Up Front

A Proposal for Financial Reform

Martin Neil Baily

This week the Task Force on Financial Reform, co-chaired by Peter Wallison of the American Enterprise Institute and myself, Martin Neil Baily of Brookings, issued its proposals. Other Brookings scholars on the task force include senior fellows Alice Rivlin and Robert Litan. Our proposals were based on five key principles:

1. The need for a mechanism to provide early warning of increasing systemic risk in the financial sector that could threaten the stability of the system. This mechanism would consist of a Financial Services Oversight Council with the heads of all the major federal financial regulatory agencies and chaired by either the Treasury Secretary or the Chairman of the Federal Reserve. The Federal Reserve would provide the expertise to monitor systemic risk and propose solutions to the Council. The Council would have the authority to require increases in capital or margin requirements in the event that it saw significant systemic risks emerging.

2. No institution should be “too big to fail.” The larger and more complex an institution, the higher the standards for capital, liquidity and leverage to which it should be held. The largest and most complex institutions should maintain wind-down plans that aim to minimize economic damage if they fail. In the event that an institution fails, a hybrid solution should be adopted for failing non-bank financial institutions. First, we should change bankruptcy law so that large non-bank failures are as orderly and predictable as possible. Then, as a back-up, we should create a new resolution process a bit like the one the FDIC uses when banks fail. Since that might be costly to taxpayers, it should be available only after tough safeguards have been satisfied. And any costs should be recovered from the industry.

3. A single regulator that’s strong and smart should replace the multiple alphabet soup of agencies current responsible for micro prudential regulation. We need a single federal regulator to get rid of gaps and turf wars; to raise the quality of regulation while at the same time saving money; to stop institutions shopping for the weakest regulator; and to make it absolutely clear who is responsible in Washington the safety and soundness of individual financial institutions. A single agency could provide the improved quality of regulation that was missing prior to the crisis. The new agency, the National Financial Regulator (NFR) would combine the micro prudential responsibilities of the Office of the Comptroller of the Currency, Office of Thrift Supervision, and Federal Deposit Insurance Corporation. All the responsibilities for the safety and soundness of individual institutions currently at the Federal Reserve, the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Federal Housing Finance Agency should go to this new agency.

4. Derivatives markets and market discipline broadly should be strengthened. While derivatives can help companies and institutions manage risk, they must be made more reliable and transparent?. Institutions would be incented to use central clearing houses and exchanges for derivatives trading. A private Securitization Board would be established to strengthen the securitization process – how the mortgages and other loans get bundled into securities. Bonuses should reward long-term success, not short-term gain.  Banks should issue subordinated debt – it will signal the health of a bank in good times and add to financial strength when times turn bad.

5. The proposals support a Consumer Financial Protection Agency (CFPA) to have the sole mandate of protecting the consumers of financial products and services. CFPA regulation should preempt state laws to support our national market for financial products and services. All the powers for consumer protection for financial products and services currently assigned to federal financial regulatory agencies should be transferred to the CFPA. Other financial regulators should be represented on the CFPA board, so that issues of safety, soundness and efficiency are taken into account as consumer protection the policies are developed and implemented.
 
The task force included fifteen distinguished financial sector experts who started with a range of views about both the causes of the financial crisis and the possible policy changes that are needed to prevent or substantially lower the probability of another crisis. Of the fifteen, eleven supported the proposals. Two of those not signing felt they were conflicted because of their positions. Two had sufficient disagreement that they could not support the proposals. All of those who signed had some level of disagreement with specific elements of the proposals, but judged that financial reform based on these principles would result in a regulatory structure that is far superior to the one that let us all down in the crisis. The task force, therefore, provided a model of bipartisan agreement and compromise in the cause of improving the safety of the financial system.

Read the full commission report »

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