Ahead of the next boom-bust cycle

Sunday, May 23, 2010

INSTANTLY LABELED "historic," the Senate financial regulation reform bill is certainly a very big deal on paper. In the course of 1,400 pages, the legislation rejiggers federal oversight of everything from systemic risk to consumer credit. Sweeping as it is, however, the bill can be evaluated only in light of the problems it purports to solve. Anyone should think twice before expecting a future free of financial chicanery -- much less financial crises -- if something like this text emerges from a House-Senate conference and gets signed by President Obama. But if judged by a more realistic standard -- the degree to which it corrects those correctable flaws in past law that contributed to the financial collapse of 2008 -- then the Senate's handiwork comes off pretty well in at least two important respects.

As we have argued previously, there is probably no ironclad solution to the "too big to fail" problem. Perhaps the best way to prevent overleveraged financial giants from taking the system down with them is to prevent them from getting overleveraged in the first place. The bill addresses this by requiring regulators to raise capital requirements.

Government can and should be equipped with options other than messy bankruptcy or total bailout when faced with events such as the collapse of Lehman Brothers and American International Group, as it was in 2008. In that respect, the bill includes a credible executive-branch resolution process, adopted as an amendment by an overwhelming bipartisan majority, that provides for an orderly wind-down of systemically important firms without rewarding its unsecured creditors.

Similarly, the crisis has provided the world with a lesson in the systemic hazard posed by derivatives -- the hedging devices that range from corn futures to synthetic collateralized debt obligations. There is widespread agreement that the greatest possible number of derivatives should be traded through a clearinghouse, with standard margin requirements and greater transparency. This, too, the bill would achieve, with appropriate carve-outs for truly non-standard swaps and for commercial businesses that use derivatives primarily for hedging, not speculation.

Where the bill goes too far, in our view, is by requiring banks to spin off their credit-swap businesses completely. This provision, drafted by Sen. Blanche Lincoln (D-Ark.) amid her tough re-election bid, sweeps aside the distinction between banks' purely speculative trades and those they necessarily engage in to hedge risk or to serve clients. It's unlikely to survive the conference committee and probably shouldn't.

The Senate bill represents progress in the sense that it might have helped prevent the crisis we have just been through and it might help moderate the inevitable boom-bust cycle in the future. Alas, even the wisest regulations cannot abolish financial ingenuity, greed and myopia. No one can safely anticipate anything about the next crisis except that, one way or another, there will be one.

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