Financial Reform: Will We Feel Better the Morning After?

Financial Reform: Will We Feel Better the Morning After?

The financial reform bills being considered by Congress will lead to a better regulated financial system, most importantly by creating a consumer protection agency that will prevent some of the worst abuses of the last decade. However, no serious person can claim that the bills passed by the House or coming out of the Senate Banking Committee will prevent future crises.

It’s not clear that any piece of legislation can accomplish that task, but we lost our best opportunity to promote crisis prevention when the Senate approved Ben Bernanke for a second term as Fed chairman in January. This act told future regulators that the failure to crack down on recklessness in the financial sector carries no consequence. This means that when a future Fed chair faces the choice of cracking down on a dangerous asset bubble – and encountering the full wrath of the financial industrial – or doing nothing, he or she will know that there are no negative consequence to the “do nothing” option, even if it has disastrous outcomes. Given the asymmetric incentives, there is little reason to believe that future Fed chairs will take the risk of confronting the financial industry for the good of the economy.

However, even if the bill cannot guarantee a crisis-free future, it can still help to weaken the political power of the financial industry so that the public has a better shot in the future. There are three hotly contested issues that will determine whether the financial industry we see post reform will be very different from the one we have today.

The first is an amendment initiated by Senators Brown and Kaufman, which would impose a size limit on the banks. The nation’s biggest banks have grown far beyond a size justified by economies of scale. Their size simply enhances their political power. It also gives them “too big to fail” (TBTF) status, meaning that the threat that their failure poses to the economy is likely to be too much for any regulator to be willing to tolerate.

This TBTF status is in effect a form of insurance, with creditors believing that the government will come to their rescue in the event the bank is faced with bankruptcy. As a result, they are willing to lend money to TBTF banks at a lower interest rate than their smaller competitors, which must operate without implicit government protection.

While this bill is supposed to end TBTF, it is unlikely that the investors will believe that the government would be willing to accept the collapse of a JP Morgan or Goldman Sachs. The surest way to end TBTF is to bring these firms down to a more reasonable size as would be accomplished by the Brown-Kaufman amendment.

The second big issue is restoring the separation between normal commercial banking and the risky trading activity that generates most of the profit for investment banks. The basis for the separation, which was enforced by Glass-Steagall until 1999, is that commercial banks have government insured deposits. There should never be a situation in which banks are speculating in financial markets with the money guaranteed by the government. This creates a one-sided bet in which the banks can only win and the taxpayers can only lose.

An amendment by Senators Merkley and Levin would prohibit commercial banks from trading on their own account. This means that if a commercial bank has a division that engages in trading, then they will have to either shut it down or sell it off.

The third big issue coming up in the floor debate in the Senate will be the treatment of derivative trading. The bill that was voted out of the Agriculture Committee would prohibit commercial banks from being directly involved as brokers in derivative trading. The rationale is that this trading creates large risks and potential conflicts of interest. This would mean a major departure from current practice, since the six major banks currently control the overwhelming majority of derivative trading. If they had to spin off their derivative business, it would lead to a very different structure in the financial industry.

There are many other issues in the financial reform bill, most of which will lead to improvements in the regulatory structure. However, without these three changes, the industry will not look very different the day after financial reform than it did the day before. Given what the industry has done to the country, it doesn’t seem unreasonable to expect some serious changes. After the next couple of weeks, we will know what we get.