Pity the poor bankers.
Beset by presidential and public anger over the so-called bank bailout, despite the fact that much of the money has already been repaid, the U. S. Federal Reserve in February may have added injury to insult by nudging up the discount rate-the interest it charges on loans it makes directly to banks-by 25 basis points, to .75 percent.
There's no question that people are upset over the large bank bailouts, says Tarun Chordia, a chaired finance professor at Emory's Goizueta Business School. There was excess risk taking, and people are upset when they see large banks that took TARP funds rewarding executives with big bonuses. But if banks in particular are punished or constrained too severely, they won't be able to function properly, and this would impact the broader economy.
The short-term effect on loan rates is likely to be limited, but in the long term it could signal the beginning of the end of an easy money policy that has helped to push banks' bottom lines back in the black.
Besides the specter of higher wholesale costs, banks have been forced to defend themselves against President Barack Obama's populist attacks-which reached fever pitch during his January State of the Union address when he derided the so-called bank bailout with the claim: I hated it. You hated it. It was about as popular as a root canal.
Bankers who may have hoped for an ally in Ben Bernanke should not be surprised if the Fed chairman is on the same page as the president when it comes to regulation.
After all, in a letter earlier this year to Senate Banking Committee chairman Christopher J. Dodd, Bernanke also spoke of enhancing surveillance and taking other steps to strengthen the Fed's oversight of financial institutions.
For the most part the president, at least, hasn't been too specific about his proposals.
But he has floated ideas like creating a federal Consumer Financial Protection Agency that would address such issues as loan contracts written to confuse and fees and penalties associated with mortgages and credit and debit cards that appear without a clear warning.
That proposal prompted a warning from the American Bankers Association. While indicating support for strengthening consumer protection, the bankers' trade group sent a January 5 letter to Senate Banking Committee chairman Christopher Dodd expressing concern over increased regulatory costs and burdens the new agency could impose on traditional banks.
Another initiative, known as the Volcker Rule after former Federal Reserve chairman Paul Volcker, would keep banks from operating hedge funds and private equity funds and making riskier investments to reap a quick reward, according to a January 21 speech delivered by President Obama.
A more drastic proposal involves reinstating the Glass-Steagall Act of 1933-a Depression-era prohibition that generally kept commercial banks from engaging in investment banking activities, until it was repealed in 1999.
Chordia and others urge caution before re-instituting such sweeping reforms.
Banks and other financial institutions need to be able to offer a wide range of products and services to their customers at a competitive cost, Chordia notes, arguing against reviving Glass-Steagall. Citicorp, for example, can structure loans, but it also provides clients with cash management, foreign exchange, swaps and other products and services that are required by sophisticated corporate and other clients.
That's not to suggest that the banking and finance industries are entirely blameless; many argue that some additional regulation may be necessary.
But Chordia and other Goizueta faculty warn that overreaching reforms could cripple the nascent economic recovery and perhaps undermine the industry's long-term ability to grow.
The administration and regulators need to think carefully about balancing safety and growth, Chordia says. If you impose exorbitant constraints, or 'one size fits all' solutions, you're going to hold back banks' ability to lend at a time when more credit is needed.
One solution he favors would involve waiting until the economy recovers, and then instituting new, higher capital requirements [the level of a bank's capital as a ratio to its outstanding loans] that are pro-cyclical, or that rise when the economy is doing well and fall when the economy is not doing so well.
To put some beef into the new capital requirements, regulators could require financial institutions to meet them by issuing debt instruments that would be converted into equity if the institution's capital ratios were to fall below a predetermined level, Chordia adds.
This way, it's in the self-interest of the bank or other institution not to take unnecessary risks, Chordia points out. If they did, and the capital reserve level was triggered, their equity would be diluted.
Some of the tongue lashing Obama has directed at banks is no doubt motivated by politics, notes J.B. Kurish, associate dean of MBA programs and associate professor of finance at Goizueta.
But some of it may be necessary, he adds. I am worried, however, about the apparent move to reinstate Glass-Steagall. The act itself was repealed because of concern that U.S. financial institutions were being constrained when they were up against worldwide competitors that were not similarly shackled.
He does see some positive elements in the president's plans, such as initiatives that may help thaw the credit jam. And an effort to get more money into community banks is likely to be helpful, he adds.
Many of the administration's statements about 'too-big-to-fail' are great sound bites, but we need to be aware that we do not want actions that may in fact make U.S. financial institutions too small to compete globally, he notes.
Perhaps instead of rolling out new regulations, federal officials should consider stricter enforcement of ones that are already on the books, Kurish suggests.
We need to offer flexibility and a framework that lets capital move in an efficient manner, he explains. If regulators over-react in one direction first and then follow it by over-reacting in the other direction, the entire financial system may suffer. My fear is that right now Washington, D.C., is not in an introspective mood. Instead, they're looking to act quickly, and that can lead to longer-term problems.
Some banks may have indeed gone overboard, say some faculty, but they're worried about a government response that could be too harsh.
A number of banks and other financial institutions were definitely over-leveraged, and something needed to be done, says Ray Hill, an assistant professor of finance at Goizueta. However, I doubt that a populist assault on the banks by the administration and Congress will produce an effective solution to a very complex problem.
He thinks that one Obama proposal, the Financial Crisis Responsibility Fee, may be headed in the right direction, but says it still needs to be modified.
As it currently stands, the fee would amount to a 0.15 percent charge against financial firms with more than $50 billion in consolidated assets, acting as a deterrent against excessive leverage for the largest financial firms, according to a White House statement.
In general, levying a fee on banks to discourage excessive speculation is a good idea, says Hill. But the current form is too broadly based. Instead of going after every bank larger than a certain size, it might be better if the fee were based on a bank's leverage. That way you'd be targeting the risky banks without penalizing the ones that don't take as many chances.
Similarly, although Hill supports some Glass-Steagall-like reforms, he's opposed to bringing the restrictions back in their entirety.
Investment banking itself was not really the issue in the latest recession, he says. If there was a securities-related element, it came about when some banks became too much like hedge funds and started holding big positions. So perhaps a nuanced approach that imposes some limits on trading activity for institutions that have access to financial support from taxpayers-but something short of a blanket prohibition-might work. Call it Glass-Steagall lite.
He points out, though, that Bear Stearns was not a commercial bank and AIG was not a bank at all, so Glass-Steagall reforms would not address their problems.
For Kevin M. Crowley, an adjunct lecturer of finance at Goizueta, the current economic mess was largely to due government meddling-and more government meddling isn't likely to solve things.
A moral hazard arises when institutions know that the government will bail them out of trouble, he says. Excessive support on the part of the government can breed excessive risk-taking on the part of financial institutions.
In 2008 when institutions got into trouble, the government extended artificial support in the form of equity injections and by guaranteeing billions of debt issued by the banks, he notes. And now, in reaction to what seems like excessive support, the government wants to impose a series of penalties and regulations aimed to punish the banks.
This back-and-forth support, followed by arbitrary punishment, creates confusion in the markets, Crowley says, adding that it's unclear if the government's actions will reduce the chances of a future crisis.
The government has established a precedent that clearly says some institutions are too big to fail, he warns. If the government keeps rescuing institutions, excessive risk-taking may return, and in a few years we could find ourselves in a similar collapse. It would be better to keep any government support and intervention to a minimum.
His suggestion: The government should restrict its role to mandates like establishing stronger capital reserve ratios, and perhaps to calls for more transparency and greater regulation of derivatives-financial instruments that are tied to the valuation movement of other assets, indexes or events.
Generally, I don't think the government should provide taxpayer support to market companies, Crowley says. If you want to change players' behaviors, let them feel the full pain of their mistakes from the market.