AFTER YEARS of talk, Congress finally has agreed on sweeping reforms to America's financial industry. The old barriers that divided banks from insurers and securities firms will be demolished or at least broken down substantially. Like any deregulation, this one will intensify competition: Banks now can compete freely with other financial players, and only those that serve customers best will be left standing.
But more than most deregulation, this one is fraught with danger. Unstable banks, unlike unstable farms or manufacturers, threaten the stability of the economy. If a bank goes bust, thousands of people and businesses who have entrusted money to it go bust also, setting off a chain reaction of disaster.
Because of that prospect, government intervenes to prevent bank failures: A federal agency insures deposits, and the Federal Reserve stands ready to pump emergency cash into banks that threaten to go under. In the past, government has demanded that banks avoid risky business in exchange for this protection: Hence the ban on securities and insurance underwriting. Now that the ban is ending, taxpayers reasonably may fear that they will be rescuing banks that dive into unfamiliar waters and then fail to resurface.
The reform agreed on in Congress goes some way to addressing this worry. It lays down that banks may combine with insurers and securities firms under the same corporate roof, but in general they may not own them directly as subsidiaries. Thus, if an insurer goes under, the losses will damage the parent holding company but not the bank. In addition to this precaution, the reform requires the biggest banks to issue a kind of bond known as subordinated debt. These bonds are worth nothing if the bank goes bust, so investors will buy them only if they are convinced of the bank's soundness. By forcing banks to issue these bonds, regulators hope to enlist the market's help in keeping banks from undertaking too much risky business.
These measures are not guaranteed to work. Yet despite that risk, Congress was right to go ahead with reform. Innovation and mergers had pierced the old barriers between different types of financial firms, making a mockery of the old rules. Banks traded futures, swaps and other instruments potentially more risky than the insurance or securities underwriting from which they were barred, and in some cases they defied the law by buying companies operating in those forbidden areas.
In the face of those changes, regulators had to catch up. But they have taken on a daunting task. Unless they remain vigilant, taxpayers may find themselves paying for the mistakes that bankers make as they charge into new businesses.