Reforming Finance

Ten areas of financial reform are regarded as being essential to re-establish the two basic functions of the banking sector, namely, extending credit to households and the business sector, and connecting investors to entrepreneurs. Pure trading and speculating should, meanwhile, be discouraged to the maximum degree possible.

The project of seriously re-regulating the financial sector requires a great deal more leadership than we have seen so far from any of the large nations. In many ways, the Obama government has been the most disappointing. To the extent that the governments of Britain, France or Germany have ventured slightly bolder proposals, they have been discouraged by the government of the United States.

To appreciate the degree of reform that we need, it is helpful to review the function of the banking system. At bottom, the role of the financial sector is to channel credit and capital to the real part of the economy, to make assessments of risk, and to price the cost of credit accordingly. Until the 1970s, the financial sector in most of our countries was well regulated and well behaved. The financial sector itself was fairly small – under 6 percent of GDP in the US. It existed to serve the rest of the economy. With deregulation, more and more of what financial intermediaries did became pure speculation, aided by extreme degrees of leverage and pyramiding. The enlargement of the financial sector became an end in itself.

One can divide the financial system into three broad functions:

• extending credit to businesses and households;

• connecting investors to entrepreneurs;

• pure trading and speculating.

The first two functions add value to the economy. But since the 1970s, more and more of the financial system and an increasing share of its profits have been based on the third function. As many critics have observed, all of the banks want to be hedge funds. But pure speculation and trading adds nothing to net economic welfare. At best, it is a zero-sum game. At worst, as in the recent crisis, it simply allows middlemen to take immense risks with other people’s money. If their bets pay off, they can become extremely rich. If their bets fail and they are large enough or interconnected enough, governments often make up the losses.

The historic task of government in this era is not just to discourage or prohibit risky practices, but to fundamentally alter the business models of major financial institutions, so that no institution that makes most of its profits from speculation or from trading is in a position to menace the entire system or to require bailouts from taxpayers. Speculation, to the extent that it is permitted at all, should be a purely private activity, and it should be discouraged.

The Obama Administration has shown little interest in this degree of fundamental reform. On the contrary, its strategy for resolving the banking crisis has been to prop up banks that are effectively insolvent such as Citigroup, and to disguise the degree of their insolvency. The consequence of this policy is that real reform is deferred, and the process of recovery is protracted because traumatized banks are rebuilding capital and setting overly strict lending standards rather than providing credit where it is needed. Though the Federal Reserve has reduced short term interest rates to barely above zero, the real economy suffers from a paradox of cheap money and tight credit.

Large money center banks continue to see speculative activities rather than ordinary commercial banking or stock underwriting as their main profit centers. This is a recipe for the next bubble economy.

The reform legislation recently approved by the U.S. House of Representatives is far too weak. It does not include serious controls on derivatives, or fundamental reform of credit-rating agencies. It leaves the most unregulated kinds of financial institutions such as hedge funds and private equity firms almost untouched. It preserves the doctrine of “too-big-to-fail”, and puts the Federal Reserve in the role of “systemic risk regulator” despite the Federal Reserve’s failure to adequately regulate sub-prime lenders or bank holding companies, both of which were its responsibility during the run-up to the crisis.

True reform would include the following:

• Capital reserve requirements for all classes of financial institutions. The larger the institution and the riskier the activity, the larger the reserve requirement.

• A strict separation of institutions that perform commercial banking from those that make their profits from trading.

• A strict separation of institutions that place orders for retail customers from those that trade for their own accounts.

• The same disclosure and reporting requirements for hedge funds and private equity firms as for publicly-traded and registered companies.

• A prohibition of the tax favoritism for borrowed money used to acquire companies.

• A prohibition of payment of special dividends to private equity owners of operating companies.

• Public ownership of credit-rating agencies.

• A requirement that all derivatives shall be traded on regulated exchanges, with capital requirements and limits on overall position.

• A provision that any firm that locates in a tax or regulatory haven shall not be permitted to do business or have financial transactions in an OECD country.

• A Tobin Tax on all financial transactions, graduated so that very short-term transactions pay the highest rate of tax.

• Corporate governance reform to ensure that shareholders and other stakeholders hold executives accountable for compensation formulas.

One disabling myth of recent years has been the premise that, because of globalization, national governments are relatively helpless to re-regulate finance; any nation that tries to regulate will simply drive business offshore. But the reality is that China and India largely escaped the consequences of the financial collapse because they simply did not permit their banks to traffic in exotic securities. India used punitively high reserve requirements to do the job. Chinese banks commit a variety of sins against free markets, including the use of artificially low interest rates for favored enterprises. But the Chinese government understands that their function is to supply capital to firms, and not to speculate. It would certainly be useful if the major nations could agree on a more effective Basel III with more consistent and adequate capital reserve requirements; or on a universal Tobin Tax. But that day will never come and reform should not be delayed in the meantime.

Much of what needs to be done can still be done by national governments. After the attacks of September 11, 2001, the Bush administration initiated a rigorous enforcement program to crack down on international money laundering to prevent movements of funds to finance terror. The same enforcement program could have been used to prevent regulatory or tax evasion – but that was explicitly prohibited.

Another disabling myth has been that any “innovation” should be welcomed as enhancing economic efficiency. But nearly all of the financial innovations of the past three decades have been aimed at evading regulation, enriching insiders, reducing transparency, increasing leverage, and passing off risks to others. The valuable innovations are those in the real economy. The proper role of the financial sector is to evaluate those risks and opportunities and make available financing.

To conclude:

• Banks need to return to their legitimate role of providing capital to households and enterprises.

• Investment banks and venture capital firms need to return to their legitimate role of financing new enterprises, expansions, and transfers of ownership.

• Private equity, as currently defined, is mostly parasitic and changes in tax policy should discourage the entire business model.

• Hedge funds exist only as pools of capital that evade regulation. They add nothing to the net economic well-being and should be discouraged as business forms.

• Derivatives, such as options and futures need to be limited to their legitimate role of providing hedges to commercial users against price fluctuations – and not be used as highly leveraged forms of gambling. Taxation can discourage very short-term trading.

• National governments, given the political will, can achieve most of this.

It should be obvious that virtually all of these proposals are far outside the current political discourse. It is our task to make them mainstream, even conventional.

This article is part of the book ‘After the crisis: towards a sustainable growth model‘, edited by Andrew Watt (ETUI) and Andreas Botsch (ETUI/ETUC) and published by the European Trade Union Institute (ETUI).

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