5 actionable steps toward financial sanity

Sheila Bair, former head of the FDIC, warns that the financial system remains far from stable – and that regulations like the Volcker Rule may be too complex to be effective. She offers 5 practical steps that the Obama or Romney governments must take in order to fix the mess of present day Wall Street, and set the financial system back on a path to supporting (rather than damning) the real economy.

See: 5 steps Obama or Romney must take to fix Wall Street  All of these are more simple than complex and most certain to make a huge impact in the desperately needed process of admit, repent, reform, recover.

1. Break up the “too big to fail” banks
In Bair’s eyes, the presence of giant institutions and untested “living wills” is one of the factors that helps to make today’s financial system unstable. Don’t draw any comfort from the fact that they all are passing the government’s stress tests, cautions Bair; those tests focus on credit risk, not interest rate risk, and a time when the Fed is artificially keeping lending rates at near zero, that’s a flaw.

2. Publicly commit to end bailouts
OK, so those bailouts have made money for the Treasury. That’s fortunate – but that’s not a reason to assume that we’ll be as lucky the next time. What we should have learned from the post-2008 bailouts is that while we couldn’t avoid those bailouts, we should never allow ourselves to be in that position again. “The market needs to punish the boneheads,” Bair said. Just because the bailouts were profitable isn’t a good reason to give Wall Street an indefinite option to “put” its losses to the Treasury and to taxpayers. “Will the candidates appoint people who believe that since the bailouts made money” future rescues may not be such a horrible option, she wonders?

3. Cap leverage at large financial institutions
“Bank capital levels maybe isn’t a mainstream issue, but it should be,” argued Bair. Putting a limit on a bank’s ability to take on risk via leverage is the only way to ensure that no matter what “idiotic new innovation” Wall Street becomes infatuated with, that obsession will have a limited ability to destroy their institutions, much less the financial system as a whole. We may not be able to stop bankers behaving badly, but we can curb the fallout.

4. End speculation in the credit derivatives market
Bair pointed out that we don’t get to buy fire insurance on someone else’s house, for a very good reason. How is speculating using credit derivatives any different? During her tenure at the FDIC, she found that hedge funds that were shorting the mortgage market via credit default swaps and had a vested interested in seeing housing values collapse were among the players who fought reforms that might have helped fix the market before it was too late.

“There’s no doubt in my mind” that credit default swaps are weapons of mass financial destruction, Bair said, referring to Warren Buffett’s memorable description of these instruments, although she admits this will be the toughest of her five changes to bring about.

5. End the revolving door between regulators and banks
This particular door is the one that separates regulators from the institutions they regulate and, Bair says, is part of what is responsible for the phenomenon of the “captive” regulator. When regulators are conscious that, with one push of the door, they could end up working for the organizations they are today regulating – or vice versa – “it corrupts the mindset” and results in their regulating organizations they are pre-disposed to think well of.

“If you did this, you would end up with a much more stable regulatory system” – and a more stable financial system, Bair argues. But the debate has to get started now.”