A Senate bill to overhaul financial regulations was issued last week and a similar bill from the House is expected soon. The White House issued a proposal for financial reform back in June and the GOP responded with a counter plan in July. So there are lots of things on the table, all extremely complicated and arcane. Like health care reform there appears to be general agreement that financial reform is necessary, and I completely support many changes, but there is little agreement on what exactly needs to be done. The one broad area of agreement seems to be the need for improved oversight of the financial markets (duh!!) but the who’s and how’s are quite different. The White House and the Democrats, led by Chris Dodd in the Senate and Barney Frank in the House, choose changes that are grander and more restrictive on financial institutions while defining how to handle firms deemed “too big to fail.” The Republican plans reduce the role of the Federal Reserve and declare no firm “too big to fail” thereby allowing managed bankruptcy for banks and non-bank financial firms in distress. I’ll give you my perspective from 20+ years in that industry of the good and the bad of the two major aspects of financial reform under consideration.
Regulating Financial Firms and the Role of the Federal Reserve. The idea is to make sure somebody is watching the financial cookie jar. Currently the job is shared by a bunch of acronyms too numerous to count. The decision-making and regulatory process must be streamlined and there needs to be someone coordinating things. Everything financial is interrelated and divvying up the jobs without a central coordinator is reckless. However, there needs to be enough slack in the rope to assure continued innovation and managed risk-taking. One thing I’m strongly convinced of is that the financial crisis should definitely not be an excuse to give more regulatory control to the political arm. Neither Congress nor the Treasury should be given a substantially larger role in managing the financial industry or my money will be on the next wire to banks abroad.
Democrats want to designate certain “Tier 1” firms as “too big to fail” and establish an emergency fund created by those same banks. The GOP argues that “too big to fail” simply encourages institutions that don’t yet meet that threshold to grow quickly by adding new risk, get themselves into Tier 1, and guarantee their survival. Unfortunately, however, there really are firms that are too big to fail because their bankruptcy would have a cataclysmic impact on global markets. AIG was such a firm because it fell in a gray area of non-regulation….it was an insurance company not a bank, its financial activities went almost entirely unregulated, and it’s risk-taking was not understood by anybody outside of the small group of people who executed the trades. AIG Financial Products took enormous risks and for years was a money-making machine for the company so nobody looked under the hood until it was far too late.
My view is that the Republicans have this one right. We don’t want firms acting recklessly either because they have already been designated Tier 1 and are therefore protected from failure or because they are Tier 2 but want to reach the protection of Tier 1 with all the benefits that accrue (because of the government protection Tier 1 firms will be able to borrow money at substantially lower rates than other competitors). We need a strong bank regulator and I think the Federal Reserve Bank is best positioned to act in that capacity (or an independent body created from folding in all the acronyms) as head of a financial stability board proposed by Barney Frank composed of federal financial regulators and charged with regulation of risk-taking, capital controls, and systemic-risk. But there should be no designation of protection for “too big to fail” firms. That will be dealt with as the cases arise (or, hopefully, don’t arise). The presumption of all firms must be that nobody is too big to fail and the regulators should act and speak accordingly. But I’d also like to see the regulator with the final authority to break up firms that simply grow too big as was done with AT&T years ago. The separation of banks and investment worked quite well for a long time. A partial move back toward that distinction may also have merit.
Consumer Protection. Chris Dodd wants to create a Consumer Financial Protection Agency to monitor the financial marketplace for consumer products including loans, mortgages, and credit cards. They would furnish restrictions on credit card company interest rates, ensure mortgages, auto loans, and personal loans were written in easy-to-understand language with all terms clearly defined and explained, focus on financial products to make certain they were easily understood before investments were entered into, and in other ways act as a watchdog for consumers. Bankers, credit card companies, and Republicans have argued that we merely need to empower existing, disparate agencies to do their jobs better. I think the point has already been made explicitly that there is nobody at home in these roles and I fully support the creation of this central regulator crafted from the pieces out there doing a half-assed job at present. The GOP argument that this will reduce access to credit and create another unnecessary regulatory agency is weak – the CFPA merely consolidates disjointed pieces currently doing a lousy job and the flow of credit will not be regulated from this agency (I think ).
There are many other elements to financial reform that are extremely important including hedge fund regulation (larger funds should definitely be required to register with the SEC), derivatives regulation (centralized exchanges should be put into place but the regulators need a means of controlling excessive risk-taking in non-traditional products in this arcane and very dangerous area), and credit agency reform (great idea from the GOP to do away with government use of ratings agencies), to mention just a few. Reform is very important to get markets under better control and now is the time while we are in the current financial market rally and things are relatively stable. The changes are far less draconian than health care reform. I hope the GOP can get past the politics of giving Obama a “victory” with an effective reform package and get something done before the next inevitable downturn.