Financial reform is complicated. Understanding why we need it is not.
When President Obama makes his pitch for banking regulation Thursday in New York, he'll have more than enough ammunition. Everybody felt the credit crunch's tsunami, and everybody knows that the wave began on Wall Street. But whereas the motivation for reform is simple to understand, reform itself is infinitely complicated. Indeed Washington is seeking to regulate an industry whose very opaqueness was the cause of the recession. If Wall Street doesn't understand Wall Street, how will Americans understand Wall Street reform?
The key is to keep things simple. In his weekly address last weekend, Obama broke down the case for financial reform into four pieces: (1) creating new consumer protections; (2) shining a harsh on shadow banking; (3) installing measures to end "too big to fail" and (4) giving more power to shareholders. If that address was a template for his Thursday address, here are four themes we can expect for this landmark address.
1. We have to fight for consumers.
The clearest case for reform is the consumers' case, because we are an audience of consumers. Our sense of appropriate leverage ratios might be murky, but our sense of indignation is bottomless. Obama will say that Americans were repeatedly duped into the same devious schemes that eventually wiped out our savings. Even before 8 million workers were victims of the recession, millions more were victims of predatory lending practices, baffling financial products, devious interest rate policies lurking in fine print, and worse. This is the easy case to make. Today we have too many agencies with consumer protection as their fourth priority. What we need is one strong defender whose sole purpose is to make sane disclosure rules so that Americans understand what we're paying for.
2. We have to drag the banks out of the shadows.
The power of light doesn't end with consumer protection. We also need to make shadow banking more transparent. Summing up the origins of the recession, Obama will explain that the crisis began in the shadows, with complex financial instruments sloshing between banks and hedge funds who did not understand the risks they were taking. It's said that what you don't know can't hurt you. But what Wall Street didn't know hurt all of us. The implosion of the shadow banking industry brought down the worldwide financial system and sent our unemployment soaring more than 10 percent.
It's easy to argue that we can't prevent the next crisis without addressing the roots of the last crisis. But it's hard to frame shadow banking reform in a way that won't make Americans change the channel. We could hear something about "turning back the clock, returning to a simpler time," and calling for banks to put a hard wall between their commercial operations and their proprietary trading desks. We could hear vague allusions an "open, free and thriving market," which would mean posting complex financial instruments called derivatives on an exchange and trading them through a central clearinghouse to protect counterparties. The details here get very confusing very fast, so expect Obama to talk more about the need for shadow banking reform rather than the shape it will take.
3. Big is bad...
This is where Obama gets to break out the stick and whip bankers for "recklessness and irresponsibility." Bankers gambled with Americans' money. When they lost, they wound up with ... well, Americans' money. Not only does this story pique our natural sense of injustice, but also there's bad policy at its heart. The implicit government support of large firms gives them unfair advantages in the market. There are two ways to fix this: end the implicit support, or make the firms smaller.
To the first solution, Obama might defend an "orderly liquidation fund," which would help the government wind down failed banks in an orderly manner so that their implosion doesn't create a black hole that swallows the financial sector with them. Last week Republicans attacked this fund for supporting permanent bail outs and the measure has lost some steam. If Obama goes to bat for it, expect something explicit like: "Let me make this clear, there will be no more taxpayer bailouts." Indeed, this "resolution" fund wouldn't bail out the firm. It would stop the chaos.
To the second solution, Obama will likely announce capital requirements or "leverage ratios" that will force banks to either have more cash on hand or make safer bets with their capital. A "safe" leverage ratio is considered about 15:1 (that means for every one dollar of capital you have on hand, you've borrowed 14 more). When Bear Sterns went under, its leverage ratio was 36:1. Lehman's was probably even higher. If we want to make banking less risky, one commonsense solution is to limit risk.
4. ... but banks are not.
You can feel this one coming. It's not in Obama's DNA to attack his enemies with a steady stream of venomous invective. His style is more like what a pick-up artist would call "negging" and an investment banker would call hedging: a shrewd balance of criticism, compliments and to-be-sure concessions. (How many times have we heard something like: "The media is vapid, salacious and petty, but essential to the democratic spirit...?") One should expect the same tone from Thursday's speech. Look out for a penultimate graph along the lines of:
"The time has come for us to reform Wall Street, not because we seek to destroy it, but we seek to save it. Credit is the lifeblood of the economy. It helps businesses grow. It puts students through college. It puts food on our tables and keeps a roof over our heads. We need our banks. But just as urgently, we need to reform them."