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Five Suggestions for Banking Reform


Among other things, FDIC insurance has to go and we must repeal the Levitt Rule.

Editor's Note: The following was posted in real time on our premium Buzz & Banter (click for a free trial).

First, as a public service announcement, I must preface my comments with the explicit request from the Treasury Secretary that you not listen to me. You see, I'm all but certain that my 10 years building JPMorgan's (JPM) securitization business during the late 1980s and early 1990s likely qualify me as one of the early "masters of noble financial innovation" whom Mr. Geithner earlier this week explicitly requested that you "listen less to" during this period of time that banking reform is being debated.

With that now out of the way, let me offer a few thoughts, which I hope may contribute to a constructive dialogue on the topic.

First, as much as I admire Mr. Volcker and the noble intentions of the "Volcker Rule," I'm afraid that attempting to re-silo the financial services industry is akin to trying to unscramble an egg. In fact, with all due respect to the myriad of regulators currently in place, I think our existing silo'ed regulation contributed mightily to our crisis. How can it be that no single regulator had a full grasp of the "too entangled to fail" world of OTC derivatives along with the authority to deal with it?

Until regulation aligns with enterprise and systemic risk, we risk more crises in the future. Banks, insurance companies, money managers, hedge funds, and broker dealers are all in the same business -- they take someone else's money and do something with it all with the hopes of making money in the process. Until we have uniform rules (globally too), I assure you we'll have regulatory arbitrage, which results in failed oversight.

Second, and at the risk of being bold, I believe the time has come to eliminate FDIC insurance. When the FDIC was created in the 1930s, it was intended to be a temporary solution. Today, it puts the US taxpayer on the hook for more than $7 trillion in bank liabilities. But as a consequence, depositor due diligence is non-existent. And putting Wall Street aside, this crisis has shown, even with specific oversight, hundreds of now-failed banks took excessive risk in their traditional banking businesses and their insured depositors neither cared nor were adversely impacted. Their risk was borne by the government, while they earned returns far in excess of comparable US Treasuries. If we're truly going to eliminate "moral hazard"/"too big to fail" we must eliminate deposit insurance in the process.

Third, we must demand that the rating agencies disregard "systemic support" when ascribing debt ratings. The fact that we still have some financial institutions receiving "uplifts" of as many as five ratings levels because of their systemic importance is unacceptable and I believe currently poses one of the greatest financial risks to our nation.

Fourth, we must repeal the "Levitt Rule." In good times, loan loss reserves must be built in anticipation of bad times. And, should FDIC deposit insurance not be repealed, as I recommend, fund premiums must also adopt a countercyclical methodology. That banks were releasing reserves and the FDIC was reducing/eliminating premiums at the top of the market defies basic logic.

Finally, our regulators must act courageously. This past week Moody's wrote:

We observe… that the current regulatory regime is already authorized to protect the soundness of banks and the financial system as a whole. In addition, the current banking laws give bank regulators the power to have banks cease and desist from activities and to require banks to have higher capital ratios. Thus, we believe that the benefits of a revamped regulatory regime will depend more upon how regulators implement and execute the law -- rather than depend on the words of the law itself -- because the proposed regulatory framework doesn't appear to be significantly different from what exists today.

Don't get me wrong, I fully understand and appreciate the value of the "safety net" provided by the government to economic growth. But as we have seen in housing, banking, (and I suspect soon in higher education), an oversized safety net -- in which risk is ultimately fully borne by taxpayers -- results in wildly misdirected capital flows. And while at the time it all feels great, as we are now seeing, the ultimately consequences are devastating.

Over the past 80 years, while done with the noblest of intentions, we've traded bank runs for country runs. The sooner we address this risk, the better.
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