Financial reform in America: A decent start
A somewhat clumsy bill is hardly a panacea, though it fixes some important things
Jul 1st 2010
The reform does make progress in three critical areas: regulatory oversight, derivatives and dealing with troubled banks that are too big to fail. Yet by itself, this bill, whose passage in the Senate is still not quite secure, is an incomplete remedy (see article). Much depends on how American regulators implement its provisions. Congress left several meaty matters for later, including the crippled mortgage giants, Fannie Mae and Freddie Mac. And even more is riding on how the Basel club of international banking supervisors compel banks to raise their buffers of capital and liquidity.
Start with what the bill gets right. Though the financial crisis was global, it originated in America’s uniquely fragmented financial system, overseen by a patchwork of federal and state regulators. Dodd-Frank missed its chance to eliminate that patchwork, but offers decent alternatives. It creates a council to advise regulators on emerging threats. It consolidates oversight of consumer financial products, from mortgages to credit cards, in a single agency. And big financial firms that aren’t banks can be yanked into the embrace of the Federal Reserve.
Though a secondary player in the crisis, derivatives are a perennial candidate for causing the next one because they add opacity and leverage to the financial system. Most derivatives that now trade dealer-to-dealer will be traded on public exchanges. That will lessen the risk that one dealer’s failure brings down others. An extreme proposal to stop banks trading derivatives has been mercifully scaled back. (The Volcker rule, limiting banks’ ability to trade on their own account, also seems likely to hurt Wall Street profits less than some feared.)
The most important provision is the resolution authority under which federal regulators can seize any financial company whose failure threatens the financial system, and quickly pay off secured creditors while imposing losses on shareholders and unsecured creditors. This is an improvement on the status quo. Such resolution authority already exists for banks, but for other companies like Lehman Brothers and American International Group, regulators face a dreadful choice of either bailing out the company and its creditors or letting it go bankrupt. Yet in its zeal to protect taxpayers, Congress has made the resolution process so similar to bankruptcy that counterparties and lenders may still choose to abandon a troubled firm to avoid losses. Other steps are still needed: for example, regulators should create a new ring-fenced group of creditors who would be exposed to losses in resolution. But the horrible truth is that the effectiveness of any such body will be discovered only when a real crisis occurs.
Meanwhile there are two other ways to mitigate the risks flowing from banks that are seen as too big to fail. One is to claw back the subsidy such firms enjoy in their borrowing, both to encourage them to shrink and to pay for the clean-up when they fail. Barack Obama has proposed a bank tax that would serve the purpose. Despite the failure of the G20 to agree on such a tax last week, America (and other countries) should press ahead. The other is to force financial institutions to have more capital and liquidity to make collapses less likely in the first place. Negotiations in Basel have slowed as Europeans fret that stiffening standards may slow lending and hinder economic recovery. Implementation should indeed not be rushed. Yet in the longer term bigger buffers are essential.
In America Dodd-Frank’s actual impact will depend greatly on how regulators like the Fed and the new consumer agency enforce its provisions. The risks cut two ways. Banks and their lobbyists may persuade regulators to interpret the new rules in the friendliest possible way to Wall Street, as they did before the crunch: the treatment of the ratings agencies, which seem to live a charmed life, will be a good test. In the opposite direction, regulators may overreach—stifling innovation which, for all its recent excesses, has over time been a force for good.
At the G20 Mr Obama boasted of “leading by example” on financial reform. In fact, Dodd-Frank is too idiosyncratically American and too incomplete to be a true template for others. And his claim that it would keep a financial crisis like the one the world just went through “from ever happening again” is bound to prove wrong. Yet imperfect though it is, the reform is proof that even a government as fractious as America’s can move with impressive speed when the motivation is there.
The original article is linked here.