Media Starting to Notice Flaws in the Senate's Financial Reform Bill

If you need a primer on current financial reform legislation, the Washington Independent has a good summary; both Republican and Democratic proposals are fairly similar. Daniel Indiviglio at the Atlantic sums up a NYT article that quotes experts questioning whether Sen Dodd's bill really gets to the causes of the economic meltdown, boiling it down to 3 glaring deficiencies:

• The bill does not deal with Fannie or Freddie, the GSEs that played a major role in the crisis (the Republican proposal begins to deal with the GSEs; Democrats say this needs to be addressed in a separate bill)
• The bill does not address the credit crunch that led to investor panic; banks were not able to turn over their short term debt
• The bill leaves it up to regulators to determine capital reserves and leverage requirements at a later date. There are concerns that regulators will be less aggressive as the economy recovers.

Erza Klein links to another proposal at the Econlog:

Here I'd direct you to Arnold Kling's 8-point FinReg fantasy. Kling is an adjunct scholar at Cato and a former economist at the Federal Reserve, but his plan -- which includes getting Fannie and Freddie out of the mortgage market, breaking up big banks, and making derivatives less attractive by deprioritizing them in bankruptcy hearings -- doesn't read like the Republican plan and it doesn't read like the Democratic plan.

The argument over the policy of financial reform -- which is distinct from its politics -- is not between Republicans and Democrats, or even liberals and conservatives. It's between people who think the financial sector needs to be changed and people who think we just need to give the regulators more information, power, and instructions so they can look after it better. Kling is a libertarian and I'm not, but we're probably closer on this than I am to either the Democratic or Republican proposal. 

Kling's proposal gets the government completely out of the mortgage market, except for some tax vouchers to the poor. He also ensures creditors hold debtors responsible for their behavior, which is what should happen in a functioning market economy: 

5. Replace capital requirements with systems that put senior creditors in line to lose money in a default. Let them discipline the risk-taking of financial institutions.

6. Define priorities for creditors in a bank bankruptcy. I think that the solution to the social value--or lack thereof--of derivatives and other exotic instruments can be handled by the priority assigned to them. I would assign them a low priority. That is, first ordinary depositors get paid off. Then holders of ordinary debt. Other contracts, such as swaps or derivatives, come after that. I think that this would provide all the incentives needed either to curb derivatives or lead them to be traded on an organized exchange. I don't think that getting them onto an organized exchange should be sought after as an end in itself.

Another alternative worth considering is in John Taylor's op-ed via the WSJ, "How to Avoid a Bailout Bill", which outlines changes in bankruptcy law to be able to deal with systematic risk type institutions quickly.  


I'm not really optimistic a "Council of Federal Regulators" will be able to stop systematic threats, or that current draft legislation will really end bailouts. Congress, current regulators and the Fed did not see the need to fundamentally change the rules in an attempt to avoid the crisis. Erza Klein points this out today when he posts to a transcript of Alan Greenspan and other Fed members in 2004, dismissing their own data on the housing bubble, believing economic fundamentals were sound.  Klein writes:

But this is why you need to be very careful with the idea that regulation plus information is sufficient. We had regulators and they had information. And it proved totally insufficient. When I asked Sen. Mark Warner how the bill would have stopped the crisis, the first thing he brought up was the Office of Financial Research, which is there to distribute real-time information. Maybe the OFR would put the dots together and maybe it wouldn't, but there's a serious chance that even if it did, the top-line regulators would find reasons to ignore the conclusions of these nameless quants who don't understand the sophistication of the risk analysis being performed on Wall Street, or the anger that the president and the Congress and the Wall Street Journal editorial page will turn on any regulator dumb enough to try and interrupt the good times based on a graph and a theory.

Unfortunately, I don't think we're going to get anything as sensible as Kling's proposal due the politics of upcoming midterm elections.