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One Cheer for Financial Reform; More Cheers Could Follow

Tuesday, May 11, 2010

Congress has made a good deal of progress on financial reform legislation; perhaps we have learned some lessons from the financial crisis after all.

The past week has seen important progress on legislative efforts for financial regulatory reform, including advances on both substantive and symbolic (but politically charged) issues.

Non-bank resolution is the most important substantive issue, and the agreement between Senate Banking Committee Chairman Chris Dodd and Ranking Member Richard Shelby resolves (so to speak) defects of the original Dodd proposal that would have fostered bailouts.

In essence, non-bank resolution will now allow the Federal Deposit Insurance Corporation (FDIC) to provide collateralized lending to a failing non-bank financial firm but require a vote of Congress to intentionally deploy public capital. Losses on the provision of liquidity will be clawed back from creditors to the extent that these counterparties receive more than would have been the case in a liquidation of the firm through a Chapter 7 bankruptcy proceeding. In other words, government money can be provided if it is well-collateralized, but if there are inadvertent losses, the counterparties who benefit are on the hook and not some deep-pocketed institutions that might make good political punching bags.

Government money can be provided if it is well-collateralized, but if there are inadvertent losses, the counterparties who benefit are on the hook and not some deep-pocketed institutions that might make good political punching bags.

The non-bank resolution compromise thus provides the government with a tool that could reduce the value destruction involved with the sudden loss of funding by a firm such as Lehman Brothers, without giving the government unlimited discretion to engage in bailouts that make counterparties better off.

The ex-post clawback of public losses still gives some discretion that could be harmful, since the government could put money into a failing firm and “accidentally” (that is, intentionally) take losses for policy purposes, with lenders on the hook to cover those losses. An example would be if, say, Citigroup fails and the government puts in money on the condition that Citi writes down mortgage principal for homeowners at risk of foreclosure. Lenders to Citi would then be forced to in effect pay for a bailout for homeowners who might not receive funds through a transparent congressional vote (perhaps because some of them look like “speculators”). This is somewhat related to the Obama administration’s proposed bank tax, in which the administration wants a variety of financial institutions to cover the costs of helping GM and Chrysler. The after-the-fact nature of the clawback means that even secured lenders will have some uncertainty about the value of their claims and this could inhibit lending, but this is the case as well in a bankruptcy proceeding (though having a judge rather than a political official such as the FDIC chairman is a big difference). Moreover, part of the point here is to give creditors pause as they realize that they will take losses and not be bailed out.

The Dodd-Shelby agreement in effect will shift part of the Fed’s 13-3 emergency lending authority to the FDIC and the Treasury Department (the FDIC would make the loan but Treasury would have to sign off). Provision of capital—in this instance, funding that stands a good chance of a loss—would require a vote of Congress, regardless of whether this is done through cash injections or loan guarantees. This is a huge improvement over original proposals from the administration, House Financial Services Committee Chairman Barney Frank, and Senator Dodd. It does not mean “no bailouts ever,” but it ensures that Congress must vote on bailouts—an important and appropriate check.

Non-bank resolution will put considerable stress on the valuation of assets at failing firms, since this valuation is needed to calculate the amount of secured funding the FDIC is allowed to provide. In the case of Lehman’s failure in September 2008, the Federal Reserve declined to lend to Lehman ahead of its bankruptcy filing because the Fed did not believe that Lehman had suitable collateral.

But one could imagine a future government official fudging this and providing lending against speculative collateral. It would thus be useful for the eventual bill to require the government to provide a detailed explanation of the judgments made in providing liquidity, including details of the assets and valuations against which the lending is collateralized. It would also be useful to have a tripwire for a congressional vote even on collateralized lending. This could require a vote, for example, within 30 days of the government deploying more than $50 billion or providing a guarantee on more than $50 billion of assets.

The Fed, Bank Size, Consumer ‘Protection,’ and Beyond

In addition to these changes, some (but not all) of the worrisome parts of the bill have been dropped:

It would be useful for the eventual bill to require the government to provide a detailed explanation of the judgments made in providing liquidity, including details of the assets and valuations against which the lending is collateralized.

The proposal to allow the Government Accountability Office to audit the Fed has been watered down to irrelevance. This proposal risked compromising the independence of monetary policy by allowing congressional intervention on Fed decisions.

A proposal to limit bank size has been defeated. Some large banks appeared to be risky during the crisis, but others did not (consider JPMorgan Chase vs. Citigroup). Having large and effective financial institutions has advantages to society, including lower costs of borrowing for families and businesses, both small and large.

A better approach than the Volcker Rule, which would impose blunt limits on the size of banks, would be to evaluate the riskiness of bank activities and ensure that regulators and supervisors take action when such activities pose a threat to the financial system and the broader economy.

There remains work to be done in other areas of the bill. A new consumer protection agency has the potential to be burdensome and counterproductive. It could also be helpful and effective. That depends on the agency’s leadership and culture—if this new agency comes into being it would be important to choose a director who is interested in substance and not superficial media hits.

The derivatives piece of the bill being debated in the Senate is more straightforward in that both the administration and centrist members of Congress oppose it because it would move risk-taking activities out of the regulated part of the financial sector. At some point, I hope President Obama will find the ability to speak forthrightly about this provision. This would be useful communication on his part.

What We Have Here Is Failure to Communicate

Such communications issues have been an unfortunate feature of the debate on financial sector reform. This debate started with agreement on substantial parts of the legislation, including systemic risk, derivatives, and the idea of ending “too big to fail” (though until recently not on the specifics). The president’s rhetoric, however, has been that anyone who opposes any aspect of his proposals is owned by Wall Street. In his speech at Cooper Union, he asserted that it was “not legitimate” to assert that the original Dodd proposal for non-bank resolution allowed and perhaps even encouraged bailouts—when it very plainly was a bailout bill and the changes discussed above are substantive corrections.

I’m not sure whether to label this communications strategy as “confrontational” or merely “aggressive.” It is hard to judge whether this communications strategy is a good one in the sense of being a political success for the president. But this is certainly not the approach of a pragmatic leader looking to bring people together. And President Obama’s communications strategy is jarring when juxtaposed with his recent call for civility in a commencement address at the University of Michigan.

I hope the president will soon heed his own call, and contribute positively to a beneficial reform of financial regulation. There has been a good deal of progress on this in Congress, and legislation has the potential to show that we have learned some lessons from the financial crisis and taken action to help avoid a repeat.

Phillip Swagel is a visiting professor at the McDonough School of Business, Georgetown University, and a non-resident scholar at the American Enterprise Institute. He was previously assistant secretary for economic policy at the Treasury Department from December 2006 to January 2009.

FURTHER READING: Swagel described the initial Dodd financial reform bill in “Yes, It’s a Bailout Bill.” He coauthored an article describing “An Uncharitable Proposal” within President Obama’s tax plans. He has also discussed “Ironing Out the Kinks in the Dodd Bill” and how the “Most Disadvantaged Get Two-Thirds of All Private Health Aid.”

Image by Rob Green/Bergman Group.

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