The Dismal Outlook for Financial Reform

| Wed Mar. 24, 2010 2:23 PM EDT

I'm going to keep collecting reactions to Chris Dodd's financial reform bill until I feel like I've made some sense out of it. First off, here's Ryan Avent on Dodd's approach to dealing with banks that are too big to fail:

To address TBTF concerns, the bill is relying very heavily on resolution authority, as opposed to measures limiting firm size or leverage or interconnectedness through direct means or the use of strong incentives. So you ensure that some firms will be really big and systemically risky, and then you give regulators discretion to use or not use resolution authority. Discretion, under these circumstances, is exactly what you don't want. It creates doubt in markets that regulators will actually pull the trigger, which will lead to greater risktaking by firms, which will make it more difficult for regulators to pull the trigger in times of crisis.

In fact, it's probably even worse than that. The problem with resolution authority is that it's like a nuclear bomb: it causes a lot of damage and you don't want to haul it out except as a last resort. So the default position for regulators is always going to be the same as it is for the banks themselves: do everything they can to avoid using it. Troubled banks will propose plan after plan to unwind their risky positions and earn their way back to solvency, and regulators, who are terrified of pulling the trigger on a big bank that might still have a chance of survival, will allow things to continue spiraling. And when the shit finally and irrevocably hits the fan, the problem will be massively greater than anyone ever thought it could be.

Much better, then, to try to keep banks from getting into crisis in the first place. That means reasonable leverage and capital regulations. Mike Konczal compares the House approach on this to Dodd's approach:

In both bills, regulators have discretion in how to set limits, as determined by internal risk managers. In the House Bill though, there’s a strict limit: no systemically risky firm can have leverage greater than 15-to-1. In the Senate, the FSOC will make recommendations to the Federal Reserve. The Federal Reserve will do like, whatever it wants — it could follow the recommendations. Or it could not.

This solution in the House Bill is a satisficing solution — there are almost certainly firms that could handle being leveraged 16-to-1. However we don’t trust the regulators to be able to detect that firm and also not bend the rules for firms that couldn’t handle that leverage. So we write down a clear rule.

And these clear rules are exactly what the lobbyists are going to go after.

The House bill is the bare minimum that's likely to work. And even at that it depends heavily on defining exactly how leverage is calculated; keeping a gimlet eye on bank shenanigans at all times; defining "bank" broadly to mean virtually any big financial institutions; getting buy-in from other countries; making sure the relevant regulators consider bank safety to be their primary mission; and then applying leverage constraints in other areas, such as residential and commercial loans. In other words: even the House version isn't all that likely to work. But it's way better than the Dodd version. Congress shouldn't micromanage, and regulators should always have the ability to tighten standards on individual banks, but Congress should put in place an absolute ceiling that can't be easily wisked away by the SEC or the Fed when times are good and everyone thinks they're going to last forever.

So that's where we are. We have a House bill that at least has the right idea, even if it probably isn't either broad or deep enough. We have a Senate bill that, even before it goes through the legislative meatgrinder, is woefully inadequate. And we still have months and months of negotiations to get through, all of it done in the shadow of a massive lobbying campaign from every financial institution in the country to water things down even more. And that's despite the fact that, as near as I can tell, that nobody really disagrees about the general shape of the problem here. There's pretty much universal agreement that reining in leverage is the single most important thing we can do to moderate future financial crises.

Color me pessimistic that this is likely to turn out well.

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