Overrating the FinReg Bill: In Which I (kind of) Disagree with Matt Yglesias and Ezra Klein
Matt Yglesias and Ezra Klein have a couple of posts up touting the merits of the Wall Street reform package that Congress approved yesterday. In general, I agree with them, but in a couple of areas, I think they're over-selling the bill. There really are some helpful new tools here for regulators, and the new Consumer Financial Protection Bureau will do a lot of good.
But they each make just a shade too much out of some of the other reforms. Here's Ezra on derivatives:
Bringing derivatives onto exchanges and into clearinghouses is a huge victory. In 2007, the over-the-counter -- and almost entirely unregulated -- derivatives market was worth about $700 trillion in notional value, and regulators had no idea what went where and few firms had serious capital or margin requirements. Those days are over.
The problem with this statement is that not all derivatives are going to be brought out of the shadows. There's an exemption for commercial firms that doesn't need to exist at all, and it is broad enough to include hedge funds and private equity firms. This just means that in the future, the riskiest derivatives dealing is going to be between banks and hedge funds, instead of between banks and other banks. The bank-to-hedge-fund section of the market is going to grow tremendously, and there will be plenty of room for unmonitored fraud, abuse and speculative excess. We still need the basic clearinghouse/exchange architecture to be developed, so this section is a positive step forward, and can be improved with a future bill. But it's not quite the slam-dunk victory that Ezra presents.
Matt praises the new resolution authority, arguing that it "will let future regulators avoid the bailout-or-crisis dynamic that plagued us in 2008."
I disagree with this completely. Like the derivatives language, the resolution authority is a necessary step for avoiding many of the problems we faced in 2008, but not a sufficient one. Without ending taxpayer subsidies for derivatives dealing, banning proprietary trading, or the creation of international standards for shutting down multinational behemoths, the authority just isn't credible. Moody's has already said that the authority can't work thanks to derivatives and prop trading. If that's the mainstream Wall Street view, we're sunk. Banks perceived as too-big-to-fail will continue to raise money at cheaper rates and take on bigger risks without market scrutiny, making it much harder for regulators to actually deploy the resolution authority when a megabank goes down. Watch the pricing on debt and credit default swaps for megabanks in the next few weeks. If either get dramatically more expensive, then investors really believe this part of the bill has teeth. I will simply be shocked if that happens.
In 2008, regulators had a resolution authority they could implement for commercial banks of any size, and they used it on smaller banks. But when Wachovia, a very large commercial bank, went down, the resolution authority wasn't exercised. Instead, regulators arranged a merger with Wells Fargo that scored billions for Wachovia shareholders. We'll see the same dynamic when megabanks get into trouble in the future.
This doesn't mean that the resolution authority is a problem, only that to make it useful, further steps need to be taken—breaking up the banks, banning proprietary trading, and forcing taxpayer subsidies out of the derivatives business.
Ezra notes that lawmakers basically had two ways to respond to the mess Wall Street made of itself: They could go for deep, structural reform of the financial sector, or a weaker effort to boost regulatory tools for dealing with the financial sector as it currently stands. That's essentially right, and he's certainly correct that Congress punted on structural reform altogether:
This is, by and large, a financial regulation bill. There are exceptions, and its authors have thought long and hard about trying to prevent regulatory failure, but in the absence of total structural reform, it was always going to be a financial-regulation bill. It had no other choice.
What bothers me about this is that the bill really could have implemented deep structural reforms if the administration or a handful of influential members of Congress had been on board. There were times this spring and summer when momentum was building on Capitol Hill for big-picture changes, and Treasury went to war against all of them ( Mike Konczal has an excellent detailed list here). After the amendment to break up the biggest banks failed, Treasury even went around bragging to the press that they could have pushed through the break-up if it had wanted to.
None of this means that the bill isn't worth supporting. It's still a very important step forward. But we will need a stronger Wall Street reform effort from Congress next year to make sure this bill can live up to its potential.