A Full Overhaul

Congress is now approaching a crucial opportunity for financial reform. Such a reform must be tough and intelligent, as a weak reform would create a dangerously false illusion of security and stability. The House passed a major regulatory bill in December, and now Chris Dodd has brought his own Senate proposal to the floor, for debating over the next few weeks. Financial regulation must specifically address capital requirements for banks, the tools to liquidate failed financial institutions, consumer protections, derivative trading, and the immense trading operations of many major investment banks.

Raising and strictly enforcing capital requirements is vital to creating a more stable financial system. During the financial crisis, plummeting assets and the consequential market panic caused almost every major bank to fear for its solvency. Had there been more stringent capital requirements, banks would not have been in such dire trouble. As Alan Greenspan notes in his recent paper on the crisis, while requirements should not be onerous, they should leave banks in a position to effectively manage during most crises. The current legislation in the Senate directs regulators to enforce higher capital requirements but without specific capital levels. This policy must be maintained in the final bill with specific requirements, despite almost-certain industry opposition to capital measures that would alter current ways of business.

Even with this cautionary measure in place, the nature of markets and a capitalist economy is such that the failure of major institutions is inevitable. The challenge for regulators in our hyper-connected economy is to ensure that such a failure can occur in a systematic and controlled manner. Resolution authority, the ability for the executive branch to unwind failing institutions in a speedy and contained manner, funded by a bank tax that would facilitate this process, is included in both the House and Senate bills, and is a good step in this direction. Such a resolution authority must be developed in concert with international bodies, as the fallout from the failure of global financial institutions is far-reaching.

An area of fierce contention in the regulatory debate is that of an independent Consumer Financial Protection Agency, but such an institution is vital. Complex financial products wrought destruction on everyone from pension fund-owners to everyday homeowners. An independent CFPA would regulate financial “innovations” such as clever securitization schemes and subprime mortgages that harm lower-income Americans and pension funds while risking the stability of the economy as a whole. The Senate bill currently has a CFPA under the purview of the Federal Reserve Bank, however the creation of an independent agency would give it greater stature and thus the power and influence to adequately do its job.

In addition, the dangerous market for derivatives, financial instruments that are used to hedge against changes in asset prices, must be strictly regulated. Complex derivatives were often traded without effective monitoring, allowing companies to quietly amass incredible risks on their balance sheets. The House bill proposes that derivatives be regulated through a clearinghouse, a useful suggestion that should be kept strong so that few, if any, derivatives escape the overview of a regulator.

Finally, and perhaps most importantly, Congress needs to take a hard look at how these banks are structured and the purpose they serve in today’s economy. As Roger Lowenstein wrote in a recent article, banks today make an overwhelming percentage of their profits from trading, in effect making them giant hedge funds-in-disguise that pose a stability risk to the market while also performing some banking operations. The Volcker rule, which would ban banks from engaging in proprietary trading, would change technical classifications that are easy to work around, as investment banks could shift risks or sell their deposit-taking businesses with little pain. As Lowenstein notes, a transaction tax such as the one that has been proposed in England could at least raise revenue and begin to change the incentives for financial institutions.

Congress has made useful progress on some of these steps but faces fierce fights against industry lobbyists in the months ahead. Their ability to keep tough protections as well as develop regulations and structures in concert with the international community will determine whether these regulations are meaningless or create a new foundation for the financial system—and the latter is absolutely necessary to prevent another international crisis.

Ravi N. Mulani ’12, a Crimson editorial writer, is an applied mathematics concentrator in Pforzheimer House.