The Good, the Bad, and the Ugly in Financial Reform

President Obama didn’t promise that the financial reform bill he signed last week heralded the Second Coming, but he did pledge that Joe Taxpayer would “never again be asked to foot the bill for Wall Street’s mistakes.” Alas, the reach of Obama’s promise exceeds the grasp of his signing pen, says Mark Williams.

“This is financial reform. It is not meaningful financial reform,” says Williams (GSM’93), a School of Management executive in residence and master lecturer in finance. Had the bill been law two years ago, we still would have had the banking crisis and recession, Williams argues. Still, there are provisions to be applauded. High-flying “banksters” put us in this soup with their daredevil risk-taking, Williams says, and the bill, in his words, puts more regulatory cops on the corner to watch them.

Williams is the author of Uncontrolled Risk, about the collapse of Lehman Brothers. BU Today spoke with him about the reform bill’s pluses and minuses.

BU Today: When he signed the bill, President Obama said, “There will be no more taxpayer-funded bailouts. Period.” Do you believe him?
Williams: It’s a great sound bite, but it’s not true. There’s one provision that FDIC insurance has permanently increased from $100,000 to $250,000 per account. Taxpayers are on the hook. If a bank goes belly-up, an account is insured for $250,000. It helps very large depositors; the average American would love $250,000 in an account. Banks fund themselves through deposits, so the banks can use that money to lend. Every time the government decides to insure more, the government is putting taxpayer money at risk.

Investment banks had said, For us to compete with commercial banks—which had a cheap form of funding, because they were FDIC-insured—we have to grow our balance sheets. Investment banks took on more debt. Leverage ratios got high. It was a financial Star Wars.

What about the Volcker rule, which, in an earlier version of the legislation, said banks could not invest their capital in risky enterprises like hedge funds or private equity funds?
It was watered down. Banks are able to invest, in these areas, up to 3 percent of their capital. Three percent may not sound like much, but when you look at State Street Bank, for example, it has roughly $15 billion in capital. Three percent is hundreds of millions of dollars. It allows banks to put a foot in the door to expand the amount of risky activities they’re involved in.

Should Obama have vetoed the bill?
No, but it’s important to look at it with open eyes. The main culprits that caused the financial crisis were weak credit underwriting standards. Too many banks gave money to too many people who should not have had these loans. If you look at this bill, there’s no area specifically that says banks cannot take risky lending practices.

Talk about what’s good in the bill.
The first [thing] is this consumer protection financial bureau. It’s going to be funded with a substantial amount of money. It has independence in the sense that the head is going to be appointed by the president. It is the equivalent of the FDA for consumer products—all mortgage products, credit card products. When you look at these contracts, they’re written by and for lawyers, and they always have escape clauses that help the banks.

The systemic risk council and financial stability oversight council are extremely important. We are interconnected globally through our financial system. We need regulators to identify financial institutions that pose a stability risk to the overall economy. They would have been able to see, potentially, the rise of riskiness at organizations like Lehman Brothers and Bear Stearns and Morgan Stanley. The devil is in the details. Who are the people who are going to be running it?

“Say on pay” is a very important provision to give shareholders a say on executive compensation. High executive compensation corresponds with high risk-taking. If shareholders have a say on pay, that’s another safeguard.

Will the bill decrease lending and bank profits, and if so, are those necessarily bad things?
The bill increases oversight. In turn, for compliance, banks will have to spend more money. The bill also focuses on reducing risk-taking, so you would expect profitability to go down. Banks have been extremely profitable at a cost to the overall economy. Profit should be based on taking not-excessive risk. Now, hopefully, there’ll be a better balance between risk-taking and return.

You like Canada’s regulatory system, which averted bank bailouts by limiting subprime mortgages and banks’ leverage. How much of the Canadian system is in this bill?
Definitely not enough. The Canadian system has one unified regulator. Having one parent, you can’t play one parent off the other. We’re continuing to have a fractured banking system.

The act puts limits on leverage. But say you take a loan out and invest in junk bonds; I take the same loan out and invest in triple-A securities. We have the same leverage ratio. But your investment is more risky. The act doesn’t measure the quality of leverage. Canada does. The leverage restriction is a positive step. But there’s a lot more work to be done.

How much of the political opposition to the bill was due to politicians’ fear of losing bankers’ campaign contributions?
A lot. I had this ongoing feud with Sen. Judd Gregg (R-N.H.). He said, Why are we trying to regulate derivatives? He gets a lot of political support from the financial community. Sen. Scott Brown (R-Mass.) received a lot of political contributions from commercial banks and hedge funds. It’s ludicrous to think they’re not influenced by lobbyists and contributions.

Rich Barlow can be reached at barlowr@bu.edu.