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Bill Poole’s Perspective on Banking Reform

By    |   Tuesday, 30 April 2013 01:55 PM

At the 31st Annual Monetary and Trade Conference of the Global Interdependence Center in Philadelphia, veteran monetary economist William Poole, former president of the Federal Reserve Bank of St. Louis, made a presentation titled "Banking Reform: A Free Market Perspective."

I have followed Poole's work for many years, and he was a highly respected colleague of the late Robert Weintraub, an economist who studied under Milton Friedman and a congressional economist drafted the Humphrey-Hawkins Act, the blueprint for efforts to hold the Fed accountable for its monetary policy actions.

At the beginning of his presentation, Poole established the standard by which banking reform proposals should be judged, which he said should apply for all industries: "The maximum liberty for parties to engage in voluntary exchange subject to the constraint that their activities not endanger the welfare of third parties." He took on the assertion that "banks are special" from the outset, pointing out that all industries have special characteristics.

He called for recognition of those characteristics with respect to banking but otherwise for the role of government to be kept to a minimum. Poole also recognized from the outset that there is a long history of financial frauds and regulatory failures and that the regulatory process should be viewed "from a public choice perspective" and not trusted to be disinterested.

Another condition of banking reform for Poole is that it be based on the rule of law rather than the interests of persons. He attacked congressional delegation of power to regulators as unnecessary, even harmful, "because it strengthens producer interests and gives consumers a false sense of security."

Citing minutes of the Federal Open Market Committee from his time at the St. Louis Fed, Poole faulted the Fed for not even mentioning the looming subprime mortgage crisis in 2008 and the effects it would have on the portfolios of several huge financial firms, whereas Michael Lewis, in his book "The Big Short," chronicled the fact that two hedge fund managers, Steve Eisman and Michael Burry, made this call five years in advance without the staff resources available to the Fed and other financial regulators.

The largest banks themselves also had resources that enabled them to make better decisions, had they elected to do so, and Poole placed responsibility for the outcome squarely on those institutions, concluding that "the large financial firms trusted but did not verify." Fundamentally, Poole found that they failed to apply a maxim of banking that dates to the 19th century: "A portfolio of long-duration, risky assets should not be financed by short-maturity liabilities with minimum capital."

He recalled that this same model had broken down in the financial crisis episodes of 1987 (portfolio insurance) and 1998 (Long-Term Capital Management). He concluded that the firms involved in the 2008 episode of the ongoing financial crisis "deserved to fail; the only regret ought to be that investors in those firms; liabilities lost too little."

So what does Poole recommend as measures to reform banking from a free-market perspective? The only answer, according to Poole, is "to require banks to maintain large capital positions." These must consist of a combination of equity and long-term debt that cannot run, defined based on simple leverage and not risk weightings, because the latter have a way of becoming "politically weighted."

The only task for regulators would be to keep score based on risks on and off bank balance sheets, including the net value of derivative positions. This would give no scope for regulators to downplay risky behavior in the name of encouraging innovation and efficiency. Therefore, regulations, such as those propounded by the Consumer Financial Protection Bureau created under Dodd-Frank, are not a substitute for adequate capital.

Poole also disapproved of what he calls the practice of banks giving grants to nonprofit organizations that advocate housing and consumer lending, instead of making loans to borrowers. However, he gives his blessing both to deposit insurance and access to the Fed's discount window to borrow at a penalty rate on securities that would be sound but not necessarily marketable.

Poole concluded with warnings about the danger posed by near banks, such as money market mutual funds, and a prescription for ending the policy of protecting banks deemed "too big to fail." Regarding money funds, he called for enforcement of accounting rules that would prevent the funds from overstating their net asset values. As for the too big to fail institutions, they would be required to issue subordinated debt of 10-year maturity that would be convertible at the bank's option. For Poole, this would have the effect of forcing the gradual liquidation of large failing banks by market action, without the need for regulatory intervention.

I would note that the ideas presented by Poole are especially timely given the growing interest in proposals such as the bill being circulated by Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., which are intended to end the policy of too big to fail. Despite the growing interest in such proposals, the odds against the enactment of reforms of either the banking or the housing finance industries now dominated by government-sponsored enterprises are very long in the face of the massive lobbying power of those industries.

These political machines give the banks virtual veto power over proposals bound to be received as inferior to the generous entitlement program they now enjoy. In this regard, the case of Fannie Mae and Freddie Mac is instructive.

Critics expressed the hope that if enough regulatory pressure were brought on these too big to fail institutions, they would voluntarily act to downsize so as to avoid posing a risk to the global financial system. More than four years after being placed in federal conservatorship and having been propped up by more than $200 billion in government funding, the market share of these companies is nearly total, and the constellation of housing lobbies is advocating "reforms" that may restore these institutions to a hybrid public/private status, this time backed by an explicit federal guarantee.

In both the banking and housing finance sectors, which are themselves intertwined and backed by an array of government support systems, the biggest impediment to reform is that from the standpoint of the highly compensated managers of these companies — the present system is working just fine.

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At the 31st Annual Monetary and Trade Conference of the Global Interdependence Center in Philadelphia, veteran monetary economist William Poole, former president of the Federal Reserve Bank of St. Louis, made a presentation titled "Banking Reform: A Free Market Perspective."
Tuesday, 30 April 2013 01:55 PM
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