Financial Reform Legislation

May 24, 2010

The Senate has passed a financial regulatory overhaul bill aimed at stopping future financial crises before they start. The bill, the most sweeping reforms since the 1930s, aims to address the problems that led to the economy’s recent collapse such as banks taking on too much risk, lax lending standards, minimal consumer protection, inflated credit ratings and regulators’ inability to wind down financial institutions in an orderly way. Economic Studies Fellow Douglas Elliott says he thinks the legislation is about as good as could be expected.


Landmark Regulatory Reform

“It would have been good to have more consolidation of the regulators. Very little is being done about that, but that is more of a missed opportunity. In terms of some bad things that are in there, there is a provision called Section 106 that says the banks can’t do derivatives, essentially. It says it in more technical language, but it makes it nearly impossible. This would be disastrous. In fact, this is a bad enough idea that it is highly likely it will come out of the bill, but were it to stay in it would be a bad thing because derivatives are an important part of risk management of our large corporations (which are a big chunk of the economy). Banks provide these services, they should provide these services, and the last thing we would want to do is take them away from the banks where we can watch them more carefully, and move them to some less-regulated part of the economy.

I think the country, as a whole, is a winner because we needed more financial stability. The basic system, in its broadest sense, worked okay, but over the course of 25 years we took out all of the safety margins because things were good. This crisis showed us there were probably 15 or 20 significant things we needed to change. To its credit, the bill does most of those things. You could argue about some of the technicalities (or even sometimes bigger things than the technicalities), but the comprehensive nature of the bill is important, and it is tackling a lot of those things. The country, I think, is a definite winner. For Wall Street it is less clear. They are certainly a loser in the sense they are going to be less profitable for some time. On the other hand they, too, benefit from stability. It is not a good business model to blow up the world every 30 years (and, perhaps, even more frequently than that). So, I think, despite the screams from Wall Street, it is mostly good for them, it is just going to take some adjustment.”

Regarding “Too Big to Fail” Institutions

“This bill does not do much about “too big to fail,” but mostly because there frankly is not that much that we can do. It does an important thing though – it says that for those firms that are systemically important (which is the fancy term for “too big to fail”), they are going to have to be significantly more safely-run than other banks. They are going to have to hold more capital, and more cash-on-hand as well. There is one thing that we found in this crisis that, I think, surprised a lot of people – access to cash turned out to be really critical. The big banks had it almost automatically because they have insured deposits. We didn’t have bank runs in this country except on a very, very small scale. It turned out that a lot of the financial system had moved away from the big banks – and the small banks, too, for that matter – to be non-banks that relied on borrowing money just from people, in general, not through deposits. They borrowed through the capital markets and it turned out that money just dried up completely. So liquidity is important, capital is important, and both of those are going to be tougher at the big banks.”

New Bill Aimed at Wall Street and Regulatory Agencies

“What we find is the Fed is nominally going to have the consumer protection under them, though in practice it is pretty independent. They are going to keep the regulation of, pretty much, everyone they were already regulating. They are going to get the most important non-banks that are financial institutions. They are going to be the main agent of the systemic council that is going to be looking at wider problems in the industry. The have actually done pretty well for themselves, and frankly I think they are well-off getting rid of a lot of the consumer protection because they are not very good at it. 

Fanny and Freddie were important parts of the crisis. I would not say ‘at the center’ in the sense that that makes them the most important, but Fannie and Freddie were critical parts of this. It is going to be extremely hard to figure out what to do about them, and that is the main reason it was not rolled into this bill. Right now the federal government, directly or indirectly, is basically sponsoring 80 or 90 percent of all new mortgages. There is not that much of a private industry right now. Politicians are desperate to make sure that middle class voters don’t see house prices continue to go down, and they don’t see mortgage interest rates go up substantially. So the logical answer, which would be to gradually move the government out of this business and keep it out, is not what is going to happen. Clearly, nobody wants the government to have this concentration in the business. We want it to be a private business, so we will gradually disengage. But, unfortunately, I think we are not going to disengage nearly far enough.”