Congress has made much more progress on financial reform than cynics might have thought. The House and Senate bills have now been passed with strong majorities and will now be reconciled in what will surely be a bruising conference committee. The conference will proceed from June 15 and Congressional leaders hope to present the final legislation to the President for his signature by July 4.
What we will get, naysayers notwithstanding, is a lot better than nothing.
- There will be a properly resourced systemic risk council, headed either by the Fed or the Treasury, depending on whether the House or Senate version is adopted. This is vitally necessary, given the interconnected nature of modern finance and the lessons we all learned from Lehman.
- Some means of forcing the industry to pay for the costs of failure will be adopted, either in the form of an advance tax (a bad idea) or subsequent ability to collect the costs (but will this really be enforceable?).
- Regulation of derivatives activity, at least through greater transparency and exchange, though whether the more radical Senate version that would force banks to push out their derivatives activities (a very bad idea) will be adopted is uncertain. The industry and even the White House will lobby very fiercely against this.
- Realistic consumer protection, either in the form of an independent bureau within the Fed (a curious idea) or a completely independent agency (which makes the most sense but which is driving the industry crazy). There will also be some ability on the part of state attorneys general to provide more local consumer protection enforcement.
- Some form of the “Volcker Rule,” either banning banks from proprietary trading or authorizing regulators to break up big banks under distressed circumstances.
- Greater focus on executive compensation to improve the links between risk and reward and prevent brokers and executives from profiting from activities that generate huge short-term fees but introduce massive long-term dangers to the institutions involved or the system as a whole.
- Regulatory responsibility to develop better prudential standards, or at least the power to impose them, on financial activities. For example, no more no-doc (we won’t check), ninja (no income, no job) or liar (say anything in the application you want) loans. Better capital standards, and much more in the details.
- New, though still to be worked out, powers to place systemically important financial players beyond the banking industry (e.g., Lehman and AIG) into fast track receivership before they fail completely and take everyone else down with them.
These reforms will together represent a major modernization of financial regulation. They will impose far-reaching changes on the business. Unfortunately Congress still ended up punting on major issues, and until these are addressed we won’t have fixed everything by any means and will continue to risk many more crises–perhaps one even bigger the Crash of 2008.
- We have not taken on the behemoths. There is increasing evidence to suggest that the ultra large financial institutions are not only inefficient and dangerously risky; a recent Bank of England study suggests they are actually a drag on national and global economic recovery. The House Bill contains powers for the regulators to break up large financial institutions when this is necessary for financial stability, but efforts in the Senate to impose even mild caps on bank size were defeated. Unlike actions by the European Commission and British government to downsize financial institutions on life support (ING, Lloyds, and others), US regulators have not taken strong action to dismantle our own juggernauts in the midst of crisis. This raises the question whether the regulators will really be able to use the provisions in the House bill, even if they survive conference.
- Regulatory restructuring has barely begun. We desperately need a strong lead bank regulator to address the complexities of modern, large-scale bank regulation. The Fed has gained greater powers but not enough for this purpose. The OTS will be merged into the OCC, but the FDIC will keep its supervisory powers in addition to its extensive new resolution powers. Insurance regulation has not been standardized, let alone consolidated. (We should not forget that AIG is primarily an insurance company.) Bank regulators don’t even have supervisory power over important financial institutions that form a critical part of the financial fabric. Unless and until we address this mish-mash of crazy quilt regulation we will never establish comprehensive financial regulation. Regulatory arbitrage will continue, and this means that financial innovation will drive new and unsupervised risks to which we are all ultimately exposed.
- Industry restructuring–perhaps like reintroducing Glass-Steagall–is advocated by some as an essential element of proper reform. This is a much more debatable issue, but we haven’t even managed to dispose of the thrift charter yet. While the OTS will almost certainly meet its demise as a separate agency, the House bill would maintain the thrift charter itself. The ability of thrifts, industrial loan companies, credit unions and other financial organizations to evade proper regulation has proven just as important in contributing to recent crises as the ability of banks and investment companies to affiliate by reason of the 1999 repeal of Glass-Steagall.
- Fannie Mae and Freddy Mac will only be addressed after the new bill is enacted. While I am not among those who believe that easy access by poor people to mortgages created the crisis, there is no question that then housing agencies that facilitated the irresponsible orgy of securitization that drove easy mortgage lending and greatly inflated the asset bubble leading that eventually burst in 2008 badly need reform. These housing enterprises have a long history of dysfunction, even corruption, and cannot heal themselves, no matter ho earnestly their current leadership tries. We have to reset our public policy priorities and restructure or recreate these agencies accordingly.
- The global dimension of financial reform remains at the level of talk. None of the financial institutions that matter confine themselves to US operations, and our own economy is heavily dependent on foreign financial activity. Indeed, three of the top ten bank holding companies in America are foreign-owned, and many, many more large foreign institutions operate in the US. There is global consensus on some of the prudential standards but we are a long way from reaching anything like consensus on overall regulatory governance. Until we do the prospect of uncoordination and international regulatory arbitrage remains as real as ever.
- Honesty remains a stranger to much financial reporting. Accounting, tax and reporting tricks are prevalent, and widely different standards apply from country to country. Until we can secure greater transparency and consistency in accounting, taxation and reporting, we cannot know what is really going on and inconsistencies will encourage widespread arbitrage.
So there is much left to be done. We have a 21st Century global financial system and a fragmented, 20th Century regulatory framework. The new reforms will help some, and at least we have greater public awareness. But we still have a leaky regulatory colander. Finding new ways to regulate the dynamic, complex global financial system will become critical.