Financial Follies

A few weeks ago, I laid out an outline for sensible financial-reform legislation. Many of the principles of this framework look as though they will be kept in the Congress’s final bill, including a stronger consumer-protection agency and an over-the-counter exchange for derivatives. Yet as the legislation has gained steam and popularity over the last few weeks, politicians are predictably spewing populist demagoguery and wasting an opportunity to implement intelligent regulations. Congress must keep the unintended effects of their measures in mind as they finalize the legislative details on trading derivatives and supervising the Federal Reserve System.

One of the perhaps most important sections of this legislation will focus on derivatives trading. Derivatives, financial instruments that are used to bet on movements of assets and thus serve as protections against risk, are often necessary for many different kinds of businesses, ranging from farms to airlines to banks. Yet during the crisis, banks took enormous risks with derivatives, and these risks were neither monitored nor regulated by the government as most of the derivatives were traded in over-the-counter transactions, private trades between two parties.

It is imperative that derivatives trading be shifted to exchanges where such trades can be monitored and regulated, and the legislation had been moving in this direction. However, Arkansas Senator Blanche Lincoln has now introduced an amendment to the legislation that will cause banks to spin off their derivatives trading businesses entirely. Although this measure seems like it will decrease risk in the financial system, in reality, it will only transfer the risk to murkier and less-visible facets of the financial world.

Under Lincoln’s proposal, hundreds of billions of dollars in existing derivatives trading would be spun off to entities such as hedge funds and foreign banks, which are beyond the scope of regulators, or associated bank entities that are not technically part of the bank, in both cases increasing risk and causing difficulties for regulators. It is smarter to keep derivatives trading within the major banks and impose tougher oversight and regulation on these institutions than to spin off the derivatives trading to where we can neither regulate nor examine the market.

Another provision in the legislation that has become popular in recent days is a measure to “audit” the Federal Reserve and open information about its operations to the general reserve. The measure, passed yesterday by the Senate, and proposed by Vermont Senator Bernie Sanders would require the Federal Reserve to disclose the recipients of its lending during the financial crisis and to open up to an examination of its programs that have “injected liquidity into the money markets” and will examine “whether the credit facility inappropriately favors one or more specific participants over other institutions eligible to utilize the facility.” By examining who has received credit from the Federal Reserve during the crisis, this amendment sets a political precedent that could result in a constrained central banking authority during future crises.

Though the amendment has been narrowed in order to ensure that it will not aim to politically influence the creation and setting of monetary policy, it still interferes with the necessity of an independent Federal Reserve with the power to act in times of crisis. In the financial system, a bank does not need actually to be running out of money for a bank run to occur; there only needs to be the impression that the bank might be running out of money. This is why all of the major banks only received Troubled Asset Relief Program funds in concert, even though some of them needed the funding more than others. This is also why the Federal Reserve must have the power to support the financial system without strict disclosure requirements. The mere appearance of needing help during a time of crisis could bring a bank down.

On an even greater scale, this amendment violates one of the basic foundational principles of our central banking system: Our economy hinges on the trust that we place in the Federal Reserve to look out for the best interests of the economy at large, independent of any political influence whatsoever.  Through administrations that might be victim to political pressures of all types, the Federal Reserve does what is right for the stability of our economy, be it the case of former Chairman Paul Volcker’s raising of interest rates to historically high levels in order to cut inflation in the early 1980s, or Chairman Ben Bernanke ’75’s opening up of lending windows to major investment banks during the financial crisis, despite the deep political unpopularity of such measures. By opening up the Federal Reserve’s operations to naked populist critiques, the Sanders amendment begins to violate this trust in an independent and apolitical central banking authority.

As the debate continues, many Democrats and Republicans are trying to outdo each other to see who can seem “toughest” on reform, but in the process, they are failing to understand which regulations really need to be in place for the economy to function well. Derivatives trading will occur throughout the future, whether in a bank or a distant unregulated entity, and it is best if it occurs in major banks under the watchful eyes of regulators. There will be future crises with politically unpopular but necessary monetary solutions, and an independent Federal Reserve will need to be there to solve them. Legislators are smart enough to realize these truths; the question is, are they brave enough to make legislation that is meant to serve the future good?

Ravi N. Mulani ’12, a Crimson editorial writer, is an applied mathematics concentrator in Pforzheimer House.