President Barack Obama signaled an abrupt shift in his financial regulatory reform efforts last week, endorsing new rules proposed by former Fed Chair Paul Volcker to restrict both the size and scope of bank activities.
The decision prompted breathless commentary: Was this a populist tack in response to Democratic political setbacks in Virginia, New Jersey, and Massachusetts? Was this a sign that the president's moderate economic advisers, Treasury Secretary Tim Geithner and Director of the National Economic Council Larry Summers, were losing influence after steady criticism of their financial policies from both the left and the right? Get beyond the Washington speculation, though, and the real story is that Obama himself is setting the tone of regulatory reform in response to political and policy considerations that have played out behind the scenes over months.
The process began last June, when Treasury released a white paper outlining the administration's regulatory-reform agenda. While it addressed nearly every issue in the financial crisis, it was also written with an eye toward Congress and thus was not as aggressive in restructuring existing banks as some critics desired. It did mention the need for regulators to restrain banks from participating businesses that increased the risk of the overall financial system.
Over the summer, Treasury officials worked closely with the staff of House Financial Services Committee Chair Barney Frank to craft a bill, focusing on the creation of a Consumer Financial Protection Agency (CFPA). The CFPA was a cornerstone of reform, designed to protect consumers from unfair and fraudulent lending, especially the sub-prime loans that were at the heart of the financial crisis.
"We had to get votes on a wide variety of issues," says Frank's spokesperson Steve Adamske. "The centerpiece of the president's plan was the CFPA; that took a lot of capital for us to do. We had to do financial regulation entirely on the backs of the Democrats -- there were no Republican votes for us. We had 29 votes against us on everything."
As the House bill developed in committee, measures were designed to consolidate regulators, regulate derivatives, stiffen capital and leverage requirements, install authorities to shut down firms that present systemic risk and otherwise plug the holes in the financial regulatory regime that became apparent during the 2008 crisis. At the same time, banks took advantage of government support programs and aggressive trading strategies to make record amounts of money and pad their year-end bonuses.
At the same time, Volcker, the former Fed chair who chairs the president's Economic Recovery Advisory Board (PERAB), had been acting as a policy entrepreneur, traveling to promote his argument that commercial banks shouldn't be allowed to engage in "proprietary trading" -- speculating with their own capital -- or to invest in hedge or private-equity funds, which potentially puts their customer's money, which is guaranteed by taxpayers, and the financial system at risk.
Rep. Paul Kanjorski of Pennsylvania agreed not enough was being done to limit the types of risks that banks could take and was receptive to Volcker's critique. He authored an amendment that would allow regulators to order any financial firm out of a certain line of business if it proved a risk to the system; for instance, American International Group could have been ordered to divest its risky Financial Products division. While the authorities in his amendment were powerful, they were to be used only at the discretion of regulators and recent history tends to support the idea that regulators rarely use their authorities with any consistency. (The Federal Reserve, for instance, had authority to regulate sub-prime mortgage lending that it never invoked despite many warnings about the market.)
Nonetheless, Kanjorski's amendment was controversial. It passed despite complete opposition from Republicans and some moderate Democratic defections; a similar amendment to limit the size of the banks from Reps. Brad Miller and Ed Perlmutter also passed. Both were supported by the administration; Geithner endorsed the amendments while testifying before the committee.
"[Geithner] indicated an open endorsement, but not many people picked it up," Kanjorski says. "I think most people felt that this is an idea that's going to die, it's got to go through the House, the Senate, the White House."
As the political climate worsened for Democrats, the White House political operation worried that continuing unemployment combined with the success the banks had trading with cheap money from the government presented an unsettling contrast, especially with lending still down. At the same time, policy advisers became increasingly concerned about the levels of risk on Wall Street, symbolized by the huge bonus pools. Volcker's proposal became more attractive -- while the behaviors he proposed limiting were not at the center of the crisis, they represented a smart way to push the banking system toward more socially responsible practices.
At this point, a White House official says, the president began taking a personal interest in the matter, asking his economic team in October to look for new ways to limit risk. Geithner, Summers, and Volcker began a series of meetings to figure out how to adapt Volcker's idea to the modern financial economy as a modernized Glass-Steagall, the New Deal-era law that separated commercial and investment banks.
In December, Obama, reacting to both Volcker's policy critique and bank risk-taking, specifically asked his team to build on the Kanjorski amendment by creating a mandatory regulation rather than a firm-by-firm approach, according to a White House official. After two more meetings, including a long private lunch between Volcker and the Treasury Secretary on Christmas Eve, Geithner and Summers produced a memo endorsing the new approach and delivered it to the president in early January, a week prior to a Republican victory in a Massachusetts special election that served as a political wake-up call to the White House.
"It's quite an accomplishment for the president to pick up [this idea] into the red zone, a football analogy. We just made up 30 yards," Kanjorski told me. "Some people are of the opinion that it may be an afterthought; I just don't think it is. I anticipated that they would either at some point endorse it or the president would endorse it.
The administration's new proposals are not, in the words of a Treasury official, "what most Americans would consider breaking up the banks," though the policies will force divestitures and changes in business; limits in bank size announced at the same time should constrain future bank consolidation. Combined with the higher capital requirements, the recently announced TARP tax on banks, and the liquidation insurance fund included in the House bill to cover the costs of shutting down a failing bank, though, it's hard to imagine banks would not become smaller under the regulatory overhaul.
Nonetheless, the decision to endorse Volcker's rule, while not sudden, does represent a shift in the administration's posture, one that Geithner and Summers were not immediately comfortable with. They were concerned that Volcker's proposal didn't solve the problems of 2008; however Obama and Volcker successfully argued that future sources of risk needed attention as well. But reports that the two Clinton veterans are being marginalized are exaggerated.
"If the president sets a policy and this is what the White House wants, you dance with the one who brung ya," says one congressional aide who works on financial reform. "[Geithner] didn't seem to sway in any way from the president's line, and it didn't matter."
Treasury officials say Geithner's influence hasn't waned, emphasizing that just the week before Geithner appeared with Obama to announce a new levy on banks intended to recover TARP losses. They also note that Volcker agrees with Geithner on the bulk of the broader regulatory reform agenda, and that Treasury is taking the lead on working with Congress to write the new laws.
The idea that Volcker was sidelined prior to the announcement also seem over-simplified; the former Fed Chair met repeatedly with Geithner, talks regularly to his friend Jeff Goldstein, who serves as the de facto undersecretary for domestic finance until he can be confirmed, and Austan Goolsbee, the White House economic adviser who works on both PERAB and the Council of Economic Advisers; his critiques clearly reached the president's ear.
Perhaps the most notable thing about the episode is President Obama's decision to take a leading role in regulatory reform. While Obama played a significant personal role in pushing the CFPA last spring, health care and other issues distracted him as the House put together and passed its bill during the remainder of the year. While the balance between his policy concerns and the political benefits Democrats expect to reap from going after the banks remains unclear, Obama's decision to push Volcker's ideas into the mix demonstrate his willingness to hear criticism and take charge of economic policy.
"The president has stepped into this thing in a way that last year was not as apparent, so that's hugely helpful," a Treasury official told me. "We feel like we have the wind at our backs."
