The Financial Reform Bill

Remarkably enough, bearing in mind the size of the bill (call it 2,300 pages) and the inordinate amount of time needed to pass it, the financial reform that the Senate sent to the president's desk on Thursday is only one more marker on a long and winding road.

The bill leaves multiple regulators with wide discretion across a range of critical issues. The argument over precisely what the new rules will be is barely getting started. Some of the most important questions -- such as the amount of capital financial firms will have to set aside -- are scarcely even addressed. Again and again, the bill calls for studies to be undertaken. No matter how these open issues are resolved, unintended consequences will come thick and fast. The whole thing is unfinished work with a vengeance. Nonetheless, better this than nothing.

The biggest and most valuable ideas in the bill are the Financial Stability Oversight Council and the new early resolution authority. Concerning the first, formal system-wide oversight was lacking in the old regime, a fatal flaw. It is good to have a single entity charged with that role, even if the entity is a panel of representatives from many different agencies. A much simpler structure would have been preferable for many reasons -- not least, it would have made international co-operation easier (more on this in a moment) -- but failing this the new oversight body is still a big improvement.

Early resolution authority is the bill's main defense against "too big to fail". The idea is to have the FDIC apply a pre-emptive liquidation procedure, like the one it currently uses for banks, to any systemically important financial firm that looks headed for collapse. The idea has been controversial, but it seems to me indispensable. The lesson of Lehman cannot be unlearned. For the foreseeable future, the authorities will not let an institution of that kind fail: unfortunately, the earlier effort to resolve the problem of moral hazard, by denying Lehman support, has enormously compounded it.

And I fear that breaking the biggest institutions into smaller pieces, as many of the bill's critics wanted, would have been a partial answer at best, as well as costly in other respects. Assume no super-banks. Even then, what regulator is going to risk a repeat of Lehman and its consequences? Planned pre-emptive intervention looks a better bet -- though, as elsewhere, the details matter. How well this will work in practice, or whether it will work at all, we are going to find out.

I expect less of the consumer-protection side, because the underlying trade-offs are so politically fraught. Dodd-Frank lays out a broad mandate for the new Consumer Financial Protection Bureau, and confers broad powers. That is all very well. Good politics too, I expect, for the time being. But wait till the new regime bites.

The law is silent on how the consumer protection agency should balance the directly competing goals of greater safety and wider access to finance. As Raghu Rajan argues (see my review of Fault Lines), the political push to widen access to credit, especially housing credit, was a crucial contributor to the crisis. The politics of acces to credit has not gone away. Let's suppose the new bureau succeeds in reducing outright fraud (of which there was plenty) and patent recklessness (of which there was more); a difficult trade-off still remains. If the agency significantly shrinks the availability of credit for low-income borrowers, it will not stay popular with the politicians who have championed it for very long. Therefore, it will not significantly shrink the availability of credit.

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