The one thing we know about the financial “reform” now moving toward what looks like eventual congressional approval is that it will be oversold, says economist Robert Litan of the Kauffman Foundation.
We will be told that it will forever prevent a repetition of the recent financial crisis; that it will root out corruption on Wall Street; that it will eliminate bailouts; that it will protect consumers against greedy lenders. President Barack Obama, Democrats and Republicans will engage in much rhetorical overkill.
What can we really expect?
History counsels caution. Every financial reform, even if mostly successful, ultimately gives way to another because there are unintended consequences or unforeseen problems. Sheila Bair, head of the Federal Deposit Insurance Corp., has noted that the reforms of the early 1990s, which curbed risk-taking within the banking system, perversely shifted lending to the largely unregulated “shadow banking system” — mortgage brokers, specialized lenders and “securitization.”
The central aim of today’s reform is to avert another financial panic. A panic is not a bubble or just big losses. These are inevitable and, in part, desirable: without losses, investors would become reckless. A panic is a stampede of selling and hoarding, driven by fear, that threatens the financial system and, through it, production and jobs. A panic occurred in September 2008 when Lehman Brothers failed. Investors and money managers fled to safety.
The legislation omits the strongest safeguards against financial meltdowns: tougher capital requirements. Capital mainly represents the stake of shareholders in financial institutions; it provides a cushion against losses. Pre-Leh man, banks’ capital represented about 10 percent of their assets. Some experts would raise that as high as 15 percent. But the legislation leaves capital requirements to regulators, led by the Fed and Treasury. They are negotiating with other countries to set global standards. The outcome is unclear, and there’s a dilemma: Overly tough capital rules will discourage lending.
Still, the legislation seems on balance a plus. Though not eliminating the threat of future crises, “it makes them less likely,” says Litan. The “too-big-to-fail” problem has been mitigated, if not entirely solved.
There are critics. Peter Wallison of the American Enterprise Institute thinks the close regulation of too-big-to-fail financial organizations will give them a privileged status and make them “tools of the U.S. government.”
Financial stability should also benefit from bringing many transactions out of the shadows, says Robert Pozen, chairman of MFS Investment Management and author of “Too Big to Save? How to Fix the U.S. Financial System.”
Chief among these are “derivatives,” most prominently the now-notorious “credit default swaps.” Derivatives can serve legitimate economic purposes — hedging against credit risk or swings in interest rates, for instance.
The Obama proposals would force much derivative trading onto clearinghouses and exchanges. This would limit risks, notes Pozen.
But there’s a deeper reason for humility. The financial system’s size, complexity and global nature defy attempts to chart its future. No “reform” is, or can be, forever.
