Sen. Dodd's regulatory rewrite

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Thursday, March 18, 2010

REGULATORY FAILURE alone did not cause the financial crisis. Regulatory reform alone cannot prevent the next one. However, gaps and weaknesses in the regulatory structure contributed to the financial system's breakdown, and Congress should make repairs before memories of the disaster fade and complacency sets in. Given the trade-off involved -- protecting against systemic risk without unduly raising costs or stifling needed innovation -- this would be a hard job for a panel of experts working under laboratory conditions. For a bitterly divided Congress, it could prove impossible.

Does the draft bill recently unveiled by the Senate Banking Committee's chairman, Christopher J. Dodd (D-Conn.), pass the test? At the heart of the crisis was the issue of "too big to fail": the perception that Washington stood behind certain giant market players, whether because of federal deposit insurance in the case of banks or implicit debt guarantees in the case of Fannie Mae and Freddie Mac. Over time, this enabled such institutions to take on much more risk than they -- or the economy -- could bear, and taxpayers got stuck with the tab.

Mr. Dodd's plan attacks this in two ways. Like the House bill, it would authorize a council of regulators to name systemically risky institutions, limit their leverage and require them to pay into a $50 billion resolution fund that would deal with a big firm's collapse. To be sure, listing "too big to fail" institutions only encourages the market to offer them artificially easy funding. But at least the bill provides a way to rein in the risks they take with that money, and taxpayers won't be on the hook if they nevertheless collapse. Unlike the House bill, the Dodd plan also includes a version of the "Volcker rule" that would ban proprietary trading by deposit-taking banks. Debate since President Obama embraced this idea suggests that, while wise in theory, the rule will prove hard to enforce in practice -- and that the banks' "prop desks" were not necessarily a major cause of the crisis.

In the health-care debate, the "public option" inflamed supporters on the left and foes on the right. The Dodd bill's counterpart is a new Bureau of Consumer Financial Protection. Though Mr. Dodd, bidding for Republican support, agreed to put the new agency nominally within the Federal Reserve, it would still have great autonomy and power to make and enforce the rules for everyone from mortgage brokers to payday lenders. If anything could provoke a filibuster and sink the bill, this is it. Unchecked subprime loans and other poorly understood consumer financial products did contribute to the crisis. More transparency, better enforced by government, would prevent repetition of that. But the causal link between poor consumer regulation and systemic breakdown is less clear. If there has to be compromise to get a bill, this might be the area to seek it.


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