Exemptions and Arbitrage

A central property of financial capitalism is that price discrepancies will be exploited for profit. This is called arbitrage. It’s an old concept but one that several of our elected representatives seem not to understand. If we create loopholes and exemptions in our regulatory framework, they will be exploited and the speculation and problematic practices lending to systemic instability of our financial system and a tremendous amount of inequity and predation will continue.

Several loopholes in our proposed financial regulation bills need to be addressed. Some may make it into Dodd’s proposal out of the Senate Banking Committee draft and some only Europeans seems to understand.

Let’s start chronologically.

First, there were the automobile dealers who were exempted from the House Financial Service Committee’s proposal to regulate lenders. There was no compelling reason to do so except a strong automobile industry lobby.

Then, the airlines and “users for commercial purposes” were exempted from rules on derivatives. The reason for the exemption was key, however, specific acceptable practices should be written into rules under which all activity is governed, but whole entities should not be exempt from regulation. In this case, hedging should be allowed but must be monitored transparently by an effective regulator.

In the House version of the bill, banks with less than $10 billion of assets and credit unions with less than $1.5 billion of assets would be exempt from regulation by the Consumer Financial Protection Agency (CFPA). Again, while there are good reasons to have lenience on community banks and credit unions that did not practice predation or contribute to systemic financial instability, the problem is that, going forward, new institutions will be created to fall into this category and will become a breeding grounds for pernicious activity. Again the activity should be the focus of the regulation, not the categorization of the entity that may or may not be engaging in it.

In the Senate version of the bill, a particular point of contention was the exemption of payday lenders, rent-to-own companies and companies processing remittance transactions from regulation. This was championed by Corker while Schumer was particularly vocal against it. However, it’s unclear if Dodd’s cowboy version drafted without bipartisan consensus will retain this provision. See the latest on this exemption here.

It is also probable that in this version the Fed will retain supervision over banks with more than $100 billion in assets as a systemic risk regulator. While consumer and investor advocacy groups have been pushing back on the Fed controlling systemic risk regulation to begin with, it is also clear that not only large firms are systemically significant as evidenced by the Savings and Loan crisis in which a number of small institutions failed simultaneously.

However, while our elected officials may not understand the importance of comprehensive coverage of the regulatory umbrella, or they have been swayed by lobbyists and campaign contributors to pretend they don’t understand, it appears Geithner is quite clear on it. And instead of fighting for full inclusion of all parts of the financial system under a regulatory umbrella, he is pushing for the opposite. He stressed in his missive to the European Commission on March 1st that US entities should be exempt from rules being drafted regulating private equity, hedge funds and alternative investment funds, entailing rules on remuneration, limits on borrowing, the disclosure of sensitive information and regulation of depository institutions. Clearly, what Treasury has outlined and expected to turn into legislation will be less robust than proposals coming from Europe including calls to ban all naked credit default swaps if not banning them outright altogether. Thus, we are pursuing international loopholes for our underregulated entities as well. This is problematic for diplomatic relations but also is bad PR for Treasury's view of our draft bills. It appears we know we are winning the race-to-bottom and we are willing to defend that internationally.

This strategy to capture market share via exemptions leaves open a playground for profitable, speculative, however unproductive, risk-taking activity to occur. You can bet that if these entities are not covered by strong regulators now including an independent CFPA, they will be the subprime mortgage brokers and asset-backed securities structurers of tomorrow.

Let's keep up the fight till the bitter end. More here.

Views expressed on this page are those of the authors and not necessarily those of Campaign for America's Future or Institute for America's Future