Home OP-ED Financial Reform: Too Big to Legislate

Financial Reform: Too Big to Legislate

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If you’re not confused about the massive financial overhaul legislation wending its way through Congress, then you probably don’t understand it.

The reform legislation has some very important objectives. Among them, protecting consumers from predatory credit practices and preventing future crises from happening.

Setting aside the consumer protection aspects of the legislation, there still are significant reasons to doubt whether this law can erect surefire safeguards to avert another economic downturn of the sort we’ve just been through. In reality, there may be no single law that can provide such guarantee.

The Senate version of the bill passed last Thursday takes aim at stopping future crises before they start. The legislation purports to address several leading causes: Whacky lending practices, risky bets by banks, unchecked credit ratings on suspect assets and the inability to unwind financial institutions on the verge of implosion.

Broadly cast, the Senate bill establishes three notional lines of defense.

Sealing Loopholes — or Not?

As a primary bulwark, the Senate bill attempts to address the relationship financial firms have to the products they are trying to sell. It requires that firms hold at least a 5 percent stake in any loan-pool securities that they sell to others. Policymakers have concluded that because firms don’t have a dog in the fight, they have little or no concern with the outcome for their clients.

Along these same lines, the bill also seeks to make the credit-rating business more competitive to serve the interests of investors, rather than the issuers of securities. In conjunction with these provisions, the law would give the Federal Reserve greater oversight of the pay incentives for executives at nation’s top financial firms.

A second line of defense focuses on the regulators themselves. The bill will establish a financial oversight council, led by the Treasury Secretary. This panel would have a new and broad mission: To track financial risks throughout the economy, not just within a single sector such as banks or insurance firms. The goal of the panel would be to implement tough capital standards to assure that prominent firms operate with a safe cushion against potential losses.

Finally, the law tries to provide the government with tools to deal with another crisis if it occurs. The idea is to give regulators authority similar to power the FDIC has over banks – to shut them down and sell off the viable assets before they collapse. If the process requires outside money, the financial industry would be billed, not taxpayers.

While each of these components is problematic, the second and third elements of this protective umbrella may prove the most vexing.

Hardly Anyone Was Prescient

To shield our economy from future downfalls, this financial oversight council must have the actual ability to identify and understand the threats. Even if such a panel had been in place prior to this crisis, there is no assurance that it would have had the acumen to act.

In this instance, the regulatory alarm bells did not sound until the economy already was drowning in an untenable sea of subprime mortgages and convoluted credit swaps. The unfortunate truth is that very few, if any, regulators or economists truly understood the peril until it was too late.

As is frequently the case, prosperity colors our perception. In other words, because everyone was making money, no one wanted to be the party pooper.

Several leading academics, working economists and regulators said that they knew that credit swaps were nothing more than fancy financial insurance policies. If they knew this, then it is doubly difficult to understand why they failed to warn us that the issuers of these policies, like Lehman Brothers and AIG, didn’t have adequate reserves to cover their losses?

Looking back, policymakers argue that following the sudden and unexpected bankruptcy of Lehman Brothers, they had little alternative but to bail out firms like AIG and Citigroup. They may be right.

At the time, other than the FDIC, there was no viable mechanism to unwind these firms in an orderly fashion. As an insurance company, AIG was not subject to federal jurisdiction. Rather, it was regulated by dozens of agencies at the state and local levels, none of which had the wherewithal individually or collectively to act.

Likewise, financial firms like Citigroup and Bank of America were beyond the functional regulatory reach of the FDIC. Traditionally, this regulator only focused its attention on smaller local and regional institutions. Even though it maintained an ongoing insurance pool, the FDIC did not have the financial resources to underwrite potential losses at these mega-banks.

On paper, this new regulatory authority makes sense. The problem, however, is that it fails to tackle the ongoing dilemma of moral hazard.

If a financial firm is identified as being systemically important, then in reality it becomes too big to fail. Knowing this, firms will have little incentive to manage their risks or to mediate their growth. In part, this explains why the biggest financial firms have grown even larger over the past two years. They now know that no matter what happens, the government will rescue them from their unrestrained imprudence.

The law also does nothing to repair the damage done by the repeal of Glass-Steagall, the post-Depression provision that separated investment banks from commercial depositor banks. Without this firewall, banks still are free to roll the dice with depositor funds.

Shareholders, unlike depositors, expect the firms in which they invest will take risks. It’s part of the game. If they loose, they loose.

In contrast, when you deposit money in your local bank, you expect it to be there when write you a check. Without the buffer provided by Glass-Steagall, there never will be a fund large enough to assure depositors that their money will remain safe.

Don’t get me wrong. Something must be done to gird us against future economic crises. I am just not convinced that this or any legislation will give us the apparatus we need to keep such a crisis from happening again.

John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com