3 Huge Problems Financial Reform Ignores

Congress has argued for months that financial reform is necessary to prevent another crisis. Some of the suggested measures it intends to take would help reach that goal. A systemic risk regulator might have better luck at spotting threats to the economy. A non-bank resolution authority might do a better job of winding down large firms. Yet, some economists worry that the effort fails to focus on many of the major problems that led to the crisis. In a New York Times article today, a diverse group of experts argue that Congress isn't paying attention to the some of the aspects of finance that need reform most.

Fannie & Freddie

One big problem: the government-sponsored mortgage entities, which essentially everyone agrees paid a major role in the financial crisis. They have been the recipient of a still growing $200 billion bailout. One Times source agrees:

Lawrence J. White, a finance professor at New York University, said it made no sense to overhaul financial regulation without addressing the future of federal housing policy. He said he was trying to find the strongest possible words to describe the omission of Fannie Mae and Freddie Mac from the legislation.

"It's outrageous," he finally said.

This is also a Republican complaint. Fannie and Freddie played a huge role in helping to overheat the U.S. mortgage market. Until those agencies experience some fundamental change in policy and procedures, it's hard to see how another housing disaster won't occur again in the future. There's no attempt at any reform for these companies in either of Congress' financial regulation proposals.

Credit Runs

The financial crisis was actually caused by a credit crunch. There was a sort of investor panic that led to banks and businesses not being able to turn over their short-term debt. Yet, nothing in the reform proposals would fix this problem. The article also addresses this point:

Gary B. Gorton, a finance professor at Yale, said the financial system would remain vulnerable to panics because the legislation would not improve the reliability of the markets where lenders get money, by issuing short-term debt called commercial paper or loans called repurchase agreements or "repos."

This was especially problematic for banks. Often, they would fund their long-term lending through short-term borrowing. That's why the credit crunch was so dangerous. Congress' reform fails to provide a solution to this problem. In fact, the non-bank resolution authority might not help avoid credit runs. How would it intend to stabilize the repo and commercial paper markets when a giant firm fails? This could be one of the "costs" that the resolution's fund would pay for, but that remains unclear. Indeed, that fund may even be eliminated before the legislation is finalized.

Leverage, Capital, and Reserves

Related to this problem is that banks had too much borrowing compared to their assets. Some institutions like Lehman and Bear Sterns had ratios around or exceeding 30 to 1. Fannie Mae was leveraged something like 60 to 1. The financial reform proposals would mostly leave leverage, capital and reserve requirements up to regulators to set at a later time. Their argument is that these rules are difficult for Washington policymakers to decide in a vacuum and should be coordinated on a global basis. University of Pennsylvania professor David A. Skeel Jr. isn't convinced that will work:

"Regulators working right now will be tough," Professor Skeel said. "But we know from history that as soon as this legislative moment passes, the ball is going to shift back into Wall Street's court. As soon as the crisis passes, what inevitably happens is that the people that are paying the most attention are the banks."

Certainly, history supports his view. Regulation tends to be far less aggressive as an economic cycle gets further from its trough. The House's version of regulation would limit leverage to a ratio of 15 to 1, but the Senate bill has no such requirement. If financial institutions had more capital to back up their borrowing -- and if their obligations were more transparently represented -- then a credit crunch might not have been as widespread a problem.