Published Commentary

Northern Light

U.S. Financial Reform Canadian Style

By Marc Seltzer and Leslie Schreiber; originally published in Commonweal Magazine on June 19, 2009, and at

. .

Amid the greatest worldwide financial meltdown since the Great Depression, there have been few examples of sound financial management and regulation. Public authorities have had to provide billions of dollars to support ailing institutions and have acknowledged far-reaching gaps in public oversight. Responding to the disastrous bubble and bust, the Obama administration is calling for comprehensive reform. International leaders have even gone so far as to call for the creation of a world financial regulator.

U.S. Treasury Secretary Timothy Geithner, while not going that far, is asking Congress to grant the Treasury broad oversight authority for virtually all financial institutions, and a mandate to monitor systemic risk. Additional proposals seek to insure that financial instruments, such as credit-default swaps, are subject to federal regulation. While Congress will ultimately be responsible for crafting legislation, Geithner’s proposals provide a road map for a new financial order, in his words-“not modest repairs at the margin, but new rules of the game.”

The economic crisis has tested the stability of financial systems across the international community. The results differ widely, from Iceland’s near-bankruptcy to Canada’s remarkable financial health and insulation from risk. Beyond the private gains and losses, the crisis has revealed strengths and weaknesses of different regulatory environments. Remarkably, not a single major Canadian financial institution has needed a bailout. In March, the International Monetary Fund praised Canada’s banks for their “remarkable stability amid the global turbulence.” Howard Kaplow, an investment executive and director of financial services in Montreal, noted that Canadians “tend to be more conservative, but we also have a more restrictive financial authority with tougher rules to follow.” The IMF agrees, commending Canada’s “strong regulatory and supervisory framework.”

In this light one may ask how Secretary Geithner’s proposals for regulatory reform measure up against the Canadian model. Are the Obama administration’s efforts to monitor systemic risk and regulate all substantial financial entities and instruments in line with the Canadian approach?

In contrast to Canada’s conservatism, the U.S. system has gone through a period of “irrational exuberance.” Over the past twenty years, Congress deregulated financial industries in order to maximize business opportunity. New financial instruments, markets, and conglomerates were unleashed without oversight. In a recent debate over the causes of the crisis, New York University Professor Nouriel Roubini (nicknamed “Dr. Doom” for having predicted the current crisis) argued that, “deregulation occurred too fast and in ways that did not provide prudential regulation for provision of the financial system.”

The dominant political ethos was trust in free markets, competition, and modest regulation-even self-regulation. Where regulators did act, they followed a framework that called for distinct regulators in compartmentalized markets. The FDIC has been highly praised for its success at handling the closing of failed banks, but neither the FDIC nor the Federal Reserve had authority to intervene when an investment bank or insurer acted unwisely or teetered on the brink of bankruptcy.

In the end, the failures were systemic and pervasive. They could not be limited to one sector of the financial system, nor were they detected by any existing regulatory agency. In warning that the problems would not respond to a quick fix, President Barack Obama observed that the crisis “didn’t result from any one action or decision. It took many years and many failures to lead us here.”

New regulations were contemplated long before Secretary Geithner was confirmed. Former Treasury Secretary Henry Paulson and the General Accounting Office oversaw substantial groundwork in 2008, but it now falls to Geithner to finish the job. While Geithner is promoting a more comprehensive regulatory regime, the proposals have been developed by financial and market experts and insiders who believe in free-market capitalism. They do not wish to stifle financial innovation. Instead, the aim is to protect the overall system while allowing risk-taking activity to continue. This approach is in line with the Canadian system, where, despite strong regulatory authority, the financial sector has prospered. Today, five of the country’s banks are among the top fifty banks in the world. Ten years ago none of them was.

The lead financial regulatory authority in Canada is the Office of the Superintendent of Financial Institutions (OSFI), currently headed by Julie Dickson. She chairs the Financial Institutions Supervisory Committee, which has broad authority to monitor systemic risk and, for that purpose, brings together regulators who oversee market stability, risk-management, and business practices from across the financial economy. The OSFI mandate covers “all banks, along with federally regulated property, casualty, and life insurers, and trust and loan companies, plus about 10 percent of private pension plans” according to OSFI spokesman Jean Paul Duval. If any of the institutions “raise a red flag, the OSFI can implement a range of disciplinary measures, affecting everything from bank capitalization to controlling assets, and even getting directly involved in business planning.” Indirectly, this also includes securities firms, which are 70-percent bank-owned in Canada (for example, RBC Dominion Securities is part of the Royal Bank of Canada). The OSFI oversees 450 banks and insurers, and approximately 1,350 private pension plans. Its authority, while not reaching all financial institutions (hedge funds are not regulated by the OSFI), is fairly comprehensive and is foundational for the soundness of the Canadian system.

Secretary Geithner told Congress in March that the oversight he was proposing “would include bank and thrift holding companies and holding companies that control broker-dealers, insurance companies, and futures commission merchants, or any other financial firm posing substantial risk” (emphasis added). Not every financial entity reaches the size and significance to affect systemic risk, but Geithner wants to avoid a system where the legal form of an entity can be used to shield it from regulation. A key component of meaningful oversight is the ability of the regulator to set standards for institutional risk management. Geithner is asking Congress for authority to increase capital requirements, to restrict leverage ratios, and to enact additional prudential rules.

In Canada, the OSFI has substantial experience with such oversight. According to Duval, since its creation in 1987, the OSFI “has always been vigilant in the development of its risk-management practices.” Capital requirements for Canadian banks have been held at 7 percent, while the global average is closer to 4 percent. Similarly, Canada’s bank-leverage ratio has been kept under twenty-to-one, while international bank leverage ratios were thirty-to-one and even forty-to-one. OSFI Superintendent Dickson remarked in November 2008, “We have seen how strong capital cushions in Canada have paid off to the benefit of our institutions and overall financial system.”

Canadian institutions were not free from risk-taking or even from exposure to subprime loans from the United States, but strong capital and leverage standards kept the damage from overwhelming Canada’s banks, let alone destabilizing the economy. In addition, Canadian banks generally still maintain the mortgage portfolios of loans they originate, retaining direct knowledge and responsibility for their management. These conservative practices reinforce sound regulation, and vice versa.

Canadian regulators give special attention to larger, “too big to fail” organizations. Duval explains that “OSFI utilizes a risk-based methodology, where institutions that we believe are operating in a riskier manner are subject to increased supervision. That said, the larger institutions will be operating in larger parts of the market, so [they] would naturally receive greater attention…and can be subject to different supervisory requirements.”

Similarly, the U.S. federal regulator proposed by Geithner will have the power to step in and manage problems when institutions fail to meet prudential standards or find themselves in financial difficulty. Special consideration would be given to entities deemed “too big to fail.” Geithner is asking Congress for the flexibility to intervene where there is risk to the wider economy. He has already intervened with a few of the big banks. Recent “stress tests” resulted in some banks being required to raise capital, although banks could choose whether to seek private or public funds.

Critics have called for regulations that would cap the size or restrict the legal structure of financial institutions. However, noting that other countries have allowed hybrid entities such as Canada’s banking and securities conglomerates, Geithner appears to trust that oversight will protect the system, and that private decision making should be allowed as much leeway as possible. The changes he proposes will require legislation. Under his lead, the Obama administration should be pushing hard for a substantial increase in federal regulatory authority. What might have been politically impossible before the crisis is now high on the legislative agenda. In addition, the chairman of the Federal Reserve, Ben Bernanke, has spoken in concert with the administration. While Congress will take a significant role in designing new regulation and is not likely to rubber-stamp the administration’s proposals, momentum is strong for the creation of comprehensive financial reform. The success of the regulatory system across the border should inspire both humility and hope.

. .

Bailout Losses Smaller Than Expected

Main Street vs. Wall Street

Originally published at on December 6, 2009

The good news is that the losses from the government bailout are far less than many feared.  The New York Times reported yesterday that the Treasury currently counts losses of only 42 billion dollars out of its several hundred-billion-dollar rescue program.

Of course, 42 billion is still beyond comprehension.  It is bad news to lose those public funds, and there are other funds still at risk.  Nonetheless, it’s better than the hundreds of billions that were in doubt.

In fact, for those who feel that the government bailed out Wall Street at the expense of Main Street, the facts may prove otherwise.  It turns out, for example, that the banks are rapidly repaying much of what was given to them.  The financial industry still has TARP funds that may cause public losses over time — no final accounting is available — but the largest share of the current estimated losses, 30 billion, come from the bailout of automobile giants G.M. and Chrysler.

The bailout of the Detroit automobile companies was designed to protect Main Street, not Wall Street.   Middle class workers at the big factories and at the auto-parts supplyers would have lost their jobs without government intervention.  The U.S. was losing more than 500,000 jobs a month at that point.  Adding auto factory closures, that number might have hit a million a month, and who knows what else might have collapsed?

I am still haunted by Thomas Friedman’s New York Times Op-ed saying that giving money to G.M. and Chrysler might stop smaller, greener, entrepreneurial auto innovators from inventing the wonder cars of the future because the competition from a subsidized G.M. was too great to overcome.  Be that as it may.  Main Street jobs and an entire industry were saved at a point when the economy was very vulnerable.

The bailout of the banks, though ostensibly done to save the financial system, gave the government rescue a bad name as it appeared to protect Wall Street over Main Street.  It certainly saved financial industry shareholders and employees from their share of losses.  It turned even uglier when it created windfalls in compensation for the already rich.  However, if the bulk of the money lost went to saving middle class jobs and helping the car companies retain some value in the bankruptcy reorganization process, we may need to rethink who we say was bailed out and why.

Follow my writing on Twitter.

December 7th, 2009 UPDATE:  Food for thought in Newsweek’s take on the jobs data.

Originally published at

Federal Reserve Independence Under Threat

Originally published December 1, 2009 on

Readers of this website have a healthy skepticism of government. They see that well-heeled special interests assert too much power in Congress.  Our representatives in Washington should devote themselves to the public interest, but too often appear to serve lobbyists and work for campaign contributions, instead. This view is held by Democrats and Republicans alike, one of few shared beliefs.

Unfortunately, this bipartisan, anti-government nexus has led to legislation to audit the Federal Reserve, the powerful financial stewards of the economy.

This is likely a bad idea and one that suckers good activist public energy down the wrong path.  The reason that the Federal Reserve is unelected and insulated from political manipulation is that its powers would be very tempting to misuse for political gain.  If Congress or the President could, for example, force the Federal Reserve to lower interest rates and stimulate the economy when unemployment goes up, they would do so.  However, the Federal Reserve manages long-term monetary policy to obtain stability and growth in light of concerns over inflation, exchange rates, and productivity.  This may include inflicting a certain amount of household suffering on the American economy to fight inflation or deal with crises where sacrifice today insures wealth and stability tomorrow.  If politicians could interfere, this would never happen.

The audit legislation responds to anguish about the failure of the government to regulate financial activity and risk in the lead-up to the current crisis. It also channels anger over the solutions to the crisis that the Fed has created.

Those who are against corporate greed and excessive wealth could better use the tax code to force corporations to pay their fair share.  Moreover, the proper response to failures of deregulation is increased regulation forcing private institutions to have higher capital reserves, lower leverage ratios and more significant safeguards and oversight than existed since Clinton-era deregulation.  No one is claiming that government got it all right.  But remember, it was political and financial interests that led to the current crisis.  And note that politicians have proposed everything from doing nothing to nearly twice the stimulus that was passed in response to the crisis.

The Federal Reserve is made up of professional economists and financial experts fulfilling a public service.  It is not immune to mistakes, but the Federal Reserve has, with specific limited exceptions, maintained a healthy independence from political authority.

Sacrificing that independence when the Fed makes mistakes or when we don’t like its decisions — which is what this legislation is really about — is not the answer.  Once the Federal Reserve is damaged, political and financial interests will use the Fed to serve current political goals at the expense of the long term financial health of the nation.

We know what that scenario looks like in practice because we have the example of Congress.  Congress never cuts expenses because our representatives are beholden for their jobs to special interests served by that government spending. One of the great examples of cost-cutting in government was done by the Base-Closings Commission, an independent panel appointed for the purpose of solving a problem that congress could not otherwise solve.

What we need is more fiscal responsibility, not less.

Stimulus: Feel-Good Spending v. Investment in the Future

Originally published at on February 7, 2009

There is no question that Barack Obama’s plan for creating jobs will ease the pain of this economic downturn.  However, in the long term, not all jobs are equal.

There are examples from the past of public spending programs that employed many Americans and paid off handsomely.  Constructing theinterstate highways cost 114 billion dollars (adjusted for inflation, upwards of 425 billion) and employed hundreds of thousands over 30-plus years.  The result facilitated interstate commerce greatly, contributing to American’s industrial and commercial success and prosperity.

John F. Kennedy’s Mission to the Moon likewise employed hundreds of thousands in the effort to send a man to the moon during the 1960s.  The payoff was in leadership in science and engineering and advances in aerospace and communications technology, which have transformed our economy and way of life.

It is against these examples that our current spending proposals in congress should be measured.  Building and repairing roads today will no longer transform the industrial or productive capacity of tomorrow.  Even repairing bridges, some badly in need, though valuable, will not multiply the economic gains through new industrial and commercial success.  Roads and bridges are important, but they should simply be included in existing infrastructure plans to be paid for where they bring value within government budgets.

What does measure up?

The types of public spending that could bring jobs now and prosperity in the future are those that successfully address current economic problems.  For example, nationally, we spend far too much money on health care for the services that we receive.  We could put doctor and insurance records on line in a step towards better managing our system and we can spend more now on research and development from pharmaceuticals and cancer to genes and stem cells with an aim to achieve cost-effective health benefits.

Similarly, in urban centers we spend too much time commuting in traffic, lowering our productivity.  Investment in substantial urban public transportation, such as a comprehensive Los Angeles Metro system and smarter choices nationwide, could make a real difference in long-term productivity and savings in pollution and energy costs.

We also need clean energy that is competitive with oil, which has been economically efficient but environmentally costly.  This might take 10, 25 or even 50 years to develop.  But the investment would pay off in securing new affordable energy that was less environmentally harmful and creating a new commodity that we make and trade rather than import to our detriment.

Most importantly, our education is failing to produce a new generation that can lead the world in science, technology, research and all the other fields of importance to our continuing leadership and prosperity. Our commitment to education can’t fluctuate with the cycles of the economy unless we accept that our leadership in the 21st century will waiver.

Investment in any of these fields, that are designed to enhance productivity and profitability of public and private activity, will increase value.  In many ways the other spending included in the stimulus bill is just a temporary fix with long-term negative budget-deficit consequences.

In this light, both Democrats and Republicans have it wrong.  Spending on anything but investments in the future is wasteful–tax cuts ease the pain, but do nothing extraordinary for the future health of the nation.

We can certainly provide unemployment insurance as a safety net for the many who are suffering, but the stimulus bill must aim for productivity and prosperity in the future economy or else it robs us of our precious resources without laying the foundation for sustainable improvement.

Ponzi Scheme or Free Market?

ponzi-scheme-or-free-market_small2Originally published at on March 4, 2009

A pyramid scheme or “Ponzi scheme” (named after legendary swindler Charles Ponzi) is the name given to a bit of financial trickery in which early investors are rewarded with big returns from money put in by later investors. The promise of big returns lures more and more people to keep adding to the pot, until the public is spooked, the market for funds tapped, or the game shut down by authorities.  (Full story)

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s