Brookings: Experts - Michael Barr

Is Housing Finance Reform Coming at Last?

Michael Barr — Wed, 06 Mar 2013 00:00:00 -0500

With the nation’s focus on the latest fiscal crisis in Washington, Congress has paid scant attention to necessary reforms to Fannie Mae and Freddie Mac. The Bipartisan Policy Center’s Housing Commission just released its report on housing finance reform, and it should help refocus attention to this crucial issue.

As we move to overhaul housing finance, let us remember how we got to this point. Private risk-taking led to a race to the bottom unconstrained by either market discipline or government oversight. Weak regulation was a recipe for a vicious cycle of deteriorating standards in practices on all levels of the mortgage market: lenders and brokers; Wall Street firms that packaged and securitized these mortgages; and the credit rating agencies that rated them.

Fannie Mae and Freddie Mac were eventually caught up in this destructive race. They had lost market share as standards deteriorated around them, and they made poor strategic choices to try to gain some of that market share back. They took on too much risk in order to grow their retained portfolios, increase returns, and inflate bonuses. The market did not discipline management's decisions because the market assumed Fannie and Freddie had a government backstop. And their regulator lacked standing and authority to substitute the discipline that was missing.

Passage of the Dodd-Frank Act in 2010 now gives regulators the necessary tools to clean up bad practices in the origination, servicing and securitization of mortgage loans. The Act should help end races to the bottom. And Fannie Mae and Freddie Mac are now under strict conservatorship. But unfortunately, legislative reform of Fannie Mae and Freddie Mac has remained stalled since their collapse in Fall 2008.

Perhaps broad bipartisan agreement on a path forward can help to jumpstart the process. Here’s what the unanimous panel of leading Republicans and Democrats agreed:

Fannie Mae and Freddie Mac, still under conservatorship, need to be gradually wound down and eliminated.
We need to get the private sector, through first-loss securitization, private mortgage insurance, and other means, to bear all but the catastrophic losses in housing, not taxpayers.
The 30-year fixed rate mortgage is an important option for American families. American homeowners are not the best bearers of interest-rate risk in our economy. To have a robust and liquid market for such mortgages for most households, there needs to be a government guarantee.
Public insurance, in the form of an explicit, fully funded guarantee of mortgage-backed securities meeting safe guidelines, should be provided. No more unfunded “implicit” backstops for private, shareholder owned entities playing “head’s I win, tails you lose.” Public insurance would only step in if the mortgages defaulted and the private sector first-loss provider went broke.
Access to affordable and sustainable mortgage credit and affordable rental housing is a critical value, and should be funded in part by guarantee fees. A balanced approach to housing requires not only ownership but also rental options. Affordable rental housing also requires governmental support, a government guarantee for certain financing, and tax incentives.

These are important areas of agreement on the path forward.

There are, to be sure, details to be worked out. The insurance entity or “public guarantor” would need to be strong and independent, like the Federal Reserve or FDIC, funded through a portion of the guarantee fee. It would need to have sufficient supervisory and regulatory powers to make sure that the private sector played by the rules—on origination, servicing, securitization, and modifications. Capital requirements on the private-sector first-loss providers would need to be robust and strictly supervised by the public guarantor. We need to be sure that the new system is set up to serve the entire market fairly and efficiently. And the system needs to work well in times of stress, unlike the system we have had.

In the meanwhile, there are a number of steps that can and should be taken under existing law. Regulators need to put in place well-aligned rules for risk retention in securitization, ability-to-pay requirements for originations, and standards for loans to be guaranteed by Fannie Mae, Freddie Mac, and the Federal Housing Administration. New servicing standards, including rules regarding loan modifications, need to be strongly enforced, with careful attention paid to incentives in the system. The size limits for loans guaranteed by these entities need to be gradually reduced, so that fully private securitization predominates in a broader “jumbo” mortgage market. Guarantee fees need to match risks and costs, and not be siphoned off by the Congress for other purposes. The retained portfolios of Fannie Mae and Freddie Mac need to continue to be reduced.

The Senate also needs to confirm permanent Directors for the Federal Housing Finance Administration (the regulator of Fannie Mae and Freddie Mac) and for the Consumer Financial Protection Bureau (responsible for overseeing consumer protection in the mortgage markets).

Now Congress needs to come together around long-needed housing finance reform.

Authors

Michael Barr

Publication: Yahoo! Finance

Obama's SOTU Should Promote a Continued Path to Financial Reform

Michael Barr — Tue, 12 Feb 2013 11:10:00 -0500

In tonight's State of the Union, President Obama should take the opportunity to remind the country of the need to stay on the path of financial reform. A collective amnesia appears to be descending on Washington-and on major financial capitals around the world-about the causes and consequences of the financial crisis. The financial crisis of 2008 crushed the American economy, cost millions of Americans their jobs and their homes, shuttered American businesses, and wiped out family savings. We're still suffering from those effects.

The President's financial reform law, enacted in 2010 against massive opposition from Wall Street and most Republicans, laid a firm foundation for a more resilient financial sector, one that works for American families, instead of exposing us all to needless risk and cost.

A new Consumer Financial Protection Bureau has been built from scratch. New rules governing derivatives transactions have largely been proposed. A resolution authority and improvements to supervision have been put in place. The largest firms have to hold a lot more equity capital. The U.S. financial system is more resilient than it was four years ago.

But nearly three years later, there's still much work to do to turn that law into reality.

And the financial sector did not leave the battlefield after their defeats in 2010. Far from it. The brutal fight over financial reform wages on, and there is a serious risk that financial sector lobbying and lawsuits will further weaken the resolve for reform. Aggressive lawsuits are being used to try to unseat the consumer bureau director, block shareholder rights, roll back protections against abuse in the derivatives market, and slow down reform. Many Republicans in Congress have blocked nominees to key posts or used the appropriations process to undermine enforcement of financial laws.

To be clear: the financial system is safer, consumers and investors better protected, and taxpayers more insulated, than they were four years ago-by a lot. But that is not enough.

In the next four years, it will be critical to stay on the path of reform.

Authors

Michael Barr

Publication: Real Clear Markets

Image Source: © Chip East / Reuters

Finish the Job of Financial Reform

Michael Barr — Thu, 27 Dec 2012 11:20:00 -0500

When President Obama came into office four years ago, the financial crisis had just thrown the U.S. economy over a cliff. The financial stability plan that the President and Treasury Secretary Geithner launched worked: the financial panic ended and the economy began to grow again. With the announcement earlier this month of AIG’s repayment of taxpayer funds, TARP and other federal investments are 90 percent repaid, and net costs of the federal intervention in the financial sector overall are expected to approximate zero. That is a remarkable achievement.

At the same time, the Administration put forward a financial reform plan, eventually enacted as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, to make the financial system more resilient, and to protect taxpayers and the broader economy in the future. The Act brings shadow banking into the daylight; regulates the largest firms regardless of their corporate form; establishes a resolution authority to wind down financial firms in a financial panic; sets new rules of the road for financial derivatives; puts in place the tools to reduce systemic risk across the market; sets out important investor protections; and establishes a new Consumer Financial Protection Bureau to look out for the interests of households.

Regulators have been working hard over the last two and a half years to implement these reforms. A new Consumer Financial Protection Bureau has been built from scratch. New rules governing derivatives transactions have largely been proposed. The resolution authority and many new approaches to supervision have been put in place. The U.S. financial system is more resilient than it was four years ago.

While much progress has been made, a combination of financial sector lobbying and aggressive lawsuits, congressional appropriations cuts and moves to delay or block nominees, and interagency wrangling, has slowed rule making.

Now is the time to finish the job of financial reform.

The Financial Stability Oversight Council needs to bite the bullet and designate systemically important firms for heightened supervision. The Fed needs to finalize its rules for tough new oversight, including limits on counterparty credit exposures and on the relative size of liabilities held by the largest firms; and it must also urgently speed up reforms to repo markets. The CFTC and the SEC need to finalize derivatives rules, and push for LIBOR reform. Regulators need to put in place a firm Volcker rule on proprietary trading. And markets need clarity and a coordinated approach to the risk retention rule for securitizations (“qualified residential mortgages”), ability-to-pay rule (“qualified mortgages”), and the practices of Fannie Mae and Freddie Mac for loans they will guarantee (let alone legislation to determine the ultimate fate of the government-sponsored enterprises).

At the SEC, a Commission deadlock has blocked the outgoing Chairman’s proposed reform of Money Market Funds, which faced a devastating run in the financial crisis, stemmed only by a massive taxpayer guarantee of the entire sector. If the SEC is unable to reach a consensus on how to proceed, the FSOC and the banking regulators will need to step in with an admittedly second-best set of steps to make MMFs less susceptible to runs, and the rest of the financial system less vulnerable to contagion from such runs.

Beyond MMFs and derivatives, the SEC faces critical regulatory policy challenges on investor protection, market structure, high frequency trading, exchange-traded funds, JOBS Act implementation, and a host of other issues. And its embattled enforcement division still has a long way to go, working with the Department of Justice, in rebuilding the public’s trust that our financial markets are being adequately policed for unlawful conduct.

Globally, new capital and liquidity rules have been proposed; the Europeans are making progress on derivatives reforms, supervision and new resolution authorities; and U.S. and global regulators have made progress on mechanisms to coordinate action on all these topics. Yet much still remains in flux, and there remains the danger that the next financial crisis, like the last, will occur when there are still no globally coordinated mechanisms for regulation or crisis management.

To be clear: the financial system is safer, consumers and investors better protected, and taxpayers more insulated, than they were four years ago—by a lot. But that is not enough. In the next four years, it will be critical to stay on the path of reform.

Authors

Michael Barr

Image Source: © Molly Riley / Reuters

Too LIBOR, Too Late: Time to Move to a Market Rate

Michael Barr — Thu, 15 Nov 2012 00:00:00 -0500

Editor's Note: In an article for International Competition Policy's Antitrust Chronicle, Michael Barr proposes four alternatives to LIBOR and argues for an actual, traded, transparent rate in a liquid market.

Barclays has been fined, the British have issued their report, and now the market is anxious for everything to go on as usual with the London Interbank Offer Rate (“LIBOR”). I think that would be a serious mistake.

The U.S. and British investigations into rate-fixing by Barclays revealed a widespread culture of pervasive, deceitful conduct in the setting of the most important private sector benchmark for over $300 trillion in derivative contracts and $10 trillion in adjustable-rate loans. It is highly unlikely that Barclays was the only major bank engaging in this conduct, and public investigations and private lawsuits against a range of participants in LIBOR rate-setting are likely to reveal further misconduct in the months ahead.

The basic structure for the setting of LIBOR is fundamentally flawed. It permits banks with obvious conflicts of interest to skew the LIBOR rate in order to benefit their own firm. Barclays, for example, was alleged to have attempted to manipulate LIBOR to benefit its traders and to hide its growing costs of borrowing in the financial crisis. The LIBOR structure also facilitates collusion among the rate-setting banks, in violation of the antitrust laws. Barclays, for example, was alleged to have attempted to manipulate LIBOR in collusion with other firms to benefit particular trades over a number of years. Both public antitrust investigations and a range of private lawsuits are likely to be pursued with vigor in the coming months.

The collusion and manipulation were alleged to have occurred during both quiescent markets and turbulent ones. That is, the attempted manipulation of LIBOR was apparently not confined to one extraordinary “once-in-a-lifetime” financial crisis, when extreme market pressures might have lured firms to engage in this unlawful conduct, but rather was ingrained in the regular setting of rates.

As it currently stands, LIBOR is not a market interest rate. It provides the illusion of market rates that are relied upon by everyone from sophisticated derivative traders to ordinary mortgage borrowers, but the rate itself is pure fiction. Banks submit a rate at which they supposedly could borrow, but there’s no requirement that the rates submitted be based on actual transactions. As Mervyn King, Governor of the Bank of England put it, LIBOR represents “the rate at which banks do not lend to each other.”

In normal times, the rate is not needed, as U.S. dollar LIBOR tracks (with a regular additional cost reflecting credit and liquidity risks of private borrowing) the risk-free rate of Federal funds and Treasury bills. In abnormal times—such as the financial crisis peak in the fall of 2008—no one can count on the fact that it tracks anyone’s true cost of funds. And if it did track someone’s true cost of funds, it could hardly be said to track the costs of funds of any particular institution facing (or not facing) liquidity or solvency strains, even among the “elite” group setting the rate.

But what about reform? Didn’t the British authorities just fix the problem?

No.

The “Wheatley Report” issued last month is definitely better than the status quo. It echoes a series of reform proposals first put out by the New York Federal Reserve Bank in 2008—making LIBOR less subject to manipulation, and requiring the auditing of submissions. This is all for the good. If we have to keep LIBOR, making it subject to greater scrutiny is definitely preferable to the status quo.

But at this point, it is not enough. The proposed reforms are too reliant on the existing structure of LIBOR, and come too late to save it. Continued reliance on LIBOR rightly undermines trust in the financial system.

What should we do going forward?

There are four potential paths:

First, reform LIBOR, along the lines of the Wheatley Report. Better than the status quo, but if you ask me, I wouldn’t trust it. The incentives for manipulation are too strong, and regulators are never going to be able to keep up with the foul play. The regulatory apparatus required to enforce the reforms are likely to make LIBOR less risk-sensitive and more litigation-averse, which undermines the point of the reform.

Second, reform LIBOR, along the lines recently suggested by Commodity Futures Trading Commission Chair Gary Gensler. Much better: banks would rely on actual transactions (lagged by a day) instead of made-up claims about borrowing costs. But the market for actual, unsecured interbank lending is currently thin, and likely to get thinner, as both the Dodd-Frank Act’s interbank credit limit and the Basel III’s liquidity requirements will penalize such transactions. Thin trading means unreliable pricing, and the incentives for manipulation and collusion would remain strong unless actual borrowing volumes are high compared to the volumes of other LIBOR-related transactions that might benefit from cooked submissions.

Third, reform LIBOR by requiring banks to “commit” to a LIBOR rate, as suggested in a thoughtful article by Professors Abrantes-Metz and Evans, even if the transactions do not take place, on the grounds that reducing the incentive to lie involves committing firms to borrow or lend at the quoted rates, and one should be concerned about making sure there’s a LIBOR rate in place even during periods of market stress when few actual transactions are likely to occur. But committing to borrow or lend at a certain rate is not likely to have much bite when you need it—during a financial panic—because other sources of borrowing, including from the central bank or from private sources on a secured basis, will often trump the option of unsecured borrowing at the quoted rate. And the benefits from misstating LIBOR to gain on trading positions may swamp the costs of borrowing (or lending) some amount at the committed rate even if the firm is forced to do so.

Fourth, reform LIBOR by replacing it with an actual, traded, transparent rate in a liquid market. For example, U.S. dollar LIBOR could be based on the Overnight Index Swap (“OIS”) rate (based on Federal funds) or Treasury-bill rate, plus a fixed spread.

At the end of the day, and acknowledging the costs, I’m with option four.

While the change will not be easy, it is time to abandon the fiction of “market” rate-setting by quotes from the largest banks. Using OIS or Treasury bills as the index rate would permit parties to hedge interest-rate risk, as LIBOR was intended. Parties that want to hedge bank credit and liquidity risk can do so with other instruments, although these instruments too have their own difficulties.

To be sure, there are costs to this approach: transition costs to moving away from a widely used market convention to a new system; the risks of market fragmentation and lower liquidity if market participants do not readily settle on a new contract rate; and the ongoing cost of having a rate that may diverge from actual bank credit and liquidity conditions, especially in a severe financial crisis.

But LIBOR apparently never actually reflected these market conditions. The supposed gains of having a rate that reflects interbank credit risk is belied by actual market practice and is unlikely to be fixed by other reforms. Transitional issues should not block fundamental reform. The markets have had to move to new contract rates in other contexts—for example, in the transition from European currencies to the Euro—and have managed these transitions quite well.

The financial sector is suffering from a deficit of trust. That lack of trust has been earned. To build a more resilient financial system, we need to start with the basics: trust in the financial system will be restored when it acts honestly.

And one key measure of that will be when the financial system bases contracts on actual, observable, transparent market transactions.

Authors

Michael Barr

Publication: Antitrust Chronicle

It’s Time to Take the ‘E’ Out of ‘LIE-BOR’

Michael Barr — Thu, 18 Oct 2012 10:53:00 -0400

Barclays has been fined, the British have issued their report, and now everything can go on as usual with the London Interbank Offer Rate (“LIBOR”), right?

I don’t think so.

The investigation into rate-fixing by Barclays revealed a widespread culture of pervasive, deceitful conduct in the setting of the most important private sector benchmark for over $300 trillion in derivative contracts and $10 trillion in adjustable-rate loans. It is highly unlikely that Barclays was the only major bank engaging in this conduct, and public investigations and private lawsuits are likely to reveal further misconduct in the months ahead.

The basic structure for the setting of LIBOR is fundamentally flawed. It permits banks with obvious conflicts of interest to skew the LIBOR rate in order to benefit their own firm. Barclays, for example, was alleged to have attempted to manipulate LIBOR to benefit its traders and to hide its growing costs of borrowing in the financial crisis. Barclays also is alleged to have attempted to manipulate LIBOR in collusion with other firms. These actions apparently occurred during both quiescent markets and turbulent ones.

As it currently stands, LIBOR is not a market interest rate. It provides the illusion of market rates that are relied upon by everyone from sophisticated derivative traders to ordinary mortgage borrowers, but the rate itself is pure fiction. Banks submit a rate at which they supposedly could borrow, but there’s no requirement that the rates submitted be based on actual transactions. A handful of banks can collude to manipulate the rate.

But what about reform? Didn’t the British authorities just fix the problem?

No.

The “Wheatley Report” issued last month is definitely better than the status quo. It echoes a series of reform proposals first put out by the New York Federal Reserve Bank in 2008—making LIBOR less subject to manipulation and auditing submissions. This is all for the good. If we have to keep LIBOR, making it subject to greater scrutiny is definitely preferable to the status quo.

But at this point, it is not enough. LIBOR, as one prominent political cartoon called it, is really “LIE-BOR,” and continued reliance on it rightly undermines trust in the financial system. As Mervyn King, Governor of the Bank of England put it, LIBOR represents “the rate at which banks do not lend to each other.”

What should we do going forward?

There are four potential paths:

Third, reform LIBOR, by requiring banks to “commit” to a LIBOR rate, as suggested in a thoughtful article by Professors Abrantes-Metz and Evans, even if the transactions do not take place, on the grounds that reducing the incentive to lie involves committing firms to borrow or lend at the quoted rates, and one should be concerned about making sure there’s a LIBOR rate in place even during periods of market stress when few actual transactions are likely to occur. But committing to borrower or lend at a certain rate is not likely to have much bite when you need it—during a financial panic—because other sources of borrowing, including from the central bank, or from private sources on a secured basis, will often trump the option of unsecured borrowing at the quoted rate. And the benefits from misstating LIBOR to gain on trading positions may swamp the costs of borrowing (or lending) some amount at the committed rate even if the firm is forced to do so.

Fourth, reform LIBOR by replacing it with an actual, traded, transparent rate in a liquid market. For example, U.S. $ LIBOR could be based on the Overnight Index Swap (OIS) rate (based on Federal funds) or Treasury-bill rate, plus a fixed spread.

At the end of the day, and acknowledging the costs, I’m with option four.

While the change will not be easy, it is time to abandon the fiction of “market” rate setting by quotes from the largest banks. Using OIS or Treasury bills as the index rate would permit parties to hedge interest-rate risk, as LIBOR was intended. Parties that want to hedge bank credit and liquidity risk can do so with other instruments, although these instruments too have their own difficulties.

And one key measure of that will be when the financial system bases contracts on actual, observable, transparent market transactions.

Authors

Michael Barr

Publication: Yahoo! Finance

Image Source: © Simon Newman / Reuters

JPMorgan Mess: Why Mitt Romney’s Wrong on Dodd-Frank

Michael Barr — Fri, 25 May 2012 10:49:00 -0400

When financial giant JPMorgan Chase recently revealed that it had lost far more than $2 billion in a credit derivatives trade gone wrong, the news sent a clear message: Opponents of financial reform are wrong. Without the Dodd-Frank Act and the global reforms being led by the United States, the financial sector would go back to its old ways, eventually putting taxpayers and the economy at grave risk of harm.

Yet for the presumed GOP nominee Mitt Romney, the news sent a very different message. He repeated his call to repeal Dodd-Frank, though it made the system stronger, and though JPMorgan’s revelations demonstrated the need for robust rules.

Romney and many Republican lawmakers seem intent on going back to the financial casino that led to the worst economic crisis in 80 years. The financial industry has spent far more than $100 million trying to roll back Wall Street reform. Romney, meanwhile, has been clear about what he wanted to get rid of — a comprehensive financial reform package that passed Congress and was signed by the president. Yet he makes only the vaguest of promises about what he might do instead.

Romney’s reaction is the equivalent of putting out a small fire in your house, then deciding that the lesson is you need to stuff your house with matches, throw out your fire extinguisher and cancel your fire insurance. And doing all this after the house nearly burned to the ground less than four years ago.

The system of rules under which the financial industry operated in the lead-up to the financial crisis was broken. Financial institutions took on too much risk with too little capital. Financial companies could escape meaningful supervision by calling themselves investment banks or insurance conglomerates rather than commercial banks, and all institutions could move assets and liabilities off the balance sheet and out of regulatory purview in the shadow banking system.

Derivatives were traded in the dark; conflicts of interest were rife; securitizations and synthetic products hid real risks; and there was no way to wind down a major firm like Lehman Brothers without causing widespread harm. Consumers and investors lacked adequate protections, which too often meant that the financial industry could take advantage of them.

These flaws blew up the financial system, crushed the economy and cost millions of Americans their jobs. They wiped out families’ savings and put homes at risk. These flaws lined the pockets of Wall Street bankers while making taxpayers the fall guy for their failures. This is what we would get back if we followed Romney’s advice and repealed Dodd-Frank.

The Dodd-Frank Act, once fully implemented, can change all that. It has already increased capital requirements and created the authority to regulate Wall Street firms that pose a threat to financial stability, without regard to their corporate form. It enacted a resolution authority to wind down these major firms in the event of a crisis — without feeding a panic or putting taxpayers on the hook, putting an end to Too Big to Fail; restricted risky activities by firms with taxpayer-insured deposits, including through the “Volcker rule”; imposed a cap on the relative size of the largest firms; and required transparency, central clearing, exchange trading and margin for the derivatives market. It established a new Consumer Financial Protection Bureau to look out for the interests of American households.

Key provisions of reform are already working. For example, measures requiring large banks to hold more capital have helped make financial institutions more resilient. And if a big firm got itself into deep trouble today, the government now has the tools to wind it down, with shareholders and creditors taking their losses.

Rules under other parts of the Dodd-Frank Act are still being drafted by regulators and must be completed to protect taxpayers and the economy. We need a strong Volcker rule to prevent banks from making risky bets with taxpayer-insured deposits and strict limits on counter-party exposures among the largest financial firms to limit systemic risk. We need robust rules for derivatives clearing and trading, and adequate funding for the Commodity Futures Trading Commission and Securities and Exchange Commission to enforce them. We need strong consumer and investor protections to keep the market fair and open.

Yet Romney and many Republicans in Congress are determined to forget the lessons of the crisis by repealing rules that could address the weaknesses in our regulatory system that allowed the financial crisis to happen. Romney suggested last week that he wasn’t even concerned by the JPMorgan losses.

But for those of us who remember how Wall Street reacted after the 2008 financial collapse, the losses reminded us why regulators need to finish the job of implementing these and other key provisions as quickly and robustly as possible; w hy Congress should stop trying to cut necessary budgets and block agency nominees; and why Romney should take a cold hard look at the ways in which his support for Wall Street’s lobbying exposes taxpayers and the economy to enormous risk of another crisis.

Authors

Michael Barr

Publication: POLITICO

Image Source: Lucas Jackson / Reuters

No Slack : The Financial Lives of Low-Income Americans

Michael Barr — Mon, 16 Apr 2012 00:00:00 -0400

Brookings Institution Press 2012 300pp.

The financial crisis lay bare how the financial system failed the nation but left hidden the many ways in which that system still fails the most vulnerable Americans. In No Slack, Michael S. Barr explores how low- and moderate-income households cope with financial stress, use financial services to make ends meet, and often come up short.

Many households were overleveraged or paid high costs for financial services, while others lacked access to useful financial products that can cushion against economic instability. The financial services system is not well designed to serve low- and moderate-income households, leaving them without financial slack: they did not have adequate breathing room for making the financial adjustments that would permit them to better meet their own needs. No Slack shows us why these families were the least prepared to handle the shock of the deep recession.

This pivotal analysis focuses on the Detroit metropolitan area’s low- and moderate-income neighborhoods, which are similar to those of other Rust Belt communities. The Detroit Area Household Financial Services study—conducted at the height of the subprime lending boom—examines these households’ decisionmaking processes, behaviors, and attitudes toward a full range of financial transactions.

No Slack reveals widespread problems in home mortgage lending, the common threads among people who file for bankruptcy, the reasons so many households are unbanked, and how behaviorally informed financial regulation can make the market work better. Drawing on his deep policy experience, Michael Barr advocates helping families seek financial stability in three primary ways: enhancing individuals’ financial capability, using technology to promote access to financial products and services that meet their needs, and establishing strong protections for consumers.

Among Michael Barr's recent publications are Insufficient Funds: Savings, Assets, Credit and Banking among Low- and Moderate-Income Households, co-edited with Rebecca M. Blank (Russell Sage, 2009), and Building Inclusive Financial Systems: A Framework for Financial Access, co-edited with Anjali Kumar and Robert E. Litan (Brookings, 2007).

Praise for No Slack:

"It is so nice to have Michael Barr back in academia, where he has resumed his scholarly research into the challenge of providing affordable financial services for the poor. In this book, he vividly illustrates that while the hidden fees and surprise charges embedded in so many financial products irritate and annoy us, for those with ‘no slack’ they can have devastating financial consequences. There has got to be a better way, and Barr has devoted his career to finding it."—Sheila Bair, former chair of the Federal Deposit Insurance Corporation

"It is inspiring to see such a thoughtful analysis of the deep financial problems that make life miserable for so many people, and to see that many of these problems can be solved with suitable behaviorally informed financial innovations. Barr faces the real subtlety and complexity of the problems that leave so many people with no slack."—Robert Shiller, Arthur M. Okun Professor of Economics, Yale University

"In many respects the American economy is too financialized. But as Michael Barr highlights in this important book, millions lack access to basic financial services and protections. Barr draws on his unmatched combination of academic expertise and policy experience to define the challenge and suggest ways to meet it. This book deserves to be an important part of any discussion of the future of the financial sector or the prospects for low-income Americans."—Lawrence H. Summers, former U.S. Secretary of the Treasury, president emeritus and the Charles W. Eliot Professor, Harvard University

ABOUT THE AUTHOR

Michael Barr

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The Financial Crisis and the Path of Reform: Three Years Later

Michael Barr — Wed, 21 Dec 2011 00:00:00 -0500

The financial crisis devastated the U.S. economy in the fall of 2008 and plunged us into a recession that shuttered American businesses, led to widespread job losses, and wiped out home values and household savings. While the U.S. financial sector has stabilized considerably, and the U.S. economy is growing again, the continued crisis in Europe threatens to halt that progress and choke off recovery.

Three years after the peak of the crisis, it makes sense to take stock.

In the U.S., passage of the Dodd-Frank Act in July 2010 ushered in comprehensive reform in key areas: creating the authority to regulate Wall Street firms that pose a threat to financial stability, without regard to their corporate form; enacting a resolution authority to wind down these major firms in the event of a crisis, without feeding a panic or putting taxpayers on the hook; attacking regulatory arbitrage, restricting risky activities, and beefing up banking supervision; requiring central clearing and exchange trading of standardized derivatives, and capital, margin and transparency throughout the market; and establishing a new Consumer Financial Protection Bureau to look out for the interests of American households.

On the global level, the international community has put forward strict new rules on capital, so that there are bigger buffers in the system in the event of failures. Capital and the risk of assets will be measured in a more conservative way, and capital levels will go up significantly. Systemically important firms will hold even higher levels of capital. And there will be new rules on liquidity and a global leverage limit.

Despite progress thus far, financial reform and the financial system face key threats. First and foremost, regulators need to finish the job of implementing the Dodd-Frank Act and the new capital rules. Yet a key problem here has been the Congress: a number of Republicans have been trying to hamstring reform by blocking the necessary funding (as with the Commodity Futures Trading Commission), blocking nominees (as with the Consumer Financial Protection Bureau), or putting forward measures to repeal parts of the Act (as with requirements for clearing derivatives).

Second, money market funds were a core source of systemic risk in the crisis. When one such fund "broke the buck," indicating that it could not maintain a stable net asset value in its funds, a massive run on the sector was ended only when Treasury put in place a $3 trillion guarantee. Going forward, the SEC has put forward a number of needed reforms regarding liquidity and other matters, but the sector will not be stabilized unless the SEC issues new rules to require stable net asset value funds to hold capital sufficient to withstand market stress.

Third, the housing finance system remains highly in flux. While the Federal Housing Finance Agency-the regulator of Fannie Mae and Freddie Mac-has been ensuring that they operate safely under conservatorship, key decisions about their future have been delayed. Moreover, regulators have yet to put in place new rules about risk retention in mortgage securitization. Thus, key questions about how the U.S. will finance mortgages going forward remain unanswered. Meanwhile, mortgage servicers continue to drag their feet in refinancing and modifying existing mortgages for underwater or troubled borrowers, adding a real drag on housing.

Fourth, as reforms are being put in place, new risks are developing. For example, just as the use of derivatives and synthetic products contributed to the opaque build up of risks in the shadow banking system, new uses of these techniques are starting to build opaque risks in Exchange Traded Funds, which threatens to undermine the stability of a product that was initially designed as a consumer-friendly, simple, low-cost way to hold a broad index of equities. The Financial Stability Oversight Council and Office of Financial Research need to get on top of new risks quickly.

Lastly, global reform and recovery can easily get off track. So far, the Europeans have done too little, too late to stem their financial crisis. The European Central Bank needs to step in more forcefully on sovereign bonds; regulators need to push through with greater transparency on their stress tests and capital raising for European banks; European derivatives reform needs to accelerate, with strong rules on central clearing, exchange trading, capital and margin, and without national discrimination; and global capital rules need to be implemented with transparent and honest assessment of the riskiness of assets, so the rules are not undermined.

Authors

Michael Barr

Image Source: Â© Jonathan Ernst / Reuters

Europe's Last Chance to Get it Right: From Monnet to Mitter-ohl and Merk-ozy

Michael Barr and Daniel Halberstam — Thu, 08 Dec 2011 13:04:00 -0500

As Europe’s leaders gather this week to tackle its economic woes, it is useful to take a step back and remember how and why Europe got here.

Even as Nazi bombs rained down on London in 1940, French economist and war munitions man Jean Monnetwas planning for the integration of Germany into a united Europe. This was no flight of fancy or act of forgiveness by the man widely credited as the architect of Europe. It was a pragmatist’s assessment of how to make sure that after this war ended, a similar catastrophe would be unthinkable in Europe ever again.

Monnet’s success – and Europe’s success – has been so great, that we take the peace it created for granted today. World War II and the centuries of animosity between France and Germany are becoming faint memories. And so we find it increasingly difficult to appreciate the achievement of these former archenemies in keeping Europe together.

Maintaining Franco-German reconciliation has also been at the heart of the deal that brought about the Euro. A common currency as part of deeper European integration had been a philosophical goal since the 1960s. By the 1980s, a common currency became attractive as a matter of hard economic politics. After suffering from years of undisciplined monetary policy, France (along with other European nations) had promised investors that it would no longer tinker with money. Instead, France would shadow the moves of the German Bundesbank. Long before the Euro came about, then, these nations had given up their currencies in all but name and local color. For them, moving from this system to a real shared currency meant not loss but gain of power. They would regain a seat at the table where decisions about monetary policy were made.

France’s moment came when Germany needed help to reunite after the cold war. Helmut Kohl was on track to becoming the longest serving German Chancellor since Otto von Bismarck (who had unified Germany in 1871). And Kohl sought to reunite Germany on his watch. But France, as one of the victors in World War II, had to agree. French President Francois Mitterand, who was terrified of the resurrection of a German superpower, offered a deal: unification, or Deutsche Mark. If Germany tried to have both, Mitterand threatened, it would find itself isolated as back “in 1913.” The “Mitterohl” deal was struck.

As Europe’s most visible symbol of unity, the Euro is therefore deeply embedded in the idea of keeping Germany in the broader West, on the one hand, and checking inflationary forces within many non-German member states, on the other. Both aspects are now in danger of being lost. The Mitterohl deal had weak oversight of member state fiscal policies. Many European states have failed to maintain the necessary fiscal discipline to make monetary union work. And that fiscal failure, combined with the common currency, ironically made Germany’s Euro-denominated exports soar while investors still flocked to German bonds above all others in Europe over the last decade. Only now has the dithering of Europe’s leaders brought the problems of the periphery to the core.

The root difficulty for Europe’s leaders attempting to grapple with the current crisis is that they have not sufficiently moved beyond Monnet’s vision of a bureaucratic Europe toward a political Europe. One cannot run a common economic system if component states can freely set fiscal policy in the hopes of being bailed out by the central government. But tough reforms at the European level lack legitimacy and support if they are seen as imposed by technocrats far from the concerns of local citizenry, or worse, by Germany imposing its will on the rest.

That has led many commentators to call the European project a failure, and to welcome the demise of the Euro. But whether the Euro was a good idea to begin with, ending the Euro, or having countries on the Euro pull out, is simply not a feasible option. The destruction of the common currency would drive Europe into its own Great Recession.

So for better or worse, Europe has no choice but to save the Euro. Up until now, Europe has done too little, too late, with national politicians and Eurocrats for different reasons both avoiding bold action.

To give Europe the legitimacy it needs to function, national politicians must have a stake in the long-term survival of the system as a whole. They must have reason to consider not only their own immediate re-election by their local electorate, but also their accountability (even if only in the form of a future career leading European institutions) to the electorate of the system as a whole.

What Europe needs, then, is to bring politics to the Center. And the way to do that, paradoxically, is by having Europe’s institutions enact tough economic reforms now. Voters will force national politicians to focus on European institutions and that, in turn, will focus their political ambitions beyond their member state.

What will it take to bring Europe out of the current crisis?

Germany is correct to insist that going forward, European member states need to commit to a binding fiscal policy (with, in our judgment, agreed-upon room for automatic stabilizers and other measures during economic downturns and crises), and Sarkozy needs to swallow hard (as he appears to be doing) and accept that European institutions will have a strong say. But good fiscal policy is the ticket to the main event, not the show itself.

As is obvious to all, Greece cannot afford to repay its debt. The Greek voluntary “workout,” with its debt-holders taking deep haircuts, needs to move forward, together with Greek implementation of promised economic reforms.

Europeans need to make clear that none of the other nations will default on their debt. While the rest of Europe (other than Germany) is facing temporarily higher borrowing costs, their economies are robust enough to repay the debts they owe over the long term.

Most importantly, Merkel needs to relent: The European Central Bank needs be unleashed to act as a lender of last resort for the Euro Zone. The bank can do this by promising to buy (non-Greek) euro zone debt to keep rates at a targeted level. They can do this through the banking system (rather than directly from nations) without a charter change, but they need political buy-in from Germany (and France). If the ECB steps in, borrowing rates will come down more in line with the underlying fundamentals of European economies.

With the ECB unleashed to provide liquidity, other institutions can step in to foster solvency. The European Financial Stability Facility , now approved to lend up to Euro 1 trillion, and with the prospect of additional private and public resources, will have the credibility to bring real stability to the markets. The IMF and BRIC nations might usefully contribute additional resources. Without the ECB, however, the facility is unlikely to work, and IMF and BRIC intervention would likely be just a sideshow. Without strong ECB action, these steps risk just another round of market withdrawals and panic.

European bank regulators need to force Europe’s banks to recapitalize, and to do so on the basis of honest and transparent stress tests, and independent supervisory assessments regarding the riskiness of bank assets. Several rounds of false starts have undermined the public’s confidence in Europe’s oversight, and this is the last chance to get it right.

That means not only transparent and honest stress tests, followed by recapitalization, but also robust enactment of new rules of the road for Europe’s banks: no backsliding on implementation of international capital rules, pushing forward on a strong new framework for derivatives (including capital, margin, central clearing and exchange trading), and enactment of resolution regimes that permit troubled systemically important financial institutions to be wound down without spawning further panics or taxpayer bailouts.

Europe now has a chance to move beyond the dual nationalism of Mitterohl, or a quick Merkozy fix, to a system in which politicians have incentives to act with Europe’s interests in mind. Only then will Europe get its political and economic house in order. As for Jean Monnet, he saw opportunity in every failure; let’s hope Europe’s leaders don’t wait for that.

Authors

Michael Barr
Daniel Halberstam

Publication: CNBC

Image Source: Â© Yves Herman / Reuters

The Dodd-Frank Act, One Year On

Michael Barr — Mon, 27 Jun 2011 17:01:00 -0400

Michael Barr delivered this speech on June 27, 2011 to the Pew/NYU Stern Conference on Financial Reform.

Over two years ago, the United States and the global economy faced the worst economic crisis since the Great Depression. The crisis was rooted in years of unconstrained excess on Wall Street, and prolonged complacency in Washington and in major financial capitals around the world. The crisis made painfully clear what we should have always known--that finance cannot be left to regulate itself; that consumer markets permitted to profit on the basis of tricks and traps rather than to compete on the basis of price and quality will, ultimately, put us all at risk; that financial markets function best where there are clear rules, transparency and accountability; and that markets break down, sometimes catastrophically, where there are not.

Over time those great strengths were undermined. The careful mix of protections we created eventually eroded with the development of new products and markets for which those protections had not been designed. And our regulatory system found itself outgrown and outmaneuvered by the institutions and markets it was responsible for regulating and constraining.

In particular, the growth of the “shadow banking” system permitted financial institutions to engage in maturity transformation with too little transparency, capital, or oversight. The years leading up to the crisis saw the significant growth of large, short-funded, and substantially interconnected financial firms. Huge amounts of risk moved outside the more regulated parts of the banking system to where it was easier to increase leverage. Legal loopholes and regulatory gaps allowed large parts of the financial industry to operate without oversight, transparency, or restraint. Entities performing the same market functions as banks escaped meaningful regulation on the basis of their corporate form, and banks could move activities off balance sheet and outside the reach of more stringent regulation. Derivatives were traded in the shadows with insufficient capital to back the trades. “Repo” markets became riskier as collateral shifted from Treasuries to poorer quality asset-backed securities. The lack of transparency in securitization hid the growing wedge in incentives facing different players in the system and failed to require sufficient responsibility from those who made loans, or packaged them into complex instruments to be sold to investors. Synthetic products multiplied risks in the securitization system. The financial sector, under the guise of innovation, piled ill-considered risk upon risk.

As the shadow banking system grew, our system failed to require real transparency, sufficient capital or meaningful oversight. Rapid growth in key markets hid misaligned incentives and underlying risk. Financial innovation often outpaced the capacity of managers, regulators and markets to understand new risks and adjust. Throughout our system we had increasingly inadequate capital buffers – as both market participants and regulators failed to account for new risks appropriately. Short-term rewards in new financial products and rapidly growing markets overwhelmed or blinded private sector gatekeepers, and swamped those parts of the system that were supposed to mitigate risk. Consumer and investor protections were weakened and households took on risks that they often did not fully understand and could ill-afford.

Rising home and other asset prices had helped to feed the financial system’s rapid growth, and to hide declining underwriting standards and other underlying problems in the origination and securitization of mortgage loans. When home prices began to flatten, and then to decline, fault lines were revealed. The asset implosion in housing led to cascades throughout the financial system, and then to contagion from weaker firms to stronger ones. Failures in the shadow banking system fed failures in the more regulated parts of the banking system. And then, in the fall of 2008, credit markets froze. The over-reliance on short-term financing, opaque markets and excessive-risk taking that had been the source of significant profit on Wall Street and in financial capitals globally, fanned a panic that nearly collapsed the global financial system.

Comprehensive reform was essential. One year ago, President Obama signed into law the Dodd-Frank Act. The Act provides for supervision of major firms based on what they do, rather than their corporate form. Shadow banking is brought into the regulatory daylight. The largest financial firms will be required to build up their capital and liquidity buffers, constrain their relative size, and place restrictions on the riskiest financial activities. The Act comprehensively regulates derivatives markets with new rules for exchange trading, central clearing, transparency, and capital and margin requirements. The Act provides for data collection and transparency so that in no corner of the financial markets can risk build unnoticed. The Act creates an essential mechanism for the government orderly to liquidate failing financial firms without putting taxpayers at risk. The Act creates a new Consumer Financial Protection Bureau and provides for consumer and investor protections. In sum, the Act provides a strong foundation on which the U.S. must now carefully build a more stable and balanced regulatory system.

Before Dodd-Frank, if an entity were a bank, then it had tougher regulation, more stringent capital requirements, and more robust supervision. But if an entity were an investment bank engaged in the same activities, then it was able to abide by different rules. For example, when U.S. investment banks needed to find a “consolidated holding company regulator” in order to meet European Union standards for doing business in Europe, the Securities and Exchange Commission set up a "voluntary" Consolidated Supervised Entity program with little oversight. The SEC was not established as a prudential regulator, did not have clear regulatory oversight for investment bank holding companies, and had little experience and few trained examiners. Moreover, the leverage requirement that served as a backstop for capital requirements on banks was not applied to these investment banks. In effect, the system allowed large financial institutions to choose the regulator that would offer the least restrictive supervision.

The Federal Reserve did not have any authority to set and enforce capital requirements on the major institutions that operated businesses outside of bank holding companies. That meant it had no supervision over investment banks, diversified financial institutions like AIG or the nonbank financial companies competing with banks in the mortgage, consumer credit and business lending markets. The Office of Thrift Supervision viewed its role as supervising thrifts, not their holding companies (such as AIG). And regulators permitted banks and thrifts themselves to engage in risky mortgage lending, stepping in with guidance only when it was too late.

Today, Dodd-Frank has provided authority for clear, strong and consolidated supervision and regulation by the Federal Reserve of any financial firm--regardless of legal form--whose failure could pose a threat to financial stability. We will have a single point of accountability for tougher and more consistent supervision of the largest and most interconnected financial firms. All bank holding companies will be supervised by the Fed, and the largest ones will be subject to heightened standards. The Office of Thrift Supervision has been abolished, and all Savings & Loan Holding Companies will be supervised by the Fed. Non-bank financial institutions designated by the Financial Stability Oversight Council will also be Fed-supervised. The voluntary investment bank holding company regime has ended.

Dodd-Frank provides for more stringent prudential standards for these major bank and nonbank firms. The Fed is charged with putting in place stronger requirements for capital and liquidity. Annual stress tests will be conducted on these firms. There are enhanced rules on affiliate transactions, lending limits, and counterparty credit exposures. The Fed is required to use macro-prudential supervision, which takes into account not only the risks within the institution, but the risks that the institution poses to the financial system as a whole. Major firms will be subject to a concentration limit that generally prohibits a financial company from engaging in mergers or acquisitions that would result in the firm’s liabilities—including wholesale funding and off-balance sheet exposures—exceeding 10 percent of the liabilities of financial companies as a whole. These enhanced prudential measures for major financial firms are likely to reduce risk in the financial system and reduce any “too big to fail” distortions.

Before Dodd-Frank, no regulator or supervisor had the legal authority or responsibility to look across the full sweep of the financial system and take action when there was a threat. Today, while the regulatory infrastructure is far from ideal, with too many divided responsibilities, the Financial Stability Oversight Council (FSOC) is accountable to identify threats to financial stability and to address them. The FSOC will have access to information across the financial services marketplace. A new Office of Financial Research is empowered to collect data from any financial firm, and to develop and enforce standardization for data collection.

Before Dodd-Frank, the OTC derivatives market--with a notional amount of $700 trillion at its peak--grew up in the shadows, with little oversight. Credit derivatives, which were supposed to diffuse risk, instead concentrated it. Synthetic securitization with embedded derivatives magnified failures in the real securitization market. Major financial firms used derivatives to increase their credit exposure to each other, rather than decrease it. We should never again face a situation – such as AIG’s $2 trillion derivatives portfolio – where the potential failure of a virtually unregulated, capital deficient major player in the derivatives market can impose devastating risks on the entire system. The opacity of this market meant that the government and market participants did not have enough information about the location of risk exposures in the system or the extent of the mutual interconnections among large firms. So, when the crisis began, regulators, financial firms, and investors had an insufficient understanding of the degree to which trouble at one firm spelled trouble for another. This lack of information magnified contagion as the crisis intensified, causing a damaging wave of margin increases, deleveraging, and credit market breakdowns. Lack of transparency, insufficient supervision, and inadequate capital left our financial system vulnerable to concentrations of risk, and to abuse.

Today, regulators are putting in place the tools to comprehensively regulate the OTC derivatives market for the first time. The Act provides for regulation and transparency for transactions in this market. It provides for strong prudential, capital, and business conduct regulation of all dealers and other major participants in the derivatives markets. And it provides for regulatory and enforcement tools to go after manipulation, fraud, and other abuses in these markets.

The Act requires all standardized derivatives to be centrally cleared, which will substantially reduce the build-up of bilateral counterparty credit risk between major financial firms. Central clearing parties would be subject to strong prudential supervision. Such derivatives would be traded on exchanges or alternative swap execution facilities, which would improve pre- and post-trade price transparency. Exchange trading will help to improve price competition as well as to improve safety and soundness in the derivatives system, as market participants and regulators will have full access to current prices in the event of system disruptions. Even non-centrally cleared OTC derivatives would be reported to a trade repository, making the market far more transparent. The Act provides for prudential regulation of all OTC dealers and all other major players in the OTC markets, so that adequate capital, business conduct rules, and prudential supervision will apply to all market participants. The Act provides for robust capital and initial margin requirements for derivative transactions that are not centrally cleared, providing a strong incentive to use central clearing and a bigger buffer should problems arise in the OTC markets.

At the same time as the Act reforms derivatives markets, it provides a new framework for regulation of financial market utilities and critical payment, clearing, and settlement activities, including not only those in the derivatives markets but also the wholesale funding “repo” markets that are critical to the shadow banking system. In the lead up to the financial crisis, major financial firms became increasingly funded not by traditional bank deposits, or even longer-term funding in the commercial markets, but rather by overnight funding in the repo markets. And these markets became increasingly concentrated in only two major clearing banks. As the market became more concentrated, it also became riskier because counterparties came to accept not only Treasury securities as collateral, but also highly rated asset-backed securities. And these securities, in turn, became riskier, as credit rating agencies became increasingly willing to label as safe assets that were lower quality—including pools of securities backed only by poorly underwritten subprime and Alt-A mortgages. When the financial crisis hit, the repo markets froze, causing a massive contraction in available credit.

The Dodd-Frank Act fundamentally reforms the wholesale funding markets by providing strong authority for the Federal Reserve to regulate financial market utilities and critical payment, clearing, and settlement activities; to set new rules for capital, collateral and margin requirements; and to establish uniform prudential standards across the market. These reforms are coupled with basic changes to liquidity requirements for major financial firms under the Basel III rules, liquidity concentration limits under the Act, and reforms to the deposit insurance system that will encompass all depository liabilities. These reforms will have the effect of taxing short-term liabilities and forcing firms to internalize more of the costs of this funding system. At the same time, SEC changes to regulations of money market mutual funds under Rule 2a-7 will mean that such funds have stronger liquidity positions.

The Act also fundamentally transforms regulation of the last major element of the shadow banking system—securitization. The Act requires deep transparency into the structure of securitizations, including information about the assets and originators. Securitization sponsors must generally retain risk in the securitizations they sponsor, so that incentives are better aligned among participants in the system. Capital rules will better account for actual risk. Parallel changes in accounting rules will now bring the most common forms of securitizations onto the balance sheet. Credit rating agencies will be subject to comprehensive oversight by the SEC, including policing of ratings shopping and conflicts of interest; ratings themselves will be more transparent—including key information on rating methodology, compliance with methodology, underlying qualitative and quantitative data, due diligence, and other protections.

Before Dodd-Frank, consumer protection regulation was fragmented over seven federal regulators, most of which chose to focus their energies in areas other than protecting consumers. Regulators lacked mission focus, market-wide coverage, and consolidated authority. Nonbanks could avoid federal supervision. Banks could choose the least restrictive consumer approach among several different banking agencies. Federal regulators preempted state consumer protections laws without adequately replacing these important safeguards. Fragmentation of rule writing, supervision and enforcement led to finger-pointing in place of effective action.

Today, the Consumer Financial Protection Bureau has market-wide coverage. The Bureau will focus on more effective regulation and supervision. The CFPB will set high and uniform standards across the market. It will focus on improving financial literacy for all Americans. And it will help to end profits based on misleading sales pitches and hidden traps; rather, banks and nonbanks can compete vigorously for consumers on the basis of price and quality.

Before Dodd-Frank, the government did not have the authority to unwind large, highly leveraged, and substantially interconnected financial firms that failed – such as Bear Stearns, Lehman Brothers, and AIG – without disrupting the broader financial system. Firms benefited from the perception that they were "too-big-to-fail." This presumption reduced market discipline and encouraged excessive risk-taking by firms. It provided an artificial incentive for large firms to grow. It created an unlevel playing field. And when the financial crisis hit, it left the government with the untenable choice between taxpayer-funded bailouts and financial collapse.

Today, major financial firms will now be subject to heightened prudential standards, including higher capital and liquidity requirements, stress tests, and “living wills.” Major financial firms will be required by these standards to internalize the costs that they impose on the system, which will give them incentives to shrink and reduce their complexity, leverage, and interconnections. And should such a firm fail, there will be a bigger capital buffer to absorb losses.

These measures will help to reduce risks in and among the largest financial institutions. In the event that such an institution fails, these actions will minimize the risk that any individual firm's failure will pose a danger to the stability of the financial system. But the crisis showed that the U.S. government simply did not have the tools to respond effectively when the failure of one or more major financial institution threatened financial stability.

That is why the Dodd-Frank Act permits the government, in limited circumstances, to resolve the largest and most interconnected financial companies consistent with the approach long taken for bank failures. This is the final step in addressing the problem of moral hazard. To make sure that we have the capacity – as we do now for banks and thrifts – to break apart or unwind major non-bank financial firms in an orderly fashion that limits collateral damage to the system. Under the orderly liquidation authority, the FDIC is provided with the tools to wind down a major financial firm on the brink of failure. Shareholders and other providers of regulatory capital to the firm will be forced to absorb any losses. Management will be terminated. Critical assets and liabilities of the firm can be transferred to a bridge institution. Liquidity can be obtained through Treasury borrowing that is automatically repaid from the assets of the failed firm, or, if necessary, from an ex post assessment on the largest financial firms—not taxpayers. In that manner, the resolution authority allows the government to wind down the firm without exposing the system to a sudden, disorderly failure that puts the financial sector as a whole at risk.

But we need to have some humility about the ability to predict every systemic failure of a major financial firm. And to be sure, the creation of a domestic resolution authority is not enough.

Resolution of a major firm will require international cooperation. That is why it is so critical that other nations implement resolution authorities, and participate in supervisory colleges.

It’s critical that the major financial capitals implement a derivatives framework that requires adequate capital and robust margining; that moves to central clearing and exchange trading; and that provides for full transparency.

On capital, in Basel III, minimum capital ratios are set at a level that will represent a significant increase in firms' requirements. These new requirements include the creation of a capital conservation buffer above the minimums, which if breached will restrict firms' ability to pay dividends or buy back stock. Basel is now at work on how to implement a capital surcharge for the largest, most interconnected financial firms. The Basel Committee is also examining how to use new contingent capital instruments—in which debt transforms into equity under specified circumstances—to further reinforce that firms must internalize the costs of their own failure.

Basel is also raising the quality of capital. The new capital requirements will focus on common equity, excluding other liabilities that did not act as a buffer to absorb losses in the crisis. There will be strict limits in the capital calculation on the aggregate contribution of investments in other financial institutions, mortgage servicing rights and deferred tax assets.

Moreover, Basel is increasing the capital required for trading positions, securitization and counterparty credit exposures in derivatives and secured lending transactions. For the first time, Basel III will also be introducing a new, internationally applied, leverage ratio requirement—and one that includes firms' off balance sheet commitments and exposures.

Furthermore, Basel III will be instituting explicit quantitative liquidity requirements for the first time, to ensure that financial firms are better prepared for liquidity strains.

This is enormous progress. The United States had an urgent obligation to fix the failures that threatened our financial system and helped trigger the worst global economic crisis since the Great Depression. The crisis caused a recession that has cost American families and American businesses dearly. The Dodd-Frank Act puts in place the key reforms that were necessary to establish a firm foundation for financial stability and economic growth in the decades ahead.

Authors

Michael Barr

Publication: Brookings Institution

Image Source: Â© Larry Downing / Reuters

Ending "Too Big To Fail"

Michael Barr — Tue, 14 Jun 2011 16:22:00 -0400

I. Introduction

Over two years ago, the United States and the global economy faced the worst economic crisis since the Great Depression. The crisis was rooted in years of unconstrained excess on Wall Street, and prolonged complacency in Washington and in major financial capitals around the world. The crisis made painfully clear what we should have always known--that finance cannot be left to regulate itself; that consumer markets permitted to profit on the basis of tricks and traps rather than to compete on the basis of price and quality will, ultimately, put us all at risk; that financial markets function best where there are clear rules, transparency and accountability; and that markets break down, sometimes catastrophically, where there are not.

For many years, a core strength of the U.S. financial system had been a regulatory structure that sought a careful balance between incentives for innovation and competition, on the one hand, and protections from abuse and excessive risk-taking, on the other. When that balance was properly struck, the U.S. financial system worked at its best. The American financial system often surpassed other major developed economies in innovation and productivity growth. It was generally good at directing investment towards the companies and industries where the returns would be the highest. Its regulatory checks and balances helped create a remarkably long period of relative economic stability which, in turn, gave rise to extraordinary national wealth. And it did so while providing investors and consumers with strong protections. It endured crises and recessions, including the costly bank and thrift failures of the late 1980s and early 1990s; these, however, did not threaten the foundations of the financial system.

In particular, the growth of the “shadow banking” system permitted financial institutions to engage in maturity transformation with too little transparency, capital, or oversight. The years leading up to the recent crisis saw the significant growth of large, short-funded, and substantially interconnected financial firms. Huge amounts of risk moved outside the more regulated parts of the banking system to where it was easier to increase leverage. Legal loopholes and regulatory gaps allowed large parts of the financial industry to operate without oversight, transparency, or restraint. Entities performing the same market functions as banks escaped meaningful regulation on the basis of their corporate form, and banks could move activities off balance sheet and outside the reach of more stringent regulation. Derivatives were traded in the shadows with insufficient capital to back the trades. “Repo” markets became riskier as collateral shifted from Treasuries to poorer quality asset-backed securities. The lack of transparency in securitization hid the growing wedge in incentives facing different players in the system and failed to require sufficient responsibility or risk retention from those who made loans, or packaged them into complex instruments to be sold to investors. Synthetic products multiplied risks in the securitization system. The financial sector, under the guise of innovation, piled ill-considered risk upon risk.

The major U.S. investment banks merged, failed, or sought a life-line from the Federal Reserve as newly converted bank holding companies. The federal government injected capital into major commercial banks shaken in the aftermath of the collapse of Lehman Brothers. The FDIC put in place guarantees across the entire banking system. The Federal Reserve pumped liquidity into the financial system to halt further economic collapse. A dangerous run on money market mutual funds was halted by guarantee and liquidity programs set up by Treasury and the Federal Reserve. Congress enacted a major stimulus plan to keep the economy from cratering.

Yet stabilizing the financial sector did not address the failures that led to the crisis. Further action was necessary to restore discipline to our financial markets, adequate protections to consumers and investors, and the market's long-term ability to generate economic growth for future generations of Americans. The test of whether a financial system works is whether it does a reasonable job of channeling savings to finance future innovation and growth. The test is whether it protects consumers and investors. And the test is also whether it can do so while supporting, not harming, the economy. In the lead up to 2008, our system failed that test.

II. Ending "Too Big to Fail" Through Enhanced Supervision, Higher Capital Levels, and Market Reforms

That is why comprehensive reform was essential. One year ago, President Obama signed into law the Dodd-Frank Act—the most sweeping reform of financial regulation since the New Deal. The Act provides for supervision of major firms based on what they do, rather than their corporate form. Shadow banking—through large, interconnected financial firms, OTC derivatives, “repo” funding markets, hedge funds, and securitization—is brought into the regulatory daylight. The largest financial firms will be required to build up their capital and liquidity buffers, constrain their relative size, and place restrictions on the riskiest financial activities. The Act comprehensively regulates derivatives markets with new rules for exchange trading, central clearing, transparency, anti-abuse provisions, and capital and margin requirements. The Act provides for data collection and transparency so that in no corner of the financial markets can risk build unnoticed. The Act creates an essential mechanism for the government to orderly liquidate failing financial firms without putting taxpayers at risk. The Act creates a new Consumer Financial Protection Bureau and provides for consumer and investor protections. In sum, the Act provides a strong foundation on which the U.S. must now carefully build a more stable and balanced regulatory system--a system that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in financial markets.

All bank holding companies will be supervised by the Fed, and the largest ones will be subject to heightened standards. The Office of Thrift Supervision has been abolished, and all Savings & Loan Holding Companies will be supervised by the Fed. Non-bank financial institutions designated by the Financial Stability Oversight Council will also be Fed-supervised. The voluntary investment bank holding company regime has ended.

Before Dodd-Frank, no regulator or supervisor had the legal authority or responsibility to look across the full sweep of the financial system and take action when there was a threat. Our financial markets have suffered for the lack of an effective system for monitoring and responding to systemic risks or threats to financial stability as they arise. Today the Financial Stability Oversight Council (FSOC) is accountable to identify threats to financial stability and to address them. The FSOC will have access to information across the financial services marketplace. A new Office of Financial Research is empowered to collect data from any financial firm, and to develop and enforce standardization for data collection.

Before Dodd-Frank, the OTC derivatives market--with a notional amount of $700 trillion at its peak--grew up in the shadows, with little oversight. Enormous risks built up in these markets – without effective constraints or any robust monitoring by regulators. Credit derivatives, which were supposed to diffuse risk, instead concentrated it. Synthetic securitization with embedded derivatives magnified failures in the real securitization market. Major financial firms used derivatives to increase their credit exposure to each other, rather than decrease it. We should never again face a situation – such as AIG’s $2 trillion derivatives portfolio – where the potential failure of a virtually unregulated, capital deficient major player in the derivatives market can impose devastating risks on the entire system. The opacity of this market meant that the government and market participants did not have enough information about the location of risk exposures in the system or the extent of the mutual interconnections among large firms. So, when the crisis began, regulators, financial firms, and investors had an insufficient understanding of the degree to which trouble at one firm spelled trouble for another. This lack of information magnified contagion as the crisis intensified, causing a damaging wave of margin increases, deleveraging, and credit market breakdowns. Lack of transparency, insufficient supervision, and inadequate capital left our financial system vulnerable to concentrations of risk, and to abuse.

III. Ending "Too Big to Fail" Through the Orderly Liquidation Authority

Before Dodd-Frank, the government did not have the authority to unwind large, highly leveraged, and substantially interconnected financial firms that failed – such as Bear Stearns, Lehman Brothers, and AIG – without disrupting the broader financial system. Firms benefited from the perception that they were "too-big-to-fail"-- a presumption that they would receive government assistance in the event of failure. Such a presumption reduced market discipline and encouraged excessive risk-taking by firms. It provided an artificial incentive for large firms to grow even larger. It created an unlevel playing field with smaller firms. And when the financial crisis hit, it left the government with the untenable choice between taxpayer-funded bailouts and financial collapse.

These measures will help to reduce risks in and among the largest financial institutions. In the event that such an institution fails, these actions will minimize the risk that any individual firm's failure will pose a danger to the stability of the financial system. Thus, bankruptcy proceedings will remain the dominant option for handling the failure of a non-bank financial institution.

The crisis, however, showed that the U.S. government simply did not have the tools to respond effectively when the failure of one or more major financial institution threatened financial stability. As Lehman's collapse showed quite starkly, there are times when the existing options under the Bankruptcy Code are simply not adequate to deal with the insolvency of large, complex and interconnected financial institutions in times of severe crisis.

That is why the Dodd-Frank Act permits the government, in limited circumstances, to resolve the largest and most interconnected financial companies outside of the traditional bankruptcy regime and consistent with the approach long taken for bank failures. This is the final step in addressing the problem of moral hazard. To make sure that we have the capacity – as we do now for banks and thrifts – to break apart or unwind major non-bank financial firms in an orderly fashion that limits collateral damage to the system. Under the orderly liquidation authority, the FDIC is provided with the tools to wind down a major financial firm on the brink of failure. Shareholders and other providers of regulatory capital to the firm will be forced to absorb any losses. Management of the firm culpable for its losses will be terminated. Critical assets and liabilities of the firm can be transferred to a bridge institution, while any remainder is left in the receivership estate. Any required funding for liquidity can be obtained through Treasury borrowing that is automatically repaid from the assets of the failed firm, or, if necessary, from an ex post assessment on the largest financial firms. In that manner, the resolution authority allows the government to impose losses on shareholders and creditors without exposing the system to a sudden, disorderly failure that puts the financial sector as a whole at risk.

The objectives of the resolution regime differ from those of the Bankruptcy Code. The purpose of the Bankruptcy Code is to reorganize or liquidate a failing firm "for the benefit of its creditors". The resolution authority is structured to manage the failure of a financial firm in a manner that protects taxpayers and the broader economy and promotes stability in the financial system. This purpose is explicitly different than the purposes of the Bankruptcy Code, but that is why the Act is narrowly tailored to situations in which there are exceptional threats to financial stability.

The Dodd-Frank approach is modeled on the long standing regime for bank failure. There are significant and tested safeguards in the Act modeled on the bank failure law to protect creditor rights. In addition, creditors in the resolution process are protected by the same system of judicial review that has existed for the FDIC (and its predecessors) for its receivership and conservatorship authorities for more than 75 years. The Act seeks to respect the Bankruptcy Code's fundamental principles of fairness and equity among similarly situated stakeholders. As is the case under the Bankruptcy Code's best-interests test and under the model in place for bank resolution, in the limited circumstances where the Act permits deviation from those principles, the Act expressly guarantees that stakeholders will be made no worse off by a regulator's use of resolution authority than would be the case in a liquidation under Chapter 7 of the Bankruptcy Code. The Act also maintains the right of an affected company to seek judicial review following the appointment of a receiver or conservator and a claimant's right to challenge a regulator's disallowance of its claim.

As with any new authority, the first and most central questions are: how would this work? How would it be different than what is possible today? What would happen if the U.S. government were once again faced with situations like those of September 2008?

Major financial institutions would have prepared a "living will" embodying a liquidation strategy and, in most cases, a supervisory recovery plan to map out contingencies for how the firm would respond to avoid failure during a period of severe financial distress or instability. Such firms would have larger capital buffers in the event of economic stress, and stringent conditions imposed on the use of "hot" money funding, including liquidity requirements over one month and one year time frames. Regulators would have the authority to supervise the firm for system-wide risks and to impose tough prudential measures. As a firm faced capital or liquidity problems, regulators would order early remediation. But we need to have some humility about the future and our ability to predict and prevent every systemic failure of a major financial firm.

In a severe crisis, if one or more major financial firms fail, and prudential measures, remedial action, and capital buffers prove inadequate, special resolution should be available. The Dodd-Frank Act builds in important safeguards for the use of such authority, including by requiring concurrence of the Treasury Secretary, two-thirds of the Board of the Federal Reserve, and two-thirds of the Board of the FDIC (or the Securities and Exchange Commission in the case of a broker-dealer). If the financial firm’s board does not consent, prompt judicial review is required.

A receivership under this authority would have three essential elements that would improve execution and outcomes relative to the tools that were available in the fall of 2008: First, the FDIC could swiftly replace the board and senior management with new managers. Second, a temporary stay of counterparty termination and netting rights, during which the FDIC could transfer qualified financial contracts to a third party or bridge institution without counterparty consent or court approval. Third, the ability to set up a bridge bank with secured financing from the FDIC to fund liquidity and capital needs, in order to mitigate the "knock on" effects of any firm's failure; to fund its operations, pending its sale or winding down; and to preserve the business franchise, and protect viable assets of stronger subsidiaries pending their sale. This would have the potential to end the firm – wind it down – without contributing to system-wide failure.

In sum, the nation would no longer have to make the untenable choice between taxpayer bailouts and market chaos. Instead, the Dodd-Frank reforms provide the FDIC with the authority to wind down any firm whose failure would pose substantial risks to our financial system, in a way that will protect the economy while ensuring that the failed firm, and if necessary other large financial firms – not taxpayers – bear any costs.

To be sure, the creation of a domestic resolution authority is not enough. Large financial institutions operate globally. Resolution of a major firm will require international cooperation among regulators participating in existing supervisory colleges which monitor the largest financial firms.. That is why it is so critical that other nations develop and implement special resolution regimes with similar tools and authorities, which is the essential first step to being able to resolve such global firms.

IV. Ending "Too Big to Fail" through International Reforms

While the United States is implementing the Dodd-Frank Act, it is critical that global reforms proceed as well. In particular, the United States should continue to press for progress on raising the quality and quantity of capital; reducing the moral hazard of systemically important financial institutions; and imposing new rules for capital, margin, exchange trading, central clearing, transparency and oversight of the OTC derivatives market.

Much progress has been made through the Basel Committee on Banking Supervision to raise global capital standards. In Basel III, minimum capital ratios are set at a level that will represent a significant increase in firms' requirements. These new requirements include the creation of a capital conservation buffer above the minimums, which if breached will restrict firms' ability to pay dividends or buy back stock. Such restrictions will help shore up a firm's capital base before it reaches a point of no return. Basel is now at work on how to implement a capital surcharge for the largest, most interconnected financial firms. The Basel Committee is also examining how to use new contingent capital instruments—in which debt transforms into equity under specified circumstances—to force firms to internalize the costs of their own failure.

Not only is Basel raising the ratios, but just as importantly, it is also raising the quality of capital that underlie them. The new capital requirements will focus on common equity, excluding other liabilities that did not act as a buffer to absorb losses in the crisis. There will be strict limits in the capital calculation on counting minority interests, as well as on the aggregate contribution of investments in other financial institutions, mortgage servicing rights and deferred tax assets.

Moreover, Basel is increasing the capital required for banks' riskiest activities, such as trading positions and counterparty credit exposures. Capital calculations for trading exposures will be based on stressed market conditions, and the charges for securitization exposures will be increased substantially. In both derivatives and secured lending transactions, firms will be subject to a capital charge for deterioration in the credit worthiness of counterparties. For the first time, Basel III will also be introducing a new, internationally applied, leverage ratio requirement that includes firms' off balance sheet commitments and exposures.

Furthermore, Basel III will be instituting explicit quantitative liquidity requirements for the first time, to ensure that financial firms are better prepared for liquidity strains. Under the new rules, firms will have to hold enough highly liquid assets to meet potential net cash outflows over a 30 day stress scenario. Basel will also require a minimum amount of stable funding over a one year time period, relative to a firm's assets, commitments and obligations. These liquidity requirements will be crucial in helping to mitigate severe strains like those that we saw on the financial sector at the time of the collapse of Bear Stearns and Lehman Brothers during 2008.

In addition, countries must implement the resolution recommendations agreed by G-20 Leaders, which are a necessary prerequisite for effective cross-border resolution of systemically important financial institutions. While many in Europe are focused on using contingent capital as a means to improve resolution, these efforts are not enough. Contingent capital will not be sufficient on its own to permit the resolution of a major financial firm without wide-scale harm to the markets, and must not be used as an excuse to avoid legislating strong resolution regimes internationally.

Both our financial system and this crisis have been global in scope. So solutions have been and must continue to be global. The U.S. has not waited for the international community to act before building a new foundation in the Dodd-Frank Act, and there must not be an international race to the bottom on regulatory standards.

V. Conclusion

The United States had an urgent obligation to fix the failures that threatened our financial system and helped trigger the worst global economic crisis since the Great Depression, and a recession that has cost American families and American businesses so dearly. The Dodd-Frank Act puts in place the key reforms that were necessary to end the perception of “too big to fail,” and to establish a firm foundation for financial stability and economic growth in the decades ahead.

Authors

Michael Barr

Publication: Subcommittee on Financial Institutions and Consumer Credit, Committee on Financial Services, United States House of Representatives

The Federal Government Going Into Default Is Unthinkable

Michael Barr — Fri, 06 May 2011 00:00:00 -0400

Ever since founding father Alexander Hamilton “touched the dead corpse of the Public Credit, and it sprung upon its feet”—in the words of Daniel Webster—the good name of the United States in global financial markets has not been impugned. Indeed, after the Civil War, the Constitution itself stated in the Fourteenth Amendment that the “validity of the public debt of the United States … shall not be questioned.”

But we have an unfortunate chance to change all that if Congress calls into question its willingness to authorize the Treasury to pay the bills of the United States by raising the so-called “debt ceiling.” Congress must periodically pass a law that permits the U.S. Department of the Treasury to pay what the United States already owes for the goods and services that Congress has already required the federal government to purchase.

Requiring a separate vote on whether the United States should continue to pay on its obligations makes no sense. If such a vote is required, it would be a serious mistake to vote anything other than yes, and yes right away. That’s why President Obama, Treasury Secretary Tim Geithner, and many in the Republican and Democratic leadership in both the Senate and the House of Representatives have made clear that the debt ceiling must be approved.

That hasn’t stopped a large block of elected officials, including those from the self-anointed “Tea Party,” from arguing that approval of the debt ceiling should be held hostage to new decisions about federal spending, or even social issues.

But even if Congress can decide—which it should—on a path to bringing down the federal debt, there are no circumstances under which the United States should refuse to pay for the debt it has already incurred. And any decisions that Congress makes about reducing the federal budget deficit would have no effect on the amount that Congress needs to authorize the Treasury to pay on the obligations that are already owed and due.

This vote must occur this spring. Treasury will run out of funds to pay the bills by the middle of May, and even extraordinary actions will only provide a short reprieve of two months’ time. Forcing Treasury to fiddle with the books to avoid default is itself horrible for the reputation and creditworthiness of the United States. And it runs the risk of increasing the cost of credit for everyone, choking off the strengthening economic recovery.

Actually defaulting would be unthinkable. The U.S. dollar is the world’s reserve currency. We benefit mightily by the desire of the rest of the world to hold our debt and transact in dollars. When doubt lingers globally, surety is found in the United States. All that would change with default.

Rates for borrowing would soar. Business credit would dry up. Homeowners and home buyers would not get finance. House prices would plummet.

Banks and other financial institutions holding U.S. Treasury bonds here in the United States and abroad would face gaping holes in their balance sheets as their securities were marked down. The “Repo” market and other funding markets critical to commercial businesses, banks and money market mutual funds would stop. We would see a wave of bank failures, business failures, runs on banks and money market mutual funds, and contagion far worse than the financial crisis we are finally pulling through.

States and municipalities would likely face massive runs and would be unable to borrow.

And the integrity of the United States, once impugned, could never be restored.

To even write or read these things is to know that Congress must and it will authorize Treasury to meet our mutual obligations. And knowing that, we need to come together now, as a nation, to avoid partisan rancor, empty threats, and misguided attempts to link a vote on paying our bills to decisions about anything else.

After all, we are still the United States of America, and our word is still our bond.

Authors

Michael Barr

Publication: CNBC

Michael Barr, Leading Expert on Financial Institutions and Regulation, Joins Brookings as Nonresident Senior Fellow

Tue, 15 Mar 2011 13:41:00 -0400

Michael S. Barr, professor of law at the University of Michigan Law School, has joined Brookings as a nonresident senior fellow, Brookings President Strobe Talbott announced today.

Barr served as the U.S. Department of the Treasury's assistant secretary for financial institutions from 2009-2010, where he was a key architect of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act and played a central role in the Obama administration's housing finance policies. Barr was previously a nonresident senior fellow at Brookings, affiliated with the Metropolitan Policy Program.

"We are delighted to have Michael rejoin Brookings," said Karen Dynan, vice president and co-director of Economic Studies. "His expertise on financial institutions and regulatory reform, together with his experience as a policymaker during the financial crisis, will bring a lot to the Economic Studies program. We look forward to collaborating with him."

At Michigan, Barr teaches financial institutions and international financial regulation, among other courses. He conducts large-scale empirical research on financial services and writes about a wide range of issues in financial regulation. Recent books include Insufficient Funds and Building Inclusive Financial Systems (Brookings, 2007).

Barr previously served as Treasury Secretary Robert E. Rubin's special assistant, as deputy assistant secretary of the Treasury, as special advisor to President William J. Clinton, as special advisor and counselor on the Policy Planning Staff at the State Department, and as a law clerk to U.S. Supreme Court Justice David H. Souter and to Judge Pierre N. Leval of the Southern District of New York.

Barr received his J.D. from Yale Law School, an M. Phil. in International Relations from Magdalen College, Oxford University, as a Rhodes Scholar, and his B.A., summa cum laude, with Honors in History, from Yale University.

An Opt-Out Home Mortgage System

Eldar Shafir, Michael Barr and Sendhil Mullainathan — Tue, 23 Sep 2008 12:00:00 -0400

Abstract

The current housing and financial crisis has led to significant congressional and executive action to manage the crisis and stem the harms from it, but the fundamental problems that caused the crisis remain largely unaddressed. The central features of the industrial organization of the mortgage market with its misaligned incentives, and the core psychological and behavioral phenomena that drive household financial decisionmaking remain. While the causes of the mortgage meltdown are myriad and the solutions likely to be multifaceted, a central problem that led to the crisis was that brokers and lenders offered loans that looked much less expensive and much less risky than they really were—and borrowers took them. It is time for common-sense reform to the mortgage market. This paper develops a new framework for understanding the mortgage markets as the interaction between individuals with specific psychological biases and firms that respond to those psychologies within specific markets. We argue that regulation needs to take account of that interaction. Our new framework leads us to propose a sticky opt-out mortgage system, under which lenders would be required to offer borrowers loans with standard terms. Borrowers could opt out for other loans, but only after heightened disclosure requirements, and lenders would face increased exposure to liability or other sanctions.

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Eldar Shafir
Michael Barr
Sendhil Mullainathan

Publication: Hamilton Project Discussion Paper

Credit Where It Counts: Maintaining a Strong Community Reinvestment Act

Michael S. Barr — Sun, 01 May 2005 00:00:00 -0400

The Community Reinvestment Act (CRA) has helped to revitalize low- and moderate-income communities and provided expanded opportunities for low- and moderate-income households. Recent regulatory steps aimed at alleviating burdens on banks and thrifts are unwarranted, and may diminish small business lending as well as community development investments and services. This policy brief explains the rationale for CRA, demonstrates its effectiveness, and argues that the recent regulatory proposals should be withdrawn or significantly modified.

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Michael S. Barr

Banking the Poor: Policies to Bring Low-Income Americans Into the Financial Mainstream

Michael S. Barr — Fri, 01 Oct 2004 00:00:00 -0400

Low-income households in the United States often lack access to bank accounts and face high costs for conducting basic financial transactions through check cashers and other alternative financial service providers. These families find it more difficult to save and plan financially for the future. Living paycheck to paycheck leaves them vulnerable to medical or job emergencies that may endanger their financial stability, and lack of longer-term savings undermines their ability to improve skills, purchase a home, or send their children to college.

High-cost financial services and inadequate access to bank accounts may undermine widelyshared societal goals of reducing poverty, moving families from welfare to work, and rewarding work through incentives such as the Earned Income Tax Credit. This paper calls for the transformation of financial services for the poor. Better access to financial services is critical for low-income persons seeking to enter the economic mainstream.

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Michael S. Barr