April 22 2010

More Bank For Your Buck

Nicole Kurokawa Neily

Although Washington focused on health care reform for the past year, that doesn't mean it's the only thing Congress has been working on. Next up: the financial market takeover of 2010.
 
Sen. Chris Dodd (D-CT) believes that the financial crisis was caused by predatory lenders and lazy regulators, so he is proposing a new set of rules - overseen by a new set of regulators. To put that another way: bureaucrats didn't do their jobs well before, so we need more bureaucrats with more power. Genius!
 
Despite being 1,336 pages long (is there some kind of sick contest going on in the Senate, for goodness sake?), the new bill does little to address the root cause of the crisis. Instead, the plan further fragments oversight of the financial industry between multiple agencies, ensuring that no one entity is positioned to identify potential systemic weaknesses. Information sharing will become more difficult between agencies, no matter how many promises of "we'll work together" may be issued.  And, just as importantly, no one entity will be accountable when things go wrong.
 
Two aspects of the bill are especially troubling: the creation of a new "consumer financial protection agency," and the creation of a permanent bailout authority to seize and liquidate failing firms.
 
Although it sounds good in theory, the creation of a consumer financial protection agency rests on the false premise that consumer interests are separate and opposed to banks' interests. Banks' primary concern - the soundness of the overall system - should also be consumers' concern; after all, if the system collapses, consumers will be the ones who suffer the most. Sending an "us vs. them" message isn't helpful and doesn't address the underlying problems facing the banking industry.
 
The new agency will have authority over both banks and nonbank institutions like payday lenders (which didn't cause the financial crisis), but not over the government-sponsored enterprises (GSEs), Fannie and Freddie, which certainly did contribute to the crisis. Demonstrating the low priority that Democrats place on reforming their lapdog, the Dodd bill lacks a single sentence on GSE reform, which will allegedly be addressed in the future in a separate bill (but don't hold your breath on passage).
 
The fundamental problem with the bill, however, is that it continues bailouts as federal policy. Major banks will be expected to contribute to a $50 billion "reserve fund" that will be used to administer any future wind-downs of failing companies. Federal regulators will have enormous discretion to determine who will be wound down, and how - i.e., who will receive money from the reserve fund, and who won't. Unfortunately, this discretion means that there are no set rules, which opens the door for political corruption and is extremely dangerous for financial markets. Markets require certainty, and this "flexibility" jeopardizes that. And let's be honest - that $50 billion isn't going to come out of thin air, either. Without a doubt, it will be paid for by bank customers through higher fees and borrowing costs, hurting the very people the Democrats claim to help.
 
Rather than a behemoth bill that promises much but fixes little, a better alternative to address financial reform would be a smaller, more incremental set of reforms.
 
First (and it's ridiculous that this even has to be said): Regulators should do their jobs - particularly before any additional authority is given to them! If the government was asleep at the switch, the solution is not to make the switches more powerful - nor to add more switches.

Second: Relaxed lending standards should be ended. Unfortunately, not everyone is responsible enough to achieve the "American dream." No money down means no skin in the game; thus incentives to repay loans are reduced considerably. Previous bad behavior by borrowers, and/ or bad credit, is a bank's best indication of future bad behavior; it should be taken into consideration when making lending decisions, not flagrantly overlooked. Rep. Barney Frank's (D-MA) vision of revising the Community Reinvestment Act to extend to rental housing should be stopped in its tracks.
 
Third: To forestall future moral hazard, Fannie and Freddie should be subject to the same rules and oversight as the rest of the financial world - and lose their special "government guaranteed" benefits. Ideally, they'd be eliminated entirely. Correct me if I'm wrong, but the Constitution does not authorize the government to meddle in the affordable housing industry.
 
Fourth: The easiest way to keep taxpayers from paying for bailouts? NO MORE BAILOUTS. Period. The possibility of failure imposes a market discipline on the system; insulating firms from failure merely encourages risky behavior. Failing firms should be obligated to go through normal bankruptcy proceedings - which should be fixed and consistent.
 
The federal government encouraged irresponsible behavior by borrowers and lenders - which, unsurprisingly, ended badly. It is imperative that those policies be ended before it contributes to the next financial crisis.
 
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