Checking Up on Financial Reform

| Tue May 25, 2010 2:25 PM EDT

If financial reform is passed — and it looks like it will be — how can we tell if it's working? Mike Konczal offers a couple of metrics:

The most obvious problem would be if the market finds resolution authority non-credible and starts lending to the five biggest firms as if they had a permanent government and Federal Reserve backstop....The next thing to watch is whether derivatives are reformed, and how much the laws are gamed in general. Will Goldman Sachs drop its bank holding company status, add a 20 percent non-financial wing and declare itself an end-user, and whatever other complicated acrobatics the lawyers are dreaming up? That all depends on the wink-winks that the regulators will give, and we will never see those on the outside. All we can do is watch for the effects.

I'd add a couple of other things. The first is leverage. This is easy to hide and hard to measure, so it's imperfect. Still, there are various good measures of leverage in the banking industry, and if reform works they should stay at moderate levels even when the economy picks up.

The second is easier: industry profitability. If reform works, Wall Street should be less profitable. Not because anyone is trying to punish them (though obviously plenty of people would like to), but because a safer, more real-world-oriented banking sector is inherently less profitable than the trading and finance-oriented one we have right now. If industry profits stay at 2005-07 levels, it's solid evidence that nothing has changed and they're acting pretty much the same way as always. So that's four things to watch for:

  • Borrowing rates for large banks
  • Derivatives trading
  • Leverage ratios
  • Industry profitability

My guess is that on all four of those metrics, we'll end up improving on where we were in 2005-07 but not by as much as we should. But at this point, any improvement at all is a big win.