An analysis of the sweeping reform bill
Earlier today the Senate passed the financial reform overhaul and will be signed into law by President Obama as soon as next week. But this huge legislative achievement has come under considerable attack from all sides of the political spectrum. For commentators on the left, it is reform in name only, unable to prevent another crisis and falling far short of the structural change that our financial system requires. On the other side of the dial, observers have added that the bill adds redundant layers of bureaucracy and the new consumer agency will have the power to impose “job-killing regulations.”
Of course the bill has no shortage of supporters. Not even mentioning the obvious support by the bill’s main promoters and namesakes, Sen. Chris Dodd (D-Conn.) and Rep. Barney Frank (D-Mass.), President Obama has praised the bill’s passage as “the most far-reaching reform since the Great Depression.” Similarly, Treasury Secretary Timothy Geithner said, “The bill that has emerged from conference is strong. It represents the most sweeping set of financial reforms since those that followed the Great Depression.” And from the other side of the aisle, former Treasury Secretary Hank Paulson told The New York Times that the final bill “gives regulation a much greater chance to be successful.”
But beyond the platitudes and the political rhetoric, the Dodd-Frank Wall Street Reform Act represents a seismic shift in the regulatory framework of our financial system. And while no one knows whether it will meet the ultimate test, preventing the next crisis, it will make our financial system more resilient and safe.
To help illustrate some of the improvements that the financial reform bill will usher in, we thought it was worth examining several of the most oft-repeated criticisms to show what the bill doesn’t, and just as importantly, does do.
Too big to fail
This criticism is most often identified with Simon Johnson and James Kwak, the team behind The Baseline Scenario and the book “13 Bankers.” They argue that if a bank or institution is too big to fail, “credit markets see you as a lower risk and as more attractive investment – enabling you to obtain more funding on cheaper terms, and thus become even larger.” This leads to a distortion in the markets as large banks grow larger due to implicit government guarantees.
The straightforward solution to this issue was the SAFE Banking Act amendment proposed by Sen. Sherrod Brown (D-Ohio) and Ted Kaufman (D-Del.), which would have imposed a 10 percent cap on any bank holding company’s share of total insured deposits, limit the size of non-deposit liabilities for financial institutions, and enact a 6 percent leverage limit for bank holding companies and selected nonbank financial institutions. In practice, the amendment would have forced megabanks to be shrunk in size to ensure that no individual failure could bring down the whole system. However, the amendment did not have enough support in the Senate.
So what does the final bill include to tackle this problem? Resolution authority, which is the ability to wind down failing firms in an orderly fashion without resorting to bankruptcy. As Treasury Secretary Geithner told NPR, the bill, “gives the government authority they did not have to limit risk-taking by these institutions … we won’t give them a second chance. We will dismember them, put them out of existence. And what this bill does establish in law, the basic principle that banks should be paying for bank failures, not the taxpayers of the United States.” Well, kind of.
The Financial Stability Oversight Council (another invention of the bill) will monitor systemic risk and make recommendations to the Federal Reserve for increasingly strict rules for capital leverage, liquidity and risk management as companies grow in size and complexity. And the bill clearly states that taxpayers will not pay to save a failing financial company or to cover the cost of its liquidation. But there will not be money set aside in advance to cover these costs, which concerns many. Mike Konzcal, a fellow at the Roosevelt Institute and author of Rortybomb, explains: “It’s much more credible when it’s prefunded; there is actually money that can be used to cover the liquidity needs of the write-down process.”
Bottom line: The financial reform bill does not end too big to fail. NPR’s Planet Money couldn’t find a single expert who agreed with the administration. But additional safeguards and tools have been added to try and prevent these types of failures in the future, including the previously mentioned Financial Stability Oversight Council, which allows for nonbank financial institutions, like AIG, to be supervised by the Federal Reserve, and makes institutions draw up “funeral plans” for their rapid shutdown in case they were to go under. And in the event that a firm does fail, the government has a new tool to help wind it down in an orderly fashion, without resorting to bankruptcy. While not ending too big to fail, we’re better positioned to spot danger before it occurs and deal with it when it strikes.
Consumer agency adds unnecessary layer of regulation
The idea of an independent consumer protection agency with broad powers to regulate consumer finance, including mortgages and credit cards, was originally proposed by Harvard Law Professor Elizabeth Warren in 2007 and quickly became one of the flashpoints of debate in the Financial Reform legislation. The Obama administration incorporated the concept as one of the centerpieces of the bill and just as quickly the agency became a source of controversy. Critics decried the proposal as unnecessary government bureaucracy that would crackdown on businesses that “had nothing to do with the meltdown.”
The original proposal in the House version of the bill was very similar to the idea proposed by Warren: an independent agency with broad powers to write rules and enforce regulations over consumer finance. The U.S. Chamber of Commerce reportedly spent upwards of $3 million opposing the agency, including the creation of an anti-CFPA website with videos, testimonials and tools to take action. They claim that the agency will restrict consumer access to financial products, drive up the cost of existing products and hurt small businesses by “restricting their access to credit.”
However, in the end the Consumer Financial Protection Bureau (as it is called in the Senate version) is a compromise. No longer entirely independent, it now resides inside the Federal Reserve (although with an independent administrator and budget) with broad rule-writing authority, but limited enforcement powers. But this compromise has not stopped it from coming under additional criticism. Sen. Judd Gregg (R-N.H.), who sits on the Senate Banking, Housing and Urban Affairs Committee, blasted the agency on CNBC, “It’s going to become an agency that defines lending on social justice purposes instead of safety and soundness purposes.” On the opposite end of the spectrum, the weakened agency has not stopped Elizabeth Warren (or the bill’s supporters) from supporting the effort. “The bureau has the authority and independence it needs to fix the broken credit market.”
Bottom line: The compromise seems almost to encompass the best of both worlds. The framers avoided having to create a totally new bureaucracy, housing the Bureau inside the Fed, but ensured it would have an independent budget and broad rule-writing ability giving consumers a powerful new ally that “consolidates and strengthens consumer protection responsibilities currently handled” by several federal agencies. Claims that the CFPB would “impose job-killing regulations” are, at this point anyway, unfounded. Moreover, strengthening consumer protections, even if some loopholes slipped by, is an important part of strengthening our economy.
No systemic change
According to a familiar narrative of the reform effort, the Obama administration had two choices when it came to reform: Change the structure of the financial industry or enhance the regulatory framework. And the financial reform bill is without a doubt the latter. “It’s a very technocratic bill” says Mike Konzcal. “It’s a bill that tells a story where regulators did not have enough powers in the middle of a crisis and the real problem was what regulators had scope to do.” And for some critics, this is a fundamental problem with the effort. Robert Reich, a Professor of Public Policy at the University of California at Berkeley and the Secretary of Labor under President Clinton, exemplifies this point of view: “Regulations don’t work if the underlying structure of an industry — be it banking or health care — got us into trouble in the first place.”
Bottom line: There isn’t one structural change (or changes) that can make our financial sector crisis-proof. If there were, we would have done it a long time ago. As David Leonhardt of the New York Times puts it:
The Obama administration and Congress were smart to avoid the magic bullet trap: the wishful idea that one sweeping solution, like breaking up the banks, could prevent the next crisis. Their goal instead has been to improve financial regulation in dozens of ways, making it harder for tomorrow’s regulators to do as poor a job as yesterday’s.
And in this effort regulators have been given a revamped toolset to keep an eye on the financial sector and do their best to avoid “regulatory capture.”
While the bill is not perfect, it’s a vast improvement on the regulatory status quo that allowed our economy to plunge into one of the worst downturns since the Great Depression. And given the political climate and myriad of challenges facing our country, the passage of this reform is a significant accomplishment. As former Fed chairman and White House advisor Paul Volcker told The New York Times: “You have a crisis, followed by some kind of reform, for better or worse, and things go well for a while, and then you have another crisis.” And reform is just that, an improvement. As Doug Elliott from the Brookings Institution recently wrote: “I am confident that the vicious recession we just lived through would have been much milder if the Dodd-Frank bill had been in place a few years ago. The bill will not eliminate financial crises, but it will make them less frequent and considerably milder, which is all we can realistically accomplish.”