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Financial reform's big unknowns

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By Robert J. Samuelson
Monday, April 26, 2010

The one thing we know about the financial "reform" now moving toward what looks like eventual congressional approval is that it will be oversold, says economist Robert Litan of the Kauffman Foundation. We will be told that it will forever prevent a repetition of the recent financial crisis; that it will root out corruption on Wall Street; that it will eliminate "bailouts"; that it will protect consumers against greedy lenders. In the present anti-Wall Street mood, no one wants to be accused of coddling America's money merchants.

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What can we really expect?

History counsels caution. Every financial reform, even if mostly successful, ultimately gives way to another because there are unintended consequences or unforeseen problems. Sheila Bair, the head of the Federal Deposit Insurance Corp., has noted that the reforms of the early 1990s, which curbed risk-taking within the banking system, perversely shifted lending to the largely unregulated "shadow banking system" -- mortgage brokers, specialized lenders and "securitization." The central aim of today's reform is to avert another financial panic. A panic is not a bubble or just big losses. These are inevitable and, in part, desirable: Without losses, investors would become reckless. A panic is a stampede of selling and hoarding, driven by fear, that threatens the financial system and, through it, production and jobs. A panic occurred in September 2008 when Lehman Brothers failed. Distrusting most financial institutions, investors and money managers fled to safety (a.k.a. Treasury bills).

By its nature, a panic is unanticipated. Reform may resemble generals fighting the last war. Suppose the next financial crisis originates in runaway federal debt, which undermines confidence in the vast market for Treasury securities. Interest rates and currency values would react violently; the ripple effects would spread globally. The irony would be clear: While preaching financial reform, the White House and Congress fomented the next crisis by sanctioning long-term budget deficits.

The legislation also omits the strongest safeguards against financial meltdowns: tougher capital requirements. Capital mainly represents the stake of shareholders in financial institutions; it provides a cushion against losses. Pre-Lehman, banks' capital represented about 10 percent of their assets. Some experts would raise that as high as 15 percent. But the legislation leaves capital requirements to regulators, led by the Fed and Treasury. They are negotiating with other countries to set global standards. The outcome is unclear, and there's a dilemma: Overly tough capital rules will discourage lending.

Still, the legislation seems on balance a plus. Though not eliminating the threat of future crises, "it makes them less likely," says Litan. The "too big to fail" problem has been mitigated, if not entirely solved. During the crisis, the government faced an unsavory choice. Letting huge financial institutions fail threatened a chain reaction by inflicting losses on their trading partners. When Lehman went bankrupt, chaos followed. But rescuing large, ailing institutions could be highly costly for taxpayers, as the AIG bailout showed.

Under the congressional proposals, the government could shut down crucial financial institutions gradually and recoup the costs through taxes on other financial institutions. Broadly speaking, this extends the FDIC's authority over banks to include large non-banks such as AIG and Lehman or, possibly, hedge funds. There are critics. Peter Wallison of the American Enterprise Institute thinks close regulation of too-big-to-fail financial organizations will give them a privileged status and make them "tools of the U.S. government." Nevertheless, something seems better than nothing.

Financial stability should also benefit from bringing many transactions out of the shadows, says Robert Pozen, chairman of MFS Investment Management and author of "Too Big to Save? How to Fix the U.S. Financial System." Chief among these are "derivatives," most prominently the now-notorious "credit default swaps." Most were traded on the over-the-counter (OTC) market; that's finance-speak for telephone and e-mail links between traders and customers.

Derivatives can serve legitimate economic purposes -- hedging against credit risk or swings in interest rates, for instance. But the reliance on OTC markets created massive exposures in almost complete secrecy. AIG's exposure to credit default swaps exceeded $400 billion. The Obama proposals would force much derivative trading onto clearinghouses and exchanges. This would limit risks, notes Pozen. Clearinghouses would require that derivatives be priced daily and that traders whose positions lose value post extra collateral. That would ensure they could deliver on their obligations.

All this sounds encouraging, but we can't know the full consequences of financial reform. It's not just that many issues remain unsettled, including the "Volcker rule" (named after former Fed chairman Paul Volcker, it would restrict banks' ability to do trading for their own accounts) and the powers of the proposed consumer finance agency. There's a deeper reason for humility. The financial system's size, complexity and global nature defy attempts to chart its future. No "reform" is, or can be, forever.


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