Financial 'Reform' or Revenge?

—Barack Obama, June 25

It is a myth to think that the new financial-"reform" legislation, assuming it passes the Senate, will insulate us for all time against financial panic and crisis. Great crises of the sort that occurred in 2008 and 2009 are usually separated by many decades, and so it will be hard to determine how much real protection the law provides. But the underlying ingredients of financial panics are always the same—uncertainty, ignorance, and fear—and no law can permanently abolish these.

We have had recent reminders of just how quickly surprises can happen. On May 6, American stock prices dropped a scary 5 percent in a few minutes. Some blue-chip stocks momentarily fell to a penny. The collapse still isn't fully understood, though it's widely attributed to an interaction between computerized trading strategies (where computers automatically buy and sell stocks) and different securities markets. Another financial scare has arisen in Europe: Greece's near default. It could lead to a major banking crisis if fears that other governments might default cause big losses for banks that hold government bonds.

Most financial shocks don't become panics. These are prevented through some combination of the self-correcting markets, industry policing and government regulation. But the paucity of panics should not prevent us from recognizing the vulnerability of a financial system that is global and dependent on complex technologies. At the end of 2009, for example, Americans owned $18 trillion in foreign assets (stocks, bonds, real estate, entire companies) and foreigners owned $21 trillion in American assets. Neither investors nor regulators can anticipate every threat to this massive, fluid system.

What the new legislation might do is reduce the odds that the next crisis will be like the last. It might, as its advocates claim, largely dispose of "too big to fail." During the crisis, the government faced the distasteful choice of rescuing teetering, huge financial institutions (Bear Stearns, AIG) or allowing a sudden bankruptcy (Lehman Brothers) to stoke panic by inflicting losses on other banks and investors. To avoid this dilemma, the legislation does two things.

First, it would police big financial institutions more closely. Until now, the Federal Reserve has supervised bank holding companies such as Citigroup. Some major institutions—such as AIG, mainly an insurance company—virtually escaped federal regulation. Under the legislation, the Fed could examine and regulate any hedge fund, insurance company, or financial-services firm whose failure might imperil the entire system.

Second, if tougher regulation and capital requirements don't prevent fatal losses, the legislation creates an orderly way for institutions to close. They would shut down gradually to avoid market disruptions; if they need cash, the government might supply it temporarily. But the losses would ultimately be borne by shareholders, lenders, and the Federal Deposit Insurance Corp., which is supported by fees on banks. (If the FDIC were overwhelmed, taxpayer funds would presumably be used.)

The trouble is that—contrary to conventional wisdom—"too big to fail" was just a symptom of the crisis, not its basic cause. That was old-fashioned bad lending: home loans to borrowers who couldn't repay. The panic arose because no one knew the size or location of the losses, now estimated to exceed $1 trillion. Ironically, the legislation may weaken the government's ability to quell future panics by restricting—in highly technical ways—the Fed's authority to lend to panic-stricken institutions in the midst of crisis.

The legislation has other gaps. It doesn't settle the future of Fannie Mae and Freddie Mac, the federally created housing agencies whose lax practices contributed to the crisis. Nor is there much to revive private-market securitization—the bundling of individual loans (home mortgages, auto loans) into bonds. This major source of credit has collapsed, down more than 90 percent since 2006. One weakness was that rating agencies (Moody's, Standard & Poor's) never verified the reliability of individual loans. The result: "liar loans" with inaccurate information. But the legislation doesn't require rating agencies—or anyone—to do selective audits of individual loans. Without that, investors may shun most "securitizations."

What's called "financial reform" has twin motivations: to stabilize financial markets and to punish "Wall Street" for the crisis. So much in the legislation (a consumer-protection agency, restrictions on "proprietary" trading by banks) is left to regulators that no one can now know the full outcome. It could be greater stability, overregulation, or a scattering of risky activities into lightly regulated institutions. History will judge whether this qualifies as genuine "reform"—or just revenge.

Join the Discussion