Financial Reform: A Global Success in Regulating Banks

Nearly everyone can agree on the cause of the recent global financial meltdown: excessive risk-taking by large banks and financial institutions.  What the right refuses to admit is another obvious: those excessive risk taking practices were enabled and encouraged by financial deregulation that started with Reagan and culminated in the Graham-Leach-Bliley Act signed into law by President Clinton in 1999.  As a response to this crisis, Congress passed, and President Obama signed into law, the most significant reform of Wall Street since the 1930s, the Dodd-Frank Wall Street Reform and Consumer Protection Act.  While Congress was working on the new law, the President provided important leadership on global financial regulations.

The reforms were popular and the right thing to do, but many have wondered if those will be rendered useless at the end of the day.  While the far right has bemoaned any additional regulation of Wall Street, many on the left have expressed concerns about the regulations not being sufficiently hard on the financial sector.  Whatever your personal opinion of the reform is, we now have early indications that the reforms are working.  US and global action seems to be paying off, reports the Wall Street Journal.
Tighter regulatory requirements are compelling giant investment banks in the U.S. and Europe to tone down their risk-taking and shift to more staid strategies. [...]

"The business models on the Street are going through dramatic changes," says Clayton Rose, professor of management practice at Harvard Business School, based on the most drastic shifts in the "political, regulatory, and economic environment since the 1930s in the financial industry."
Global and US regulatory reforms seem to be working in tandem, as even Swiss banks move to safer practices.  You read that right.  Swiss banks are getting tighter regulations.
The latest example of this new pressure came Monday, when a Swiss bank panel recommended that the country's banks be forced to raise their capital cushion against risky assets by a higher margin than standards issued last month by a global bank-reform group. Analysts say U.S. regulators could take similar steps as they implement the Basel III Accord.
Forcing banks to cushion their risks with a higher capital requirement, huh?  Why didn't we think of that?  Well, as it turns out, we did.  The Dodd-Frank bill did not explicitly set capital requirements, but empowered US regulators to work with international authorities to set international standards instead.  That turns out to have been the right thing to do, as the huge financial firms requiring regulatory oversight are international institutions by nature, and the financial crisis was global in nature.  Banking practices across the globe needed to be regulated, not just in the US.

These international regulations are written in Basel, Switzerland, and are named after the city.  Under the Basel II agreements, which were in place before the Basel III accords that came in September, banks were required to hold a mere 2% of their total assets in hard capital.  The standards leading up to the financial crisis were, as Tim Fernholz at the American Prospect pointed out, rather weak:
Flash back to the financial crisis: In 2008, American regulators enforced a modified version of Basel II, the last international agreement on bank standards. Under that agreement, banks were required to monitor the ratio of how much hard capital they held to their total assets, expressed as a percent. This capital ratio had to be greater than 2 percent, so (roughly) for every hundred dollars in assets, banks needed to have $2 of capital on hand. Banks had to hold another class of capital, too, but with a wider definition: Some securities -- including subprime-mortgage instruments -- were considered as good as cash. Meanwhile, some assets, like over-the-counter derivatives and credit lines that clients hadn't accessed yet, weren't fully included as costs on the asset side of the ratio.
In other words, banks had to hold almost no cash for the big trades on their balance sheets.  Well, we found out what happens when that's the case.  Once traders stop their drunken-sailor uber-risk taking behavior, the banks find themselves unable to operate without cash, and they come to taxpayers to bail them out, which we had to for the sake of the stability of the financial system.

Basel III, the new international accord reached in September, significantly ramps up capital requirements to cushion against both out-of-line risk taking by financial institutions and systematic disasters when trading subsides.
The Dodd-Frank financial-reform bill that passed this past summer, then, included provisions calling for higher capital standards but not a clear idea of what they would be, leaving the specifics up to the regulators in Basel. Critics fretted that during the regulatory process, the financial sector would convince often-amenable regulators to create lax rules.

Not this time. On Sunday, when the Basel Committee, which includes Federal Reserve Chair Ben Bernanke, voted to approve a new global capital regime, the capital requirement more than doubled, to 7 percent. That includes a 2.5 percent "capital cushion," where banks that don't meet the 7 percent standard cannot issue dividends or take other steps that decrease their reserves. A broader category of capital, called "Tier1," now has a stricter definition and will bring total bank reserves up to 10.5 percent of assets.
Increasing capital requirements does two things.  First, it reduces the risky trades, puts more money in reserves on the banks, reducing the need for a taxpayer sponsored rescue in a downturn.  Second, consider this: the big banks have two functions: trading (which is how the biggest financial firms make most of their money) - including things like stocks, mortgage and subprime-mortgage backed securities, derivatives, etc - and lending.  Raising capital requirements encourages less trading and more lending (as trading is a more risky activity, and lending comes with a smaller increase in assets in form securitized loans, meaning banks will have to keep less cash on the reserves).  Less trading and more lending is likely to increase loans to businesses, spurring business-to-business activity as well as hiring, instead of increasing funny money on Wall Street.

Reformers noted the pro-reform clout of the Obama team over the Basel III Accord:
The Basel III agreement -- named after the Swiss city that hosts the Bank of International Settlements, the institutional home of global financial coordination -- fulfilled the Obama administration's vision for overhauled bank regulation and demonstrated impressive clout abroad.

"One can only conclude from this outcome that the U.S. regulators were quite aggressive and that they were able to have certain disproportionate influence over the outcome," says Raj Date, who heads the reform-minded Cambridge Winter Center on Financial Policy. "Both of those things are good news."

Trading volume by these large financial behemoths is already dropping (and, aww, cutting into their profit lines), according to the WSJ article cited at the beginning of this piece.
Now, global investment banks are getting squeezed. Profit from securities trading plunged in the third quarter. In the bond market, for instance, investors were "paralyzed and trading desks fell silent during the quarter," research firm Sanford Bernstein said in a note last Thursday. The firm slashed per-share earnings estimates for Goldman Sachs and Morgan Stanley.  [...]

Return on average equity for the major investment banks, a key barometer of profitability, could be halved from the 20% range a few years ago, according to SNL Financial. [...]

New international bank-capital requirements, called Basel III... will force many banks in the U.S. and Europe to jettison trading businesses, such as mortgage securities.
Oh noes!  You mean banks are going to have a little more trouble selling off their mortgages in pieces to investment banks?  You mean the lender of a mortgage might actually have to hold the loan and have an interest in collecting (thereby not giving out liar loans without properly checking to make sure the borrower can pay the loan)?  Oh how will we survive?  Watch me shed some crocodile tears for the big banks.

What else?
The obligation to hold more capital "means that return on equity will go down," said Huw van Steenis, a bank analyst at Morgan Stanley in London. He predicts that return on equity could fall an average of 4% and potentially as far as 8% at investment banks in the U.S. and Europe. [...]

The U.S. financial-regulatory law is forcing big investment banks to shed proprietary-trading desks, in which firms made bets using their own capital. Already, banks are losing traders and business to nonbanks...
Regulators and lawmakers, in conclusion, seem to have gotten this right, for once.  That's good news.  Finally, we are setting some rules of the road for Wall Street before we find ourselves on the edge of another financial disaster.  Barney Frank and Chris Dodd are to be commended for considerable legislative success on financial reform, and President Obama and his economic team are to be applauded for their success in pushing through not just national but international regulatory reform.  These are progressive reforms and policies we can be proud of.

But this also demonstrates why it matters who is in power.  While Republicans controlled Congress for 12 years and the presidency for eight, they deregulated everything and caused the disaster that Obama and the Democrats are having to tackle today.  It matters who is in charge.  It matters who is writing our laws, and who on our behalf is negotiating with the international community.  It matters whose side they are on.  With financial reform, Democrats and President Obama have shown that they are on the side of the reformers, progressives, and regulating Wall Street.  Less than four weeks from today, it's important that reformers, progressives, and advocates of regulation stand on their side at the polling booth.