28 Jan 2014

Douglas Elliott discussed current reforms in the US financial sector

On 23 January 2014, Douglas Elliott, fellow in Economic Studies at the Brookings Institution and former financial institutions investment banker at J.P. Morgan, presented “A US Perspective on Current Financial Stability Reforms”. The lecture was part of the SAFE Policy Center lecture series and organized in cooperation with the Institute for Law and Finance (ILF).

Elliott highlighted the considerable progress that has already been made on financial reforms in the US, despite the complex and frustrating nature of the process. He believes that the financial crisis revealed many problems, but regulations like the Dodd-Frank Act for the US and the global standards set by Basel III are offering the right solutions. Positive and important changes have been made in regard to: capital; liquidity; securitizations; credit ratings; derivatives, especially in regard to counterparty risks; rules for the resolution of troubled banks and other important financial institutions; and in many other areas. Consequently, he argued against the more radical reforms that have been proposed, such as breaking up the largest US banks. He fears this would do economic damage.

In his view, the school of thought downplaying the current reforms as consisting mainly of technical details, whereas “real and big” reforms are needed, may be appealing on the surface but very damaging in its content and consequences. For instance, there is a minority in the US pushing for capital levels far above the newly proposed supplementary leverage ratio, but Elliott warned that this could lead to high costs to society, which would not be justified by any additional safety.

There are a number of people in the US who want to restore the Glass-Steagall legislation, which had required the division of investment and deposit-taking activities of banks. But Elliott voiced doubts that this would solve the problem, as most of what went wrong in the financial crisis happened in either full-fledged investment banks or banks concentrating on traditional activities, while the diversified banks did better on the whole. The Volcker rule started as an attempt to restore the Glass-Steagall legislation, by abolishing proprietary trading altogether. However, according to Elliott, as nobody could truly give a simple definition of proprietary trading and define which kinds of trades fall under this definition, in practice this would result in very subjective assessments. For implementing the Volcker rule “you would have to look into the heart of the banker to see why they are doing what they are doing”, he said. Elliott emphasized, that there had been also many examples of excessive risk taking by commercial banks, for instance in the case of subprime credits. On the whole, traditional banking was not safer than investment banking, and the undertaken reforms are therefore missing the point.

The lively discussion that followed the lecture, facilitated by Patrick Kenadjian, senior counsel in the London office of Davis Polk, brought up many questions. A dominating subject was the rise of shadow banking, to date not well explored by academia. Further questions touched on the incentive structures resulting from the remuneration practice of banks and risk taking by banking institutions. The final question voiced the hypothesis that regulators hate having to make value judgments and therefore refused to apply existing laws which could have prevented the banks’ behavior leading to the crisis. Patrick Kenadjian argued that this is the main reason for having very detailed bank laws now (the Volcker rule alone amounts to 950 pages).