Will the financial regulatory bill prevent another panic?

The Obama administration, especially Tim Geithner (Secretary of the Treasury), have repeatedly said that the financial reform bill being debated in Congress will not completely prevent another financial crisis. As you can probably guess, it is difficult to see into the future and guess the kind of money-making schemes Wall Street will come up with next. But, what it can do is help mitigate the next financial crisis and protect the tax payers.

Robert Samuelson, in his most recent Newsweek article explains:

History counsels caution. Every financial reform, even if mostly successful, ultimately gives way to another because there are unintended consequences or unforeseen problems.

By its nature, a panic is unanticipated. Reform may resemble generals fighting the last war. Suppose the next financial crisis originates in runaway federal debt, which undermines confidence in the vast market for Treasury securities. Interest rates and currency values would react violently; the ripple effects would spread globally. The irony would be clear: While preaching financial reform, the White House and Congress fomented the next crisis by sanctioning long-term budget deficits.

Samuelson then goes on to explain what the current financial reform bill omits, which would make it a much stronger bill.

The legislation also 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-Lehman, 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.

As I stated earlier this bill will mitigate future crisis, not eliminate or prevent. Samuelson agrees and writes:

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

How does the bill carry out this?

Under the congressional proposals, the government could shut down crucial financial institutions gradually and recoup the costs through taxes on other financial institutions.

But, there is still a problem. By not completely getting rid of too-big-to-fail institutions, you are still allowing the banks to believe that it is OK to take risk, because there is still money to prop them up. They still have the privilege that those on Main Street do not.

Samuelson writes:

Peter Wallison of the American Enterprise Institute thinks close regulation of too-big-to-fail financial organizations will give them a privileged status and make them “tools of the U.S. government.” Nevertheless, something seems better than nothing.

In conclusion, Samuelson writes:

All this sounds encouraging, but we can’t know the full consequences of financial reform. It’s not just that many issues remain unsettled, including the “Volcker rule” (named after former Fed chairman Paul Volcker, it would restrict banks’ ability to do trading for their own accounts) and the powers of the proposed consumer finance agency. 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.

Break up the too-big-to-fail institutions. Create an independent consumer protection agency. Increase capital requirements. And eliminate derivative trading, or at least bring them out of the shadows. But, until the banking industry no longer makes up 60% of our GDP, it will always have the possibility of causing crisis after crisis.

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Published in: on April 26, 2010 at 4:47 pm  Leave a Comment  
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