Senator Warren Today

    Dec 9, 2014Mike Konczal
    I'm very excited to share that AFR, EPI, and the Roosevelt Institute have teamed up to host a conference on monetary policy, the recovery and the financial sector today. The conference will feature keynotes from Paul Krugman and Senator Elizabeth Warren.
    I'm very excited to share that AFR, EPI, and the Roosevelt Institute have teamed up to host a conference on monetary policy, the recovery and the financial sector today. The conference will feature keynotes from Paul Krugman and Senator Elizabeth Warren. It also features, among many other great panelists, friend of the blog and Roosevelt fellow JW Mason (who recently wrote about monetary policy here and here, and at the old rortybomb blog here), and who has been part of the financialization project we'll be releasing soon.
     
    Though the event is sold out, EPI will be posting the video after the event, and I hope you'll watch it.
     
    Tuesday, December 9, 2014
     
    12:30 – 4:00 p.m. ET
     
    Hart Senate Office Building 902
    Washington, DC
     
    Sponsored by Americans for Financial Reform, Economic Policy Institute, and Roosevelt Institute's Financialization Project
     
    FEATURING
    Senator ELIZABETH WARREN
    Economist/columnist PAUL KRUGMAN
     
    Today, pressure is building on the Federal Reserve to use monetary policy to raise short-term interest rates, a move that could short-circuit a still far from complete economic recovery. Proponents of this move argue it is needed to avert wage and price inflation and prevent excessive risk-taking in the financial sector. But there are serious questions about this argument, and there are new tools available to the Fed to influence Wall Street and the wider economy. These tools and better economic analysis could allow the Fed to better target specific concerns regarding Wall Street financial risk-taking while minimizing unnecessary drag on the Main Street economy.
     
    Join Elizabeth Warren, Paul Krugman, and experts on monetary and regulatory policy for a discussion of Federal Reserve economic management. The discussion will range from what the Fed’s next moves should be in monetary policy to the ways in which the Fed can use new regulatory tools to address problems in the financial market without causing unnecessary problems in the broader economy.
     
    AGENDA
     
    12:30pm – Keynote by Senator Elizabeth Warren
     
    1:00pm -  Panel: Monetary Policy and the Economy
     
    Panelists: 
     
    Josh Bivens, Research and Policy Director, Economic Policy Institute
    William Spriggs, Chief Economist, AFL-CIO
    JW Mason, John Jay College, Roosevelt Institute
    Robert Pollin, Professor of Economics and Co-Director of PERI, University of Massachusetts Amherst
     
    2:15pm – Keynote by Paul Krugman
     
    2:45pm – Panel: Regulatory Tools For Managing Financial Cycles
     
    Panelists: 
     
    Marcus Stanley, Policy Director, Americans for Financial Reform
    Jill Cetina, Associate Director for Policy Studies,  Office of Financial Research
    Jennifer Taub, Professor of Law, Vermont Law School
    Jane D'Arista, Author, “The Evolution of U.S. Finance"

     

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