Fixing the Financial Sector in the Wake of the Economic Crisis

November 12, 2009

Senator Christopher Dodd (D-Conn) has introduced legislation to reform the financial sector in the wake of the recent economic crisis. Most notably, Senator Dodd’s proposal calls for consolidating the four federal financial regulatory agencies into a single regulator. Economic Studies Fellow Douglas Elliott says regulation consolidation is definitely in order.


The Dodd bill is over 1,100 pages. Any kind of comprehensive reform is a huge undertaking and has many, many asterisks. The big thing that stood out about Dodd’s bill compared to the administration or the House bills is that he is looking to consolidate all of the federal bank regulators into one new agency. That is a huge thing. It may not seem that way, but in Washington it is extremely hard to ever get rid of an agency. It will make a difference. My biggest concern about the administration’s proposal (which I have generally been quite supportive of) is they did not go very far at all in consolidation. They took the four that Dodd would make into one and cut four to three by taking out the weakest of the regulators. But the problem is, unlike in the free market, if you have multiple regulators it is the weakest regulator that gets big, not the strong one. So I am worried about a crisis 10 or 20 years down the line, not so much where we are now. In that future crisis we will have had plenty of time for a weak regulator to have developed, and to have most of the industry move under that regulator’s coverage. …

The legislation that has been proposed (all of the proposals) are focused both on fixing what went wrong before, and they are also forward looking. I think most people who have been heavily involved in this recognize we are not going to have another major crisis in the next several years, and whatever comes up won’t be exactly like the last crisis. We are looking, now and again, 10 or 20 years to when the real danger is. Nobody knows what the exact form will be. It will probably be some new instrument that we convince ourselves is not dangerous, but, in fact, is. Combined with, almost certainly, a high level of leverage, lots of debt is what makes these bubbles so dangerous. When we have something that blows up like the tech bubble did without a lot of debt involved, it has much less damage. Most of the proposals involve things that would deal with, pretty much, any type of crisis. Now, we will still have some future crisis – we are not going to eliminate that from happening – but crises like these happen and bubbles develop because people run this earth. And we make mistakes, and we tend to run in crowds, and we convince ourselves of things that are too optimistic. There is no way to completely eliminate that, but what you want to do is have things like higher capital requirements so that if something blows up there is less damage done. …

I think we have, probably, three things going on on Wall Street. First, we went from a point in, maybe, March when there were people who though we seriously might be heading into a depression – we went from that to recognizing that it is just a severe recession and that we are clearly coming out of it. So that is a big swing in forward anticipation (which is what the market does – it looks forward some period of time). The significant part of this is a rational change in view. Secondly, the banks and the investment banks are deliberately being helped very considerably by the administration and the Fed. Given how weak they were, there has been a deliberate attempt to keep interest rates low (particularly short-term rates), and so what you have is the banks are borrowing money very cheap and they are lending it out significantly more expensively. This is an ideal environment to be a bank other than the old loan losses, but they’re making so much on new business that they are working their way through those losses. Third, my own personal view is that the market is over-shot. One thing I think the market is missing is that the economy is having a serious problem with all business right now; now, that doesn’t fully show up in the stock market because the stock market is about bigger companies, but the drag from small business’ problems will hold down economic growth which will hurt the big companies, too.