The Good and Bad of the Republican Financial Reform Alternative

The Republicans may have some legitimate concerns about Democrats' financial reform bill, but their reported alternative has some problem of its own. The Wall Street Journal's Real Time Economics blog has obtained a 20-page summary of the Republican plan. It eliminates the concerns Republicans have, some of which include the controversial resolution fund, forcing banks to spin off their derivatives business, and a too powerful consumer protection agency. While some of their ideas are good, others need a little more thought. Here are some highlights.

The Good

GSEs

Perhaps the most sensible move by Republicans is to add in some oversight and regulation for Fannie Mae and Freddie Mac. Virtually everyone agrees these government-sponsored entities played a pivotal role in the crisis, as they were the biggest bailout recipients. Yet Democrats' financial reform proposals completely fail to address these troubled firms.

Financial Stability

The Democrat bill would create a list of systemically regulated firms. This remains an area of contention, because Republicans worry that these firms will be seen as too big to fail and receive a special competitive advantage in the market as a result. The Republicans appear to create a similar systemic risk regulator to watch over the economy, but without the list of firms.

Derivatives

The Republican bill almost certainly wouldn't require banks to spin off their derivatives desks, though this isn't explicit in the WSJ highlights. As long as banks remain in the business, the derivatives industry will be much more stable. Their large capital bases will provide for a safer market.

The Bad

Resolution

Republicans identified a legitimate problem with the Democrats' proposed resolution fund used to wind down large firms. The right believes that it would provide an advantage to those firms, since their creditors and/or counterparties would be more willing to do business with them, due to their access to these funds through failure. Yet, here is the Republicans' strange alternative:

The FDIC would be able to advance funds to creditors, but it would have to recoup from creditors any money a creditor received in excess of what it would have gotten in bankruptcy.

That sounds great in theory, but in practice -- what happens if those creditors can't pay back the FDIC? One can only imagine that the cost falls on the shoulders of taxpayers. Even though the Democrats' resolution fund has some problems, at least taxpayers would be left out of it.

Fed

The Republicans want greater Fed oversight. That's not necessarily bad -- so long as it doesn't interfere with the Fed's independence. But it also looks like the Republicans want to limit the Fed's ability to stabilize the financial markets. That's inadvisable. Without the Fed's ability to calm markets and restore liquidity, the financial crisis would have been much, much worse.

Derivatives

Yes, this was just listed as a good idea. But it isn't all good. Republicans appear to fall prey to the same misconception about derivatives as Democrats. They intended to allow for clearing exemptions as regulators see fit. That's good. What's not good is that they continue worry about the distinction between "swap participants" (think speculator/investor) and "end users" (think farmer or other non-speculators), saying the latter doesn't need to clear its derivative exposure or maintain collateral requirements. Yet, more often than not, these two kinds of parties are on either side of a derivatives transaction. Does only one side need to clear? How much will that screw up netting for the clearinghouse? And why shouldn't non-bank firms be forced to put up collateral? If they run into financial trouble, they could also default on their derivatives obligation.

In a perfect world, Congress will reconcile Republicans' good ideas with the smart ones that Democrats have already offered. That might happen to some extent, as it appears that Democrats will have to make concessions to get to 60 votes, after failing for the past two days to pass a test vote. How much they'll give, however, is hard to say. Clearly Republicans won't get all of what they want, but they might get some of it. Both sides of the aisle know financial reform must pass. Let's just hope Democrats incorporate Republicans' good ideas and not their bad ones.

Update: Just found the full summary text here.