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The Art of Financial Reform

The ability of Congress to adopt smart regulations hinges on six critical questions.

Most economists believe excessive deregulation of the financial sector was a major cause of the Great Recession. So it seems obvious that financial regulations should be redesigned. Yet banks and other financial firms oppose any regulations requiring them to significantly alter the behavior that almost sank the U.S. economy.

They claim regulation never works and that regulators are likely to be outsmarted by the industry they regulate. That argument disguises a more powerful motive: banks don't want the ability to make huge profits constrained by regulations, even if it helps the economy.

Yet most citizens rightly believe that allowing the financial industry to continue under current regulations will result in worse future crises. The contentious issue centers on which organizations should be given the power to regulate various parts of the financial sector. And what specific rules should they adopt?

As pointed out in my previous columns, the U.S. financial sector is inherently unstable. But it should be possible to prevent its vacillations from creating major financial crises. The challenge is to determine which regulations are likely to be most successful in detecting crises early enough to limit their damage.

Financial regulations should produce answers to the following six questions:

  1. How can potentially destabilizing policies within the financial sector be detected far enough in advance to prevent major crises? This involves recognizing “systemic risk” before it is too late to avoid disaster. A proposed bill by U.S. Sen. Christopher Dodd (D-Conn.) calls for a nine-member council of the heads of major regulatory agencies to perform this function.

  2. How can mortgage borrowers be protected from fraudulent and harmful lenders? And how can investors in mortgage-related securities be informed enough about the quality of those securities to avoid a high probability of defaults or losses?

    The Federal Reserve Bank has already adopted new regulations concerning the origination and distribution of home mortgages. But how to organize credit rating agencies that will be honest and accurate has yet to be determined.

  3. How can all types of financial derivatives be registered in public exchanges so as to provide accurate data to regulators about the nature and extent of derivatives?

    Currently, derivatives can be dreamed up and carried out in private by two or more parties who are not required to report to anyone. Dodd's bill proposes that nearly all derivatives be registered in exchanges. Bank lobbyists are strongly opposed to that provision.

  4. How can lenders be prevented from becoming so large that their failure causes major disruptions in the financial system? If banks become too big to fail, the federal government has to bail them out with taxpayer funds if they over reach their ability to support their debts. Knowing this, managers of such banks are motivated to undertake highly risky activities in order to reap huge profits.

    Simon Johnson, former chief economist for the International Monetary Fund, has proposed in the book “13 Bankers” that no financial institution be allowed to hold assets exceeding 4% of U.S. GDP, or about $570 billion as of December 2009.

    At the time, the assets in each of six banks exceeded that amount: Bank of America, J.P. Morgan Chase, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley. Johnson and his co-author James Kwak say Congress should force these banks to downsize.

  5. Which existing or new financial regulatory agencies should be assigned to cope with the above issues? After all, how can the agencies entrusted with these issues be prevented from being captured by the financial sector?

    President Barack Obama has recommended a separate Consumer Protection Agency, which Dodd places within the Federal Reserve Bank, but with significant powers of its own. Most banks and Republicans oppose this agency.

  6. How can regulatory agencies be insulated enough from electoral politics to avoid being manipulated by Congress and the administration? This is a critical problem with a congressional election looming in 2010 and a presidential election in 2012.

    Lenders who have earned giant profits are lobbying heavily against any serious re-regulation of the financial sector. In view of Wall Street's lobbying, greedy members of Congress will probably neither reduce the size of banks too big to fail, nor force nearly all financial derivatives to flow through exchanges.

    Only powerful leadership from President Obama has a chance of making financial reform more effective.

Tony Downs is a senior fellow at the Brookings Institution. He can be reached at [email protected]

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