Years before the 2008 financial crisis hit, regulator Brooksley Born raised the storm flag, but no one heeded her warning. After the crisis, scholar Anat Admati sorted through the aftermath to deconstruct how ineffective regulation of the financial industry caused the worst economic crash since the Great Depression.
In early May, the Cassandra and the academic took the stage together in Washington, D.C., to discuss whether anyone is listening now.
Their talk was part of a daylong conference entitled Finance and Society that also included a rare onstage conversation between Federal Reserve Chairwoman Janet Yellen and International Monetary Fund Managing Director Christine Lagarde at the IMF headquarters. Every panelist who addressed the audience, dominated by a sea of black suits, was a woman, prompting Financial Times writer Gillian Tett to note that this was the first time in her nearly 20 years of reporting on finance that she had attended any conference in which more than half the presenters were female.
Admati, a Stanford GSB finance professor and a key organizer of the conference, sponsored by the Institute for New Economic Thinking, says she did not set out to choose only females, but as the agenda filled up, it became clear that there was no reason to stop with just a few — there were plenty of influential and insightful women to include in the discussion.
She is one of them. As a researcher, a commentator, and a co-author of the book The Bankers’ New Clothes: What's Wrong With Banking and What to Do About It, Admati takes on the banking sector and the policymakers who tolerate its harmful practices with the fury of someone who once believed in the system.
Before the crisis, Admati covered the usual fare in her classes — valuations of companies, projects, and financial securities such as stocks, bonds, and derivatives. “I told my students … that the financial system is really useful for the economy, for society, because it helps move money around, because it helps us allocate resources, manage risks, invest in things,” she says. She now thinks the financial system in the developed economies is too unhealthy and doesn't serve society as well as it can. She now teaches a course called Finance and Society which explores the broader implications of finance.
“What changed my life was seeing bad science and flawed claims winning policy debates,” she says. “Innocent people, powerless and often ignorant of the issues, are harmed by bad policies,” she says.”
“I needed to step out of my silo and question my assumptions.”
Now, more than six years after the crisis, which included the largest bankruptcy filing in American history, the sinking of a housing market floating on a fragile raft of subprime mortgages, and the federal bailout of investment banks that were deemed “too big to fail,” neither Admati nor Born is fully convinced that enough safeguards are in place to prevent a repeat performance.
“A short summary of where we are is that this is an unfocused, complex mess,” says Admati about the regulations spelled out in the “massively complex” Dodd-Frank Act signed into law in 2010. Not all the provisions of the act have been implemented, and some were badly designed or have been repealed as the powerful financial sector continues to lobby against some of the rules. “Some say that even if the law is imperfect, every part of it must be protected at all costs,” says Admati, who does not support all its rules. “Others want to dismantle it altogether.”
Debate Over Derivatives
One of the most debated parts of the act concerns the regulation of derivatives, a market well-known to Born.
While serving as the chair of the Commodity Futures Trading Commission in the late 1990s, Born argued that over-the-counter derivatives should be regulated because of the risk they posed to the overall economy, and wrote a paper explaining why.
But there was no “political will” to do so, she says. Then-Federal Reserve Chairman Alan Greenspan was known for his defense of deregulation. “The financial sector had poured billions of dollars into convincing federal policymakers of the need for such deregulation, supported by the fallacious beliefs championed notably by Alan Greenspan that financial markets are self-regulating and are capable of policing themselves,” says Born, a Stanford Law School graduate.
After the crisis, Born went on to serve as a member of the Financial Crisis Inquiry Commission that blamed the crisis on lack of regulation, and failures in corporate governance and risk management among major financial firms.
Her take on derivatives was spot on. Intended as insurance for banks to manage their credit exposure, a type of derivative known as a credit-default swap played a major role in the crisis. Buyers bet on the default of the debt, typically receiving face value of defaulted loans. When the bottom fell out of the housing market, the insurance company AIG, which sold an enormous amount of these derivatives, needed a massive bailout to avoid a collapse that would have also inflicted major losses on some of the banks that bought insurance from it. “This market contributed to the financial crisis by helping to fuel the housing bubble, and then by amplifying and spreading the losses when the bubble collapsed,” Born says.
The market, which is bigger than ever, is estimated to be $400 trillion (in so-called "notional value") in the U.S. alone. The Dodd-Frank Act gives the commission that Born once led the power to regulate them. She says the Commodity Futures Trading Commission “has performed the herculean task in finalizing more than 50 new rules required by the act” related to derivatives. Yet there are too many exemptions to the rules, which makes her wary. “The jury is still out whether the regulatory regime under Dodd-Frank will be adequate to address the dangers of this market.”
Still Too Big to Fail?
The massive size of today’s investment banks still concerns both Born and Admati. Some firms have actually grown through mergers following the 2008 crisis. Almost all the 100 largest companies listed by Forbes as measured by asset size are financial institutions, says Admati. “These are the assets they need to manage, mostly with depositors’ money and other debt money. They’re unreal sizes.”
“In my view,” Born adds, “these institutions continue to be too big and too interconnected to be allowed to fail without serious repercussions for the financial system and the economy as a whole, despite provisions of the Dodd-Frank Act meant to alleviate this problem.”
Interconnectedness is not the only problem posed by the sheer size of the companies. “They are also arguably too large and complex to be susceptible to meaningful management, supervision, or regulation,” she says. Companies should “fragment themselves” not only so that they are easier to regulate but also so that they have less incentive to dominate policymaking, and more incentive to go out and be competitive business entities.
“My approach to breaking up is to begin to see the kind of breakups that conglomerates faced because these sizes are completely unmanageable,” says Admati.
Other companies, she adds, don’t get so big or become so highly leveraged because they have to face investors in markets. Large banks, by contrast, have too many privileges and maintain access to cheap debt with few strings attached.
Keep It Simple
The complexity of the financial regulatory debate leaves most people out of it, and Admati argues that the solutions are simpler than some of the overengineered Dodd-Frank rules. She thinks some of the new rules and regulatory tools, such as “living wills” stress tests and liquidity requirements, are problematic and not clearly worth their cost.“Some of the complaints from the industry about these regulations have merit,” she says.
Admati advocates more straightforward regulations that counter incentives for recklessness, and make the system safer and healthier.
“Among what’s most wrong with the financial system, and the most essential to correct, is that there is too much opacity and hidden risk and too much reliance on debt funding,” she says.
Video | Making Financial Regulation Work for Society: A Conversation with Anat Admati & Brooksley Born
Tackling the Sacred Cows
Admati also points out that some other laws should be reconsidered. “We make life harder for ourselves by keeping counterproductive laws that create more of a conflict between what’s good for those in the financial firms and what’s good for the rest of us,” Admati says.
These include “a bad tax code” that encourages the use of debt while punishing equity funding for corporations, and a bankruptcy code that gives priority to certain contracts such as derivatives “perversely enabling and rewarding reckless practices,” she says. “These laws are not in the Bible or the Constitution; they can be changed.”