Real Financial Regulation

| Sat Dec. 26, 2009 9:56 AM PST

Nicole Gelinas writes in the LA Times that the proposed new Financial Services Oversight Council wouldn't work:

Such an "omniscient" regulator could not have prevented our current crisis. Five years ago, such a regulator likely would have declared triple-A-rated mortgage-related securities safe, allowing financial firms to borrow more liberally against them than they could against seemingly riskier securities. The bankrupting losses that eventually occurred from such borrowing seemed impossible back then.

Well, she's got a point. They probably would have looked kindly on financial "innovation" back in 2004. Still, it's possible that a regulator independent from the Fed would have at least a fighting chance of not being completely captured by the banking industry and therefore applying a little bit of pushback against the swelling tide of the finance lobby. Besides, does Gelinas have a better idea?

Oh wait, she does:

Congress should instead follow the regulatory philosophy that served the nation well for 50 years after the Depression: Set consistent limits on borrowing across similar financial instruments, no matter what their perceived risks.

....In 2000, for example, the Federal Reserve counseled Congress to prohibit borrowing limits and requirements to disclose trading activity on some new financial instruments, including credit-default swaps. Regulators believed that they, and financial industry executives, had already done what today's proposed systemic risk regulator would do: identify and erase the potential for error.

What if regulators had instead allowed innovation to flourish within some reasonable rules? AIG, for example, would have had to put a consistent cash percentage down behind the $500 billion in promises — a form of borrowing — that it made through credit-default swaps. And it would have had to execute those promises on public exchanges, making them transparent.

AIG might have gone under anyway — failure is a healthy part of capitalism — but it would not have threatened to take the economy with it, necessitating a government bailout that set a dangerous precedent....Borrowing limits in the housing market would have protected the economy too. As the bubble expanded, people would not have been able to keep up with a requirement for, say, a consistent 20% down payment, thus dampening demand. And when the bubble burst, it would not have left behind so much unpaid debt.

I'd make that trade. In fact, with a few exceptions, I'd trade virtually all of the proposed financial regulations for a single set of new standards that placed clear, simple, and direct limits on financial leverage everywhere in the system. Banks, hedge funds, consumers, you name it. If it's leverage, there's a limit to it.

Anyway, it's the day after Christmas and I don't suppose anyone cares about this. But I do! And besides, Nicole Gelinas had the misfortune to have her op-ed run on Christmas Day itself, probably the single most ignored day of the year on the op-ed pages. (There are no ads for after-Christmas sales on the editorial pages, after all.) So I figured she could use a little break.

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