GOP Should Push Tough Regulation of Wall Street

It's not hard to predict how the coming fight over financial regulation legislation will be framed by most of the mainstream media. Democrats like Christopher Dodd, the sponsor of the pending Senate bill, will be portrayed as cracking down on greedy Wall Street operators. Republicans will be portrayed as letting Wall Street operators have their way.

That might be a fair characterization if Republicans concentrate their fire on the consumer protection agency the bill would establish in the Federal Reserve. But that's a peripheral issue, and Republicans would be well advised to leave the opposition to chief executive officers like JPMorgan Chase's Jamie Dimon, a Democratic contributor, who argues persuasively that regulators should just do a better job of enforcing already existing rules.

The real heart of the Dodd bill is the provision creating a $50 billion fund collected from large financial firms and authorizing the Federal Deposit Insurance Corporation to use the funds to reorganize any such firm it decides is failing. Under the bill, the FDIC would use this "resolution authority" rather than have the firm go into bankruptcy courts, as Lehman Brothers did after it collapsed in September 2008.

The 2008 financial collapse shows we need smarter regulation that will discourage, not encourage, government bailouts of Wall Street.

This sounds reassuring. But actually it's very dangerous. It amounts to granting "too big to fail" status to financial firms like Goldman Sachs and JPMorgan Chase. As my American Enterprise Institute colleague Peter Wallison and University of Pennsylvania law professor David Skeel explain in the Wall Street Journal, it tells those firms' creditors and shareholders that Uncle Sam will bail them out if they make what turn out to be imprudent loans.

The Lehman Brothers bankruptcy process was orderly and did not result in the financial collapse of the firm's counterparties in financial transactions. But it did impose severe losses on creditors, shareholders and managers. Players in the financial markets were put on notice that they face dire penalties for placing trust in shaky firms.

FDIC resolution authority would work differently. The Dodd bill specifically authorizes the agency to treat "creditors similarly situated" differently, i.e., it can pay off creditors who would get little or nothing in bankruptcy proceedings.

Moreover, as Wallison and Skeel note, the FDIC does not have experience in dealing with the abstruse financial instruments of the largest financial firms. It does a good job of winding up the affairs of small banks, paying off depositors and selling deposits to another bank. But it has never handled anything as big and complex as Lehman Brothers, as the bankruptcy courts have.

Granting large firms "too big to fail" status is dangerous on two counts. It can be hugely expensive to taxpayers. The bailouts of Fannie Mae and Freddie Mac have cost more than $120 billion so far.

In addition, "too big to fail" status means that, as Wallison and Skeel write, "large financial firms will be seen as protected by the government and, with lower funding costs, will squeeze out their Main Street competitors."

Little wonder that Goldman Sachs likes the idea. It will be able to borrow at lower cost than small competitors and will be assured that its large counterparties will qualify for government bailouts. Big firms tend to favor regulation because it insulates them from competition and protects them against loss.

Republicans owe no political debt to the big Wall Street firms. In the 2008 campaign cycle, according to the Center for Responsive Politics' opensecrets.org Web site, Goldman Sachs personnel contributed $4.5 million to Democrats and just $1.5 million to Republicans.

Add in three other big Wall Street firms--Morgan Stanley, JPMorgan Chase and Citigroup--and the total take was $12.7 million to Democrats and $6.7 million to Republicans. The image of Wall Streeters as solid Republicans is as dead as J. P. Morgan himself.

The big media tends to portray Republicans as opposed to all financial regulation. But every intelligent person knows that some form of financial regulation is necessary. And the 2008 financial collapse shows we need smarter regulation that will discourage, not encourage, government bailouts of Wall Street.

Republicans have good policy and political reasons to argue not for weaker regulation but for tougher regulation of Wall Street firms. They should oppose resolution authority that helps the big firms and, while they're at it, seek to increase the capital requirements on such firms that are left vague in the Dodd bill. Democrats have taken the side of Wall Street. Republicans should stand up for Main Street--and taxpayers--instead.

Michael Barone is a resident fellow at AEI.

Photo Credit: iStockphoto/mddphoto

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