Regulating the Financial System to Encourage the Financing of Innovation (as opposed to innovation in finance)

1. Regulating the Financial System to Encourage the Financing of Innovation(as opposed to innovation in finance) Presentation of Damon A. Silvers Policy Director, AFL-CIO To the Conference on Financial Institutions for Innovation and Development Rio de Janeiro, June 27, 2013

2. The True Cost of the Financial Bubble and Its Aftermath to the United States, not just measured in losses, though those were huge: http://www.zerohedge.com/article/bank-england-estimates-global-output-losses-financial-meltdown-200-trillion Excerpted from Andrew G Haldane, Executive Director, Financial Stability, Bank of England, The $100 Billion Question (March 2010)

3. Source: Peter Coy, American Families Are Poorer Than in 1989, Bloomberg (June 12, 2012), http://www.businessweek.com/articles/2012-06-12/american-families-are-poorer-than-in-1989; Felix Salmon, Chart of the day: Median net worth, 1962-2010, Reuters (June 12, 2012), http://blogs.reuters.com/felix-salmon/2012/06/12/chart-of-the-day-median-net-worth-1962-2010/

4. The cost of the financial bubble also includes the effects of the failure to productively invest capital, including the decline of government investment in research and development. Source: Center for American Progress and Global Climate Network, Low-carbon Innovation: A Uniquely American Strategy for Industrial Renewal

5. Between 1999 and 2008, U.S. domestic expenditures on R&D—led by private sector investment—remained almost unchanged as a percentage of GDP, while many countries saw significant increases in R&D investment as percentage of GDP. Source: OECD, http://www.oecd-ilibrary.org/sites/sti_scoreboard-2011-en/02/05/index.html?contentType=&itemId=/content/chapter/sti_scoreboard-2011-16-en&containerItemId=/content/serial/20725345&accessItemIds=/content/book/sti_scoreboard-2011-en&mimeType=text/html

6. While it is difficult to measure the implications of underinvestment, there are three areas critical to U.S. competitiveness and global environmental stability in which the underinvestment is obvious: • Clean technology • Infrastructure • Information and communications technology • And perhaps most importantly, a political economy that undermined the foundations of the “entrepreneurial state.”

7. Clean Technology: The U.S. remains one of the world’s largest per capita producers of CO2 • Recent reductions due to recession’s impact on economic activity overall and development of cheap natural gas—not at all clear they can lead to reductions necessary for US to meet UN targets

8. Green Technology • 2004-2008, when the U.S. financial markets were rapidly innovating new financial products, was the key period of investment for other advanced economies in clean technology.

9. Infrastructure: • US has significantly reduced the level of public investment in key transportation infrastructure, as illustrated by this graph of U.S. government spending on highways as a percentage of GDP.

10. Infrastructure: • The American Society of Civil Engineers recently measured the size of the US infrastructure deficit: Source: American Society of Civil Engineers, http://www.infrastructurereportcard.org/a/#p/grade-sheet/gpa • Similarly, for US to meet 21st century low carbon fuel standards, an additional $150-250 billion of research and development is necessary according to some researchers.

11. Information and Communication Technology: • As was the case with telephones and electricity in the early 20th century, the US jumped ahead with internet and cell phone access during the years of the tech bubble. • But as broadband technology raced ahead in the 2000’s, the US fell behind other advanced nations in terms of the extent of broadband access. • This is not an innovation problem—rather a public good problem of the type that underlies innovation.

12. These Developments Resulted from Two Problems with US Financial System Regulation: • Imbalance between private and public finance—i.e. public policy founded on idea that there really is no such thing as a public good. • Idea that capital markets are more efficient if less structurally regulated—i.e. if capital can flow freely from commercial banking to insurance to public debt and equity markets, both within larger markets and within financial firms. • Both these ideas led inevitably to vast private gains based on both direct and indirect subsidies and the socialization of losses—e.g. TARP and the Chicago Parking Meter fiasco.

13. Source: Mark Hirscheya, HillaSkibab and M. BabajideWintokia, The Size, Concentration and Evolution of Corporate R&D Spending in U.S. Firms from 1976 to 2010: Evidence and Implications (January 2012)

14. Impact of Deregulation on the Behavior of Financial Institutions toward Innovation: • In the post-war era of regulated, siloed financial institutions, innovation was funded in part by the federal government through defense and aerospace spending, much of which was routed through universities at least in part, and in part by large, integrated private firms that depended on retained earnings, bank financing, and investment grade bond issues for financing. • In this system, neither banks nor capital markets funded innovation project by project—they funded integrated firms that allocated resources to research and development and process innovations within their larger business strategy. • The rise of the shareholder primacy model and the availability of capital through the high yield debt markets destabilized the large integrated operating firms. • Facing competition from public markets, including both high yield and commercial paper markets, bank commercial credit margins shrank, just as banks themselves became subject to shareholder demands and CEO demands for higher rates of return than banks had historically provided.

15. In this environment, banks moved into a variety of higher margin businesses—residential mortgage origination and securitization, unregulated insurance brokerage (derivatives), and proprietary trading. Source: Michael Chui, Derivatives markets, products and participants: an overview, IFC Bulletin No 35 (February 2012), http://www.bis.org/ifc/publ/ifcb35.htm

16. Ultimately, the result was the transformation of banks from their previous status as regulated utilities into high risk, high return institutions. • This destabilized the basic credit intermediation function. • And, as it turned out the new universal bank holding companies could not execute their business plans and remain solvent through the business cycle without explicit central bank and government support.

17. What Replaced Banks as Sources of Finance for Innovation? • Venture capital funds and leveraged buyout, or private equity, firms have been the main capital market innovations that have provided financing to operating companies in the place of the now diminished commercial credit departments of banks. Source: PricewaterhouseCoopers National Venture Capital Association, MoneyTreeTMReport

18. What are the implications of changing sources of innovation finance? • This change is not just about the substitution of private equity partnerships for banks, this shift means fundamental change in the role of operating firms in the process of innovation. • Venture capital invests in single idea startups and the venture fund itself is a portfolio of ideas loosely connected if at all. The venture fund itself is a portfolio of ideas, loosely connected if at all. • Leveraged buyout funds may be interested in better management of operating firms, they are almost never interested in innovation in their portfolio companies—too risky for the highly leveraged business model they are pursuing. • Venture funds and leveraged buyout funds are the beneficiaries of large public subsidies in the form of very large tax benefits.

19. The Political Economy of Deregulated Finance and the Shortfall in Public Goods • Deregulated finance led to large buildups in wealth among the managers of financial assets, both at a personal level on the part of the managers of private capital, and at an institutional level on an even larger scale by the managers and board of the now dominant universal banks.

20. This wealth, translated into political power, seeks to do two things—to keep the taxman from the door and to open up new opportunities for high fee money management on favorable terms. • The combination of these two agendas, which are the natural consequences of the rise of the winners in the game of financialization, operate together to lead to underinvestment in public goods of all kinds, including infrastructure and the foundations of innovation • Ten-year budget costs of tax breaks for financial activities: Tax loophole for derivatives traders- $3 billion; carried-interest loophole for investment fund managers- $17-21 billion; preferential treatment of capital gains and dividends for top 2 percent of earners- $500 billion. (Americans for Tax Fairness) Source: Americans for Tax Fairness, http://www.americansfortaxfairness.org/

21. The Paradox of Bubbles and Innovation • Financial bubbles have been associated with investment in innovation beyond that which investors acting in a rational climate might have done—railroads in the late 19th century, automobiles and aviation in the 1920’s, the nifty 50 in the 1960’s, and the telecom and tech industries in the 1990’s. • However, the bubble of 2004-2008 and that of the late 1980’s led to overinvestment in housing and commercial real estate. The 2004-2008 bubble might have produced a better housed country and a more equitable distribution of wealth had it been followed by debt restructuring, but neither bubble produced positive side effects in terms of innovation.

22. Financial Regulation and Innovation—Key Principles • To foster innovation, financial regulation must be structural—it cannot be merely prudential. • The regulatory structure must be comprehensive and driven by economic functionality, not legal formalisms. • Financial regulation must be integrated with tax policy • Financial regulation must be integrated with corporate governance, particularly around incentives, risk management and insider trading. • Policy responses after financial crisis are as important as ex ante regulation.

23. Structural Regulation • Keep government-insured credit intermediation separate from more speculative capital market activity. • Foster public financial institutions to invest in public goods and to explicitly, and with upside going to the public, participate in financing innovation.

24. Regulate by Function, Not Legal Form • Ensure that there are no dark spaces in the capital markets where risk can be undertaken without capital to back it and without transparency. • Innovation in finance is usually not real innovation—a credit default swap is simply unregulated bond insurance—but capital will flow into financial activity that has this type of regulatory subsidy at the expense of investment in the economic sense.

25. Tax Policy • Tax subsidies can push financial activity toward or away from investment, and can have powerful political economy effects. • Tax policy drives basic financial structures. • Degree of leverage • Time horizons of investors • Dividends, stock buybacks and retained earnings

26. Corporate Governance and Risk Management • Incentive structures for financial firm executives critical to financial firm behavior • Governance of risk management— • Who do risk managers report to • Are financial institution boards actively involved in risk management • As Lazonick points out, allowing operating company insiders to transact personally, while simultaneously controlling firm buybacks, leads to perverse outcomes—managers of operating companies should not be able to actively participate in secondary markets while serving as senior managers.

27. Post Crisis Financial Regulation • Bankruptcy has served to ensure debts incurred in bubble environments do not cripple operating firms post-bubble. • Resolution processes for financial institutions serve a similar function. • When they processes are thwarted, as occurred in the US post 2008, both economic growth and investment by business are suppressed.

28. The Dodd Frank Act and the US Experience with Financial Reform since the 2008 Crisis • Dodd Frank has failed to effectively separate commercial credit from secondary market speculative activity within large financial institutions. • Dodd Frank has made significant progress toward a comprehensive financial regulatory structure, but the implementation process threatens to undo this progress, particularly in the area of derivatives. • The US tax code with respect to issues of capital gains, dividends, private pools of capital, and financial transactions remains largely unchanged since the crisis. • The Dodd-Frank Act and US bank regulators made some changes with respect to compensation—their full impact is unclear. There has been no meaningful change in insider trading rules. • The US approach to dealing with the financial crisis during 2008-2009 has led to increased economic inequality, reinforced the power of large financial institutions, and constrained both consumer spending and business credit. However Title 2 of the Dodd Frank Act creates a much better way of dealing with the failure of systemically significant financial institutions—unclear whether either the Treasury Department or the Federal Reserve Board will have the courage to use it.

29. Future Challenges • The US financial system and its economy remain vulnerable to speculative bubbles, whose political economy is fundamentally driven by wage stagnation. • The political power of the financial sector threatens what progress has been made. • However, public opinion is strongly in favor of more accountability for finance, and some politicians in both political parties are listening. • There is a financial regulatory agenda that needs to be accomplished globally to finance to play its proper role in the global economy—separate commercial credit and secondary market speculation, clear international resolution processes, coordinated adoption of financial transaction tax, coordinated regulatory action around compensation and incentives. • It’s not the lack of ideas—it’s the political power.