The Financial Reform Bill: A Very Limited Step Forward

By Roosevelt Institute |

money-question-150FinReg bill falls short, especially in not ending Too Big to Fail.

The final compromise bill approved by the conference committee on Friday will improve regulation in the financial sector. However, given the severity of the economic crisis caused by past regulatory failures, the public had the right to expect much more extensive reform.

On the positive side, the creation of a strong independent consumer financial products protection bureau stands out as an important accomplishment. Such an agency would have prevented some of the worst lending practices that contributed to the housing bubble. It will be important President Obama choose a strong and effective person, such as Elizabeth Warren, as the first head of the Bureau to establish its independence.

The requirement that most derivatives be either exchange traded or passed through clearinghouses is also an important improvement in regulation. However, important exceptions remain, which the industry will no doubt exploit to their limit.

The creation of resolution authority for large non-bank financial institutions is also a positive step, although the fact that no pre-funding mechanism was put in place is a serious problem. Also, the audit of the Fed’s special lending facilities, as well as the ongoing audits of its open market operations discount window loans, is a big step towards increased Fed openness.

On the negative side, there is little in this legislation that will fundamentally change the way that Wall Street does business. The rules on derivative trading will still leave the bulk of derivatives to be traded directly out of banks rather than separately capitalized divisions of the holding company. The Volcker rule was substantially weakened by a provision that will still allow banks to risk substantial sums in proprietary trading.

More importantly, there is probably no economist who believes that this bill will end too big to fail. The six largest banks will still enjoy the enormous implicit subsidy that results from the expectation that the federal government will bail them out in the event of a crisis.

Also, the fact that no regulators, most obviously Ben Bernanke at the Fed, were fired for failing to prevent the crisis leaves in place serious doubts about the structure of incentives for regulators. Cracking down on reckless behavior by politically powerful financial institutions will always be difficult for regulators. On the other hand, if regulators know that failing to crack down carries no consequences, even when it leads to disastrous outcomes, we can expect that regulators will have a strong bias toward ignoring reckless behavior.

It is possible that Congress may take stronger steps toward restructuring the financial sector, most obviously in the context of a financial speculation tax. While this is not likely to pass at the moment, in the context of severe budget pressures, a tax that can raise $150 billion a year in revenue may look more appealing than most alternatives. Such a tax would do far more to restructure the industry than this financial reform bill.

Dean Baker is the co-director of the Center for Economic and Policy Research.

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