Jeffrey Garten

MGT585 – TUESDAY, JANUARY 24, 2012, CLASS #3

Jeffrey Garten:

There are four things that I would like to do this evening and before I start I would like to say that Steve is at Davos this week and he’s going to start the next class with a debrief of all that happened there and particularly how it relates to our classes. He plays a really big role at the annual meeting of the World Economic Forum. He’s asked to be on virtually every panel, so he’ll be really well plugged in.

Tonight the theme is “regulatory issues” and I’m going to start with an overview of some key concepts and then we’re going to go right into a movie (“The Warning”); it’s a shorter movie, but it’s a really good documentary about the regulation of derivatives, or I should say lack of regulation of derivatives. But I think it’ll be a good set-up for the two presentations that we have – one on Dodd-Frank and domestic regulation, and one on international regulation. And then I want to start the discussion about the trips and we have the itinerary for the New York trips, and I’m just going to give you a little glimpse of that and explain how they work and next week we’ll go into that in more detail.

For everyone who’s making a presentation, please make sure to check with Caitlin first – send her your outline several days in advance. I’ve asked her not to be shy about contacting you if you don’t. That’s really important.

Let me start now with this introduction. In the first class we talked a little bit about history. And the main point that I want to recall is that regulation has arisen almost every time in relationship to a crisis or to some very sharply defined event. And you can see on this slide that if it wasn’t a war, it was a banking crisis of one sort or another; and the very last one, in Sarbanes-Oxley, it wasn’t really a banking crisis, but it was a corporate crisis that resulted in a huge spate of regulation as you all know, Sarbanes-Oxley, that spilled over into banking.

If you took away these events, you would find virtually no significant banking regulation in the U.S. except the tweaking of what already exists. So it is, in the best of worlds, in fact I would say in 2006, the Treasury under Hank Paulson, put out a concept paper for Reform of the Financial System – this is before there was any financial. The Treasury had been working on it for a couple of years. That got about a nanosecond of attention – there was just nobody interested. Why? Because it was exactly the rational and sensible thing to do. Write regulations when there isn’t a crisis; think it through; send it around to everybody and get a year’s worth of comments. If there was ever a demonstration of how that doesn’t work in the real world, that was it.

Also when you think about history, realize that when you regulate in a crisis, it means a lot of things. One, it means that you probably almost surely don’t have the objective information you need because it takes a long time to figure out what actually caused the crisis. You’re regulating in the heat of emotion; you’re pushed by political forces. It is the exact opposite of a precise calibration, but it happens every time. Also, you’re constantly fighting the last war. You figure out what happened, you try to plug the holes, it’s as though the financial system was static, but by the regulations actually unfold and they’re passed, the financial system has moved on and even if you did plug the right holes, they’re not the right holes any longer.

Also, historically, regulation has been done – to understate the case – with a silo mentality. That is, banks were regulated by one agency, securities firms by another. There were a lot of turf battles. And the silos did not recognize the interaction. They did not encompass the shadow banking system of which there has always been one, and they didn’t encompass one other thing which I’m going to come back to which is… when I say silos, there was a domestic and an international silo. And until this last crisis, it is very hard to define any time national regulation was actually done with a very strong presumption that there would be international coordination or international harmonization. Always lip service to that, but in fact, in part because the US and the EU were so dominant, they went their own way and then put a gloss on it.

There was a presumption that the silos were separate, stemming from the 1930’s regulation, but there was also just a lot of turf grabbing and also the way it works in the US is that every one of these regulatory agencies is backed by a congressional committee and actually the congressional committees wanted the silos because it gave each one of them control over something. And control, especially in the finance area, translated into financial support. So if you were the agriculture committee, you didn’t want commodities in the SEC because there was another committee that actually oversaw the SEC. But I think it’s not just in the US; it has been a fact of life in the financial arena up until recently that people didn’t worry so much about the silos. In academic discussions, they’d say they were bad, but it just wasn’t that big an issue. As I’ll come to in a minute, it’s a really big one.

Now I want to go through 10 key challenges that we face today in terms of global regulation. And I’m just going to go through these fairly quickly. The first is national vs. international vs. global. That is that there are some regulations that are purely national. I’ll give you an example from today would be the Volcker Rule. There are some that are international; that is, that lots of countries actually implement them, or several countries implementthem, and they try to coordinate that. I’d say derivatives is an example of that where everyone recognizes there’s a big issue and there is a major effort to coordinate derivatives regulation. Not so Volcker because the big European banks, they don’t believe in a separation between the investment banking and commercial banking. And then there’s global which is sort of a rule that applies to everybody and that would be bank reserves. So the challenge is which of these categories should be in effect and how do you actually get from one to the other on the theory that the financial system is truly global and at some point that’s where you want to end up?

A second challenge is what I would call the historic regulatory pendulum. That is, we have periods of no regulation and then periods of intense regulation. And that pendulum swings all the way and then it swings back. But what we see now is that it’s swinging in both directions at the same time. Think of it – we had this major financial crisis. In the heat of it, there was a spade of massive regulations, not just in the US but in Europe as well. And no sooner was that regulation being debated than there was another debate about the size of government, the inefficiency of government. And so if you ask today where is that pendulum, you can’t really tell. Is it for more regulation, or is that pendulum coming back very fast that already the financial system is too regulated? So we’re seeing something that we haven’t seen before which is, at a minimum, a very quick swing, but maybe a constant swinging back and forth as governments and society at large really don’t know where that pendulum should be.

Not to be cynical, I think it’s the result of people trying to do the right thing but being pushed by all kinds of pressures and saying to themselves, well this is better than it was. It’s filled with holes, it has a lot of defects, but we have to do something, and we’ve done more than just sit still. There is something called the regulatory bias, the bias to action, which is much broader than anything we’re talking about in this course. But basically, when there’s a crisis, you don’t sit there; you do something. And even if it’s very imperfect, your judgment is better to do something that’s imperfect than to do nothing. The interesting thing about this pendulum is that here we have this financial crisis with reverberations that continue, right? With the recession, with huge unemployment, and there is a major debate as to whether or not the financial system is overregulated. So if anyone would have said this is where we would be politically two years ago, you just wouldn’t have believed it. And nobody can say where we’ll be a year from now.

The third big challenge is the link between financial and macroeconomic, and here I want to come back to the issue of silos. Virtually all regulation, financial regulation has been done historically as if it isn’t linked to the economy. That is, when you have a banking crisis you try to fix it. But what is clear now is that there’s a very strong link between finance and macroeconomics. And to put it simply, if the banking system fails, or when the banking system fails, we go into a recession. The recession worsens the situation of banks. The banks are not in a position to lend, and so the recession gets worse. The only way to get out of this is to loosen up on the banks, not put so many restraints on it, allow them, basically, to be profitable and require capital so that they can lend and get us out of the recession. It’s a circular thing and nobody quite knows how to break it or how to deal with it, but it is a key fixture of the situation that we’re in now and makes it much different, at least from the standpoint of what regulators and economic officials are thinking about and talking about and are worried about than the past crises.

There’s another link which is also very important. And that is at the heart of this course; it’s the link between banking and government. And you see this most clearly in Europe, where you have a recession and you have a banking crisis. The central bank of Europe lends money to the banks so the banks can purchase European sovereign debt. The banks then are loaded with paper that is shaky at best, but the paper doesn’t go bankrupt because the banks keep buying it. And why do the banks keep buying it? Because the government keeps lending the banks money to buy it. So here you have a very strong incestuous relationship between banking and government and we’ve never quite seen it on a global scale the way that it exists right now, which makes it very, very difficult to say how do you regulate? And what should you regulate? Because everybody is in bed together. And just to give you the US counterpart – right now US treasuries are in great demand and they’re in great demand in part because everyone else is in such big trouble. So interest rates remain low and the US fiscal problems are pulled further out. The rest of the world is buying treasuries just to be safe. But if that were to stop, what the US government would have to do is to find somebody to buy these treasuries. And the history of financial crisis is that the government will never admit that it’s doing this, but it will engage in something which economists call financial repression. That is, the first thing it will do is look at all of the rules, all of the laws regulating pension funds and make it so that pension funds have to have more US debt and less foreign debt. Or let’s put it this way - make foreign debt much more costly. The point is that when you have so many countries in such deep debt, they are obsessed with the financial system buying their paper, buying their bonds, and they’ll do everything they can in order to make sure that continues. And the banks or insurance companies, pension funds, the financial system, the domestic financial system, is right on the front line and the government will induce the purchase of their own bonds by their own financial institutions through many different mechanisms. It could be moral suasion, it could be taxes, it could be regulations. So this kind of interaction makes what you regulate, how you regulate exceedingly complicated.

[STUDENT QUESTION]

Jeffrey Garten:

You’re talking about the last thing I was talking about? Well, in Europe it didn’t take very long at all because the central bank lent money to the banks, the government said to the banks each, individual government, you want our support, you know what’s involved. And so the Portuguese banks bought the Portuguese debt. And because, don’t forget, every one of these banks is beholden to their central government for all kinds of support. And in the US it wouldn’t take that much time because you could pass a regulation; it doesn’t even require a congressional vote, which says for example state pension funds can’t hold more than (I’m making the number up) 10% foreign bonds in their portfolio, when bonds from foreign countries are doing much better and the economic activity outside the US is so great. So it wouldn’t happen in 24 hours, but it wouldn’t take two years either.

I don’t think the private sector is necessarily playing less of a role; it’s having a massive impact on the effectiveness of regulation. It is unlikely to say wipe away let’s say the Volcker Rule. But through all kinds of pressure they can create so many loopholes that it is effectively neutered. And I think that going to the second point, we are in a very curious position where you would have thought that after the financial crisis, the governments would call all the shots and in fact the financial markets are driving policy, in my view, as much as they ever have. They’re certainly determining the entire restructuring scene in Europe. The central banks are keying on what the private financial system is doing. The need for private investment, the need for private lending, the ability of private banks to push interest rates in one way or another; it’s all really massive. So we’re kind of in a position while governments say we’re in the driver’s seat, if you actually watch what’s happening, not clear at all.

There are a lot of reasons why the domestic institutions would buy domestic debt. What really matters is on the margin and that’s where the government can say you need to take up a larger share of the subscription. The government’s not going to get them to go from 0 to 60, but in the all-important last couple of basis points or stepping in as a purchaser of last resort, they have that option. In terms of banks moving outside, well we’ll ask Jamie Dimon that question. I think that there’s a lot of talk about it; it hasn’t happened very often, and in Europe the German banks have been talking about it for years and they haven’t done it. So, technically could they? Possibly. Psychologically would they, I don’t know. They tend to use it as a threat. They use it all the time, you know,if we’re over-regulated, we’re going to move somewhere else. But the grass is always greener until you actually examine the kind of regulation we don’t have, the tax rates, or the limitations on … people would say, we’re going to move to Singapore, they’re very accommodating, very good regulation, but low taxes until they start seeing that you don’t have any freedom of expression. So I don’t think it’s around the corner. Plus, there’s more and more at least international coordination. And if it isn’t happening now, that’s the trend, so you could move and then all of a sudden find five years from now you’re in a very similar situation and you’d have a very hard time probably coming back.

The link between regulators and the markets is a function of a lot of different factors. But one of them certainly is the movement of people back and forth. When we go to Washington we’re going to meet several people like this, but one of them is the head of the Commodities Futures Trading Corporation who was a partner at Goldman and a major trader of derivatives and is now the big champion of regulating derivatives – Gary Gensler. And I personally think there are a lot of people who are going back and forth and certainly the conventional wisdom is they tend to favor the industry that they were in. From my experience and as someone who’s gone back and forth, I think it works the other way, often, at least at the higher levels where there’s something psychological where you don’t want to appear that you were captive. Now at lower levels where you may go back and forth and you’re looking for the next rung in the ladder, that could be a little bit different. In any event, here is my bottom line, I think that in this past crisis there was a huge amount of attention to Goldman and the reason was that traditionally Goldman’s top guys went to Washington and at one point here they were the last two Secretaries of Treasury, they were head of CFTC, they were all over the White House and there was quite a backlash. And it created quite a bit of public focus, especially when Goldman got into trouble. So my guess is that the days of people moving back and forth from very senior levels is ending. And so the bigger question to me is, well what does that do to the spread of the knowledge, because it’s very, very difficult for regulators to understand the complexity of some of these markets given one, their lackof resources and two, their lack of exposure. So I think it’s a big issue.