Robert Johnson testifies before Senate Agricultural Committee, reveals 4 major flaws in financial sector

Thursday, 11/19/2009 - 11:18 am by Lynn Parramore | Post a Comment

Robert Johnson, Director of Financial Reform at the Roosevelt Institute, testified before the Senate Agricultural Committee yesterday on what he sees as dangerous flaws in the financial sector during the committee’s hearing on regulatory reform. Below is his oral testimony, along with a link to the full written text. As you may recall from these pages, Johnson presented hard-hitting testimony on the derivatives bill before the House Financial Services on Oct. 7, which was cut off after 5 minutes. The subsequent kerfuffle over our attempts to get his written testimony published on the House website was reported by Ken Silverstein of Harper’s.

“Chairman Lincoln, Ranking Member Chambliss, and Members of the Committee, thank you for inviting me to testify before you today.

The American people clearly sense that there is something deeply flawed in the current structure of our financial markets. The financial sector’s calamity has spilled over and done great harm to the lives of many Americans and people throughout the world.

When they are properly designed, financial markets play a fundamental role in the resource allocation for our society. Financial markets serve to aggregate savings and allocate them to productive use and to transfer risk to entities that bear it most comfortably. The system we had in place in recent years, and the one that is still in place as we meet today, has revealed itself to be profoundly flawed.

Efforts to repair these market structures in light of the crisis should address and seek to rectify 4 core problems:

1) Excessive leverage
2) Opacity and complexity rather than transparency and simplicity
3) The ability to buy insurance without an insurable risk
4) A misalignment of incentives where the private incentive to take risk exceeds the social desire to bear risk.

Certain types of derivative structures have contributed to all of these problems. It is time for a thorough redesign of these market systems to fortify the real potential of derivative instruments and repair the obvious flaws in structure have caused so much harm.

I must admit that I am very surprised by the intense focus on “End Users” of derivative instruments. They are at present, by their own claims, a relatively small part of the market. That focus does appear to me to have substantially misdirected energy away from the essential task of financial reform before the United States Congress that centers on the the regulation of the large financial institutions who threaten our economic system. This diversion to focus on end users is not independent of that quest and is a dangerous exercise for at least two reasons.

First , efforts to legislate what types of institutions are exempt from the restrictions of healthy market practice runs the risk of creating loopholes large enough to fly a jet aircraft through. End user exemptions that are drawn too broadly would allow anyone and everyone to claim them, especially the large and too big to fail financial institutions that stand next to the public treasury and are the dominant actors in the opaque OTC market. That would directly undermine the need to bring these markets out of the dark. It would enable the largest market participants to remain in the shadows where they earn extraordinary profits but put society and the public treasury in peril.

In addition, end user exemptions may inadvertently spawn large speculative organizations or divisions of those organizations. The incentive to create Enron-like entities is the risk implicit in creating legislative that confers special advantage for certain types of market participants.

The second danger is that the exemption of certain classes of financial products such as foreign exchange forwards and swaps, or any products that are traded on foreign platforms, will surely serve to drive more activity offshore, perhaps to locations where the underpinning market structures are themselves unsound.

Foreign exemptions will also likely divert creative energy into the creation of complex “foreign exchange”-based products to qualify for that exemption and thereby avoid the scrutiny and structures complex products do require for systemic safety.

There has been a great deal of recent testimony that goes to some length to justify end user exemptions. This body of testimony tries to illuminate the consequences for end users of requiring them to trade upon exchanges or submit their transactions to clearinghouses.

While I do agree that some increase in cost will be borne by these end user institutions if the current market structures are replaced by more robust and healthy market structures, I believe the magnitudes of the costs they report they would incur pale in comparison to costs that this crisis has inflicted on society, and even on their own firms.

I do agree that end users were not the primary cause of the recent crisis and that they are not deserving of any particularl punishment. Yet punishment is different than adjustment to the removal of an unhealthy subsidy. I do not believe that their arguments should dissuade you from undertaking substantial financial reform, even reform that impacts their practices.

First of all, as economists are fond of saying, there is no free lunch. Efforts to hedge market exposures by commercial users are primarily a transfer of risk, rather than a diminution of the underlying risk. An oil hedger is not reducing the volatility of oil prices, but merely transferring that risk to another party who will bear that oil price volatility risk for a price.

When market structures are weak and unsound, they under-price that insurance and encourage the overuse of insurance. In the case of the OTC derivatives markets that are largely run by the handful of TBTF banks, the insurance offered to end users is often under-priced because the risk is in part borne by the public/taxpayers who underpin the safety net that backstops those banks.

Removing that back room subsidy and the excessive use it inspires, something often called moral hazard, would lead to an increase in the cost of providing risk transfer insurance.

Removing the subsidy would lead to a diminished profits for end users, and less use of insurance, and some more costs for the consumers of those services end users provide. Where I differ from many of the end user’s claims is that I believe that this would be a good thing for the nation and the economy as a whole. Removing subsidies to the buyers of insurance does not make the world a more dangerous place. It merely redistributes who bears that risk away from those who had provided the subsidy.

The American private sector, be it end users of financial products or financial institutions, does not need to clamor for subsidies from the taxpayer in order to thrive. That type of rent-seeking behavior is demoralizing for society and it is unproductive. It weakens the economy in the long run.

Furthermore, government willingness to abide efforts to extract subsidies from the public fisc actually weaken the companies who receive them. The dependency on government subsidy allows the private sectors creative powers to atrophy.

We would all do much better in the long term if they were shown tough love, were refused state welfare and forced to focus on new product development and innovations in the marketplace that would create a stronger more profitable productive future for the business sector and our nation.

Reforming the financial structure of the U.S marketplace is essential to restore confidence in the United States. Transparent market structures, proper capitalization, regulation and restoration of market discipline to our largest financial institutions are the essential ingredients needed to restore that confidence.

Those reforms are a public good that nourishes us all. The transition from subsidy based commerce to a proper realignment of incentives for the use of financial instruments is a painful but healthy transition.

If done properly it will also greatly diminish the possibility that future financial bailouts will reemerge and crowd out the use of our public finances for much needed infrastructure, education spending and healthcare that make our society stronger and our lives more secure.

I will submit the balance of my remarks for the record.”

Click here to read Robert Johnson’s written testimony .