Financial System Reform

By David H. Krikorian

Until and unless we reform our financial system a sustained recovery cannot begin

In order to do this, we must honestly address the systemic flaws in our financial system and implement structural changes including:

- Separating commercial and investment banking activities

- Eliminating the use of extreme leverage

- Addressing "too big to fail" and reinstituting moral hazard

- Implementing transparency and oversight to derivative securities

- Practicing sound, non-politicized monetary policy

- Separation of Commercial Banking & Investment Banking

Banking deregulation in the late 1990's, enabled by campaign contributions from financial services companies to Congress, allowed commercial banks to engage in speculative activities in a similar fashion as investment banks. With minimal oversight, commercial banks began proprietary trading operations, extensive hedge fund and private capital dealings and underwrote derivative securities.

The deregulation of commercial banks has had disastrous consequences. Commercial banking, by its nature, uses deposits to fund loans to businesses and individuals. In contrast, investment banking is speculative as firms employ leverage to drive returns. As a result of mixing investment and commercial banking activities, the government has had to extend credit, provide a financial backstop and/or make direct investments in many commercial banks (e.g. Citigroup, Wachovia, JPMorganChase) at great cost to the taxpayer.

The high leverage inherent in investment banking is inconsistent with the commercial banking business and the businesses are clearly distinct from one another.

Commercial banking firms should no longer be allowed to engage in investment banking activities. Also, capital for investment banks should come from equity risk capital not customer deposits. The FDIC exists to provide insurance for deposits; however, the use of deposits to fund investment banking operations is a gross misappropriation of the spirit of deposit insurance.

Excess Leverage

Leverage ratios at financial institutions were dramatically increased under the Bush Administration (again, in exchange for campaign contributions). In many of the high profile financial collapses of the recent past including Bear Stearns, Lehman Brothers, AIG, Freddie Mac and Fannie Mae, leverage ratios ballooned from 8 to 1 to 60 to 1. Leverage used in moderation is not a negative practice; however, if employed to an extreme, our country's financial system becomes compromised and, as we have seen, can necessitate unprecedented and unacceptable taxpayer bailouts.

Investment banks and other large financial organizations have demonstrated the inability to prudently self-regulate as the profit motive is too great. Congress unwittingly sowed the seeds of our current crisis and should now institute leverage ratios at no greater than 10 to 1 on all financial firms.

Too Big to Fail

To justify the massive bailout, some have argued certain financial firms were "too big to fail". For example, it was argued that the failure of AIG would break the financial system and lead to a second Great Depression and hardship on Main Street. While that may have been the case (we'll never know), the country should not be placed in such a position again.

As financial firms are an integral part of the economy, allowing financial institutions to become "too big to fail" must no longer be tolerated. In addition to separating commercial and investment banking and limiting leverage, the US government should reinstitute the concept of moral hazard. If a financial institution fails, then losses should be born by all asset classes including debt holders. The taxpayers should never be a backstop for failed private enterprises.

In a capitalist economy, it is the responsibility of management teams, boards of directors, and institutional investors to hold financial services firms accountable and if they fail to do so then they should lose commensurately.

Financial Derivatives and Securitization

Warren Buffet has described the unregulated market for over-the-counter derivatives as "weapons of mass financial destruction". This is certainly true. When companies can create artificial securities using massive amounts of leverage to speculate on outcomes unrelated to their core business, there exists a recipe for disaster. Such action is similar to placing a bet at a casino.

The situation became toxic with the lack of regulatory oversight in the over-the-counter derivative securities market. With the sheer size of the derivatives market measured in the hundreds of trillions of dollars (many times the size of worldwide gross domestic product), when things go wrong, the effects are global and the repercussions are catastrophic.

All derivative securities should be regulated and traded on an exchange to insure transparency and proper valuation. Sound Monetary Policy

Financial system reform is incomplete without addressing monetary policy. The speculative activities within the financial industry were enabled by the loose (arguably reckless) monetary policy of the Federal Reserve, highlighted by artificially low interest rates and the practice of quantitative easing.

The Federal Reserve should make policy decisions without political influence. Decisions should be made in the best interests of the country and not in the interests of Wall Street. Although, the Federal Reserve should be free from politics, it should be held accountable for its decision making process and its balance sheet. Therefore, I support auditing the Federal Reserve as proposed in HR 1207.

Failures of private financial institutions should never be a burden to taxpayers. It is no consolation that some of the TARP money has been paid back. Without making structural changes as outlined above, the problem remains and we implicitly encourage the same bad behavior and disregard for moral hazard that got us into this situation in the first place.

It is worth repeating that I do not believe we can have a sustained economic recovery until we reform the financial system. These efforts should be immediately undertaken by congress and should be devoid of campaign contributions by industry. Common sense tells us that campaign contributions from financial services companies while reform is being evaluated leads to compromised efforts. Congress would be wise to remember that it serves the people.