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Dodd 2.0: Maybe we need to reboot

Sen. Chris Dodd unveiled a financial reform bill.
Sen. Chris Dodd unveiled a financial reform bill. (Andrew Harrer - Bloomberg)
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By Steven Pearlstein
Wednesday, March 17, 2010

OMG! I'm turning into Mitch McConnell! :(

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Wading through the 1,336-page "chairman's mark" of the Senate's financial regulatory reform bill, my initial reaction was the same as the Senate Republican leader's response to any Democratic initiative: Put this sucker aside and start over.

Don't get me wrong -- I'm all for clever compromise, but this one looks like the proverbial camel concocted by a committee that set out to design a horse.

When banking committee Chairman Chris Dodd (D-Conn.) unveiled his first draft last year, it was noteworthy for its elegant policy design, its intellectual integrity, its determination to build a robust new regulatory architecture from the ground up, no matter whose toes were stepped on.

Dodd 2.0, by contrast, reads like the chairman and his Senate colleagues couldn't make up their minds about who or what caused the financial crisis or who could be trusted to fix the system. They've come up with a set of jury-rigged patches designed to placate as many interest groups as possible while preserving the existing regulatory apparatus and prerogatives.

One of the big new ideas was supposed to be the creation of a super-regulator whose job would be to scan the horizon for the next threat to the financial system and order day-to-day supervisors to take steps to contain it. Unable to decide, however, whether to hand this awesome responsibility to the Treasury Department, a council of regulators or a Federal Reserve that failed to notice the last storm on the horizon, the senators compromised on a council of regulators, headed by a veto-wielding Treasury secretary, with the power to make recommendations to the Fed. Pretty clever, huh?

To streamline what it called a "convoluted system," Dodd 1.0 would have consolidated federal supervision from four existing agencies into one. Dodd 2.0's less radical solution was to reduce four supervisory agencies down to three: one for state-chartered banks, one for banks with federal charters and one for the biggest financial institutions. This retreat was largely a political accommodation to thousands of small and regional banks that say they had nothing to do with the "Wall Street" crisis, conveniently forgetting their tens of billions of dollars in soured loans to local builders and developers. But having spent years cultivating "friendly" regulators, these pillars of Main Street weren't about to sit by and let Congress saddle them with "one-size-fits-all" regulation and a pesky set of new bank examiners.

Certainly, the strangest compromise in the latest draft was the creation of a new consumer protection agency for financial products within the Fed, which until the crisis had a record in the consumer area unblemished by success. This was supposed to be a clever accommodation to industry types who warned of the end of finance as we know it if consumer protection were transferred to a single-minded new agency. But on closer inspection, housing it at the Fed was just a political ruse. Under Dodd 2.0, the Fed's governors cannot appoint or remove the agency's director, intervene in any enforcement action, review any of the agency's reports or reject any of its proposed regulations. Indeed, the only involvement the Fed would have with its new division would be to write a blank check to finance its operations. The only concession to the industry is that it couldn't directly enforce its rules on small and medium-size banks. That would be left to their regular bank supervisors.

Surely the strongest section of the latest Senate bill is the one, crafted by Mark Warner (D-Va.) and Bob Corker (R-Tenn.), that would bury the idea that there are banks that are too big to fail and therefore must be bailed out when they get in trouble. Under this proposal, any big bank facing possible insolvency could be taken over and forced into an orderly, government-supervised liquidation, with shareholders and managers losing everything and unsecured creditors forced to accept losses. But even that section reflects distaste with recent bailouts given its arcane, convoluted process for deciding whether to pull the plug, one that involves the Fed, the systemic risk council, a panel of bankruptcy judges in Delaware, the Treasury secretary and expedited legal appeals all the way to the Supreme Court. Call it checks and balances on steroids.

Still to come is the bipartisan provision requiring that credit-default swaps and other derivatives be traded on regulated exchanges or processed through regulated clearing houses. It's already clear, however, that there will be so many exceptions for "customized" contracts and companies using such instruments to hedge business risks that it's only a matter of time before trading-desk wise guys figure out how to subvert the new rule.

And that's the problem with Dodd 2.0. There are so many political accommodations involving carve-outs and size limits and overlapping responsibilities that it creates exactly the kind of complexity, the opportunities for regulatory arbitrage and the lack of accountability that got us into this mess in the first place. It's worth remembering that many of the credit-default swaps that contributed to the recent crisis were originally devised by banks as a way around the old Depression-era law meant to keep banks out of the securities business, and by insurance companies looking to avoid insurance regulation.

Financial regulation works best when the rules and structures are simple and straightforward and regulators are invested with discretion for achieving broadly stated goals. Obviously, such an approach requires trust in the competence, integrity and reasonableness of regulators, which as we all know cannot be guaranteed. But, at the end of the day, if you can't trust the regulators, the system is doomed to fail, no matter how the law is written.


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