The Future of Financial Reform

Editor’s note: In testimony before the U.S. Congress’ Joint Economic Committee, Robert Litan addressed the central question of how and when private sector activity – consumption, investment and exports – will begin to not only sustain overall growth, but also start bringing unemployment down continuously and significantly.

Chairman Maloney and members of the committee: Thank you for inviting me to appear before you today.

My name is Robert Litan and I am here today primarily to discuss financial reform issues on behalf of the bipartisan Task Force on Financial Reform, of which I am a member. The Task Force is ideologically diverse and has as its members both academic economists and financial industry practitioners. This group was first convened in June and given the task of producing bipartisan, consensus recommendations designed to meet one overriding goal: to create a financial system that allows the U.S. economy to grow without the kinds of risk we have recently witnessed and unfortunately experienced. I am pleased to discuss here today, together with Robert Steel, another Task Force member, the Task Force’s five core principles for reform.

We are meeting at critical time for the economy, underlined by the President’s plans to hold a major jobs summit tomorrow. Hopefully, some creative ideas will come out of that meeting.

But there are already some ideas and subjects already on the table that need to be addressed if we are going to put our economy on a sustainable footing. One of those subjects is fixing the financial system. Until this happens, businesses of all sizes, large and small, cannot expect to gain the credit and financing they need as long as our financial institutions remain weak and at risk of future crises. Banks won’t lend otherwise, or if they do and the incentive structures that helped lead to the recent financial crisis are not fixed, we will simply embark on yet another boom-bust cycle which none of us wants to repeat.

I understand that some feel that we should take time to better understand the causes of the financial crisis before we reform the system. While I have some sympathy with view, I also believe the danger from inaction is greater. Moreover, if we remember back to the Pecora Commission that investigated the causes of the Depression, that Commission only launched a debate that continues even today. Meanwhile, Congress did not hesitate then to act and, in my view, most of what it did to fix the financial system has stood the test of time remarkably well. Likewise, Congress should not wait this time to fix what clearly needs fixing.

I will spend little time on going through the extensive list of causes of the crisis, of which we and you know there are many: an extended period of low interest rates coupled with the continuous heavy inflow of savings from abroad; the widespread perception that U.S. housing prices would not fall; various government policies that encouraged excessive home mortgage lending; opaque mortgage backed securities (CDOs and their progeny) that were unwisely rated by the ratings agencies and insured by the monoline bond insurers; major failures in oversight of financial institutions; failures in risk management at many financial institutions; compensation structures that encouraged imprudent excessive risk-taking by mortgage originators and securitizers; unscrupulous mortgage lending practices; and so on. I know others have used this analogy, but it won’t stop me from repeating it here: the culprits of this financial crisis are many, like all those on the train in the famous Agatha Christie story and movie, Murder on the Orient Express.

The members of the Task Force extensively debated these causes and what to do about them. We ultimately did not agree on every item of reform, or agree to take up every subject that has been connected to this crisis. But we did concentrate on some of the major issues in need of legislative attention. After much very useful and instructive back and forth discussion, we agreed on some consensus recommendations, backed by what we hope is useful analysis that will help the Congress as it goes about the critical task of reforming our nation’s financial laws to dramatically reduce both the likelihood and severity of future financial crises.

In this connection, all of the Task Force members commend the Congress – both the House and the Senate – for the hard work that has been on reform so far. You will find many common elements between our recommendations and the specifics in the bills that have come out of the House Financial Services Committee and that are now being considered in the Senate Banking Committee.

It is in that spirit that I now briefly outline our five key principles of reform and a brief summary of some key recommendations. My colleague on the Task Force Robert Steel will offer some additional details on some other key Task Force recommendations.