The Political Importance of Financial Reform

Today at 2:00pm ET, exactly 2 years after the collapse of Bear Stearns in March 2008, Senate Banking Committee Chairman Chris Dodd will unveil his financial reform bill. This bill promises to bring sweeping change to all major US banks. Even Morgan Stanley and Goldman Sachs will not be spared as the bill is said to contain a provision that hinders these firms from revoking their bank holding company charter they adopted during the financial crisis.

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Structural Reform Is More Effective Than Regulation

The discussion on banking reform usually focuses on higher capital requirements, less leverage, and more oversight. In my opinion, this focus is misguided. Repealing the de-regulatory acts of the late 90s might be more effective because structural limitations are generally harder to bypass than something judgement-based, such as risk-weighted capital. I think history is on my side.

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A "Sucker's Rally"

The Business Insider has an interesting gallery of prominent analysts who called the stock market rally since March a "bear market rally" and advised clients to take money out of equities. Here's a graphical representation:

Not surprisingly, the bears who most accurately predicted the crash, such as Nouriel Roubini, John Mauldin, and David Rosenberg, were also among the first to call the rise in stocks a "sucker's rally."

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Armageddon in Retrospect, Part 3

The magazine pictured above is from November 2, 1987, but it could just as well be from November 2, 2008. In 1987, Time declared cryptically that the world had changed after Black Monday, when the Dow lost 22% in a single day. Oliver Stone's Wall Street and Michael Lewis' Liar's Poker predicted an end to Wall Street.

But the financial world didn't change much in 1987. There was actually less regulation after the crash. Lessons to be learned in 1987 about fat tail risks were ignored until 1997, after which they were ignored again.

Now compare that to 1929. The 1929 crash completely changed the landscape of finance. New legislation such as the Glass-Steagall Act and Securities Exchange Act effectively addressed some of the causes of the crash. But enacting change after the crash took much longer than one would expect. It took 10 years before the most significant repercussions occurred.

Its intuitive that regulation intensifies with the downturn. In the first years after the crash, sentiment was still positive. Stocks rallied, banks hired new employees, and newspapers declared the "new era" wasn't over. In Spring 1930, Hoover declared the recession was over. After the outlook worsened, a Republican-majority Senate eventually launched the Pecora Commission, but it took public pressure over time to make it effective. Even after the big wave of finance legislation in 1933, the strongest public backlash didn't occur until 1938.

It took a deepening of the depression in 1937 to spur a renewed effort for reform. From John Steele Gordon's history of Wall Street, The Great Game, "Had it not been for the return of the depression in the autumn of 1937, when all the indices that had been improving steadily, if not dramatically, for the last few years, suddenly turned down again, Douglas would have had a much harder time pursuing reform through Wall Street." This backlash led to a crackdown of illegal practices, resulting in the conviction of people such as Richard Whitney, president of the NYSE.

What will be the legacy of the 2008 crash? Dept. of Treasury issued white papers and fact sheets about future reform, but nothing substantive has emerged. Maybe the massive stock rally has something to do with it. From Sept. 25th 1987 to Sept. 25th 1988, the S&P only fell a total of 15.7% after steep losses in the beginning of that period. Over the last year, the same time frame 21 years later, the S&P has fallen less than that; it is only down 13.1%. From the reaction of equities so far, one would expect 2009 to be more like 1987 than 1929, but that has little meaning considering the similar rally of 1930. Forget the talks on regulation at the G20. Ultimately, the scope of future regulation depends entirely on the economy.