Why Financial Reform Is Stalled

According to the media's narrative about Washington, the Obama administration's financial regulation proposals have not gotten through Congress because the town is gridlocked by partisan warfare. It's a simplistic story that does not require much thought to generate or accept.

Here's a better explanation: The proposals are not grounded in a valid explanation of what caused the financial crisis, reflect the same impulse to control a sector of the economy that underlies its health-care and cap-and-trade proposals, and more than anything else reflect Rahm Emanuel's iconic motto for all statists that a good crisis should never go to waste.

The administration appears to have begun its regulatory reform effort with the idea propagated by candidate Barack Obama that the financial crisis was caused by deregulation. There was never any evidence for this. The banks, which were in the most trouble, are the most heavily regulated sector of the economy and their regulation has only gotten tighter since the 1930s.

The same failure to understand the power of moral hazard is what makes the administration's call for a resolution authority most inapt and troubling.

Since its proposals first met with congressional opposition, the administration has been impervious to contrary evidence, and to this day it continues to lunge for ideas that will further government control of the financial system without giving them serious thought. So we have the spectacle of Paul Volcker, having recently persuaded Mr. Obama to back the idea of restricting proprietary trading by banks or bank holding companies, telling a puzzled Senate Banking Committee he can't really define proprietary trading but knows it when he sees it. Didn't anyone in the White House ask him what it was before the president moved to restrict it?

So it goes with the rest of the administration's plan. More power to Washington, but neither a persuasive analysis of why that additional control was necessary nor a recognition of the fairly obvious consequences.

For example, the central element of the administration's reforms was to give more power to the Federal Reserve. That agency was to become the regulator of all large nonbank financial companies deemed likely to cause a systemic breakdown if they fail. These companies--securities firms, hedge funds, finance companies, insurers, bank holding companies and even the financing arms of operating companies--were to be regulated like banks.

It didn't take long for both Democrats and Republicans in Congress to see the flaws in this scheme. The Fed had been regulating the largest banks and bank holding companies for over 50 years--among the very companies that would be considered systemically important--yet it failed to see the risks they were taking or the impending danger.

How, then, did it make sense to give the Fed the vast additional power to regulate all the largest nonbank financial companies? Wouldn't designating particular companies as "systemically important," and subjecting them to special Fed regulation, signal to the markets that these companies were too big to fail? How was that a solution to the too-big-to-fail problem? And wouldn't these big companies--designated as too big to fail--then have the same preferred access to credit that enabled government-sponsored enterprises Fannie Mae and Freddie Mac to drive all competition from their market?

Then there is the proposal to give a government agency the authority to take over and "resolve" failing financial firms. Here, the administration has pointed to the chaos that followed the bankruptcy of Lehman Brothers in September 2008. To prevent that kind of breakdown, the administration says all large and "interconnected" financial firms in crisis should be dealt with by a government agency, rather than by a judge in bankruptcy proceedings.

The term "interconnected" is important here. It implies that when one large firm fails it will carry others down with it, causing a systemic crisis. But that is clearly not the lesson of Lehman. Although the company went suddenly and shockingly into bankruptcy, none of its large financial counterparties failed. The systemic significance of "interconnectedness" proved to be a myth.

To be sure, there was a freeze-up in lending after Lehman. But that episode demonstrated the power of moral hazard--the tendency of government action to distort private decision-making. After Bear Stearns was rescued by the Fed in March 2008, market participants assumed that all companies larger than Bear would be rescued in the future. As a result, they did not take the steps to protect themselves against counterparty failure that would have been prudent in a panicky market. When Lehman was not rescued, all market participants immediately had to review the credit standing of their counterparties. No wonder lending temporarily froze.

The same failure to understand the power of moral hazard is what makes the administration's call for a resolution authority most inapt and troubling. Although the administration has argued, and some in Congress believe, that moral hazard and too-big-to-fail would be curbed by a resolution authority, the opposite is true. Both would be enhanced.

This is because the principal danger of moral hazard--the key to its adverse effects on private decision-making--is its impact on creditors and counterparties. The fact that shareholders and managements will lose everything in a government resolution is largely irrelevant. What really matters are the lessons creditors draw about how they will be treated. And it is clear creditors will be treated far more favorably in a government resolution process than in a bankruptcy.

To understand why this is true, consider the administration's reasons for preferring a government resolution process. The claim is that large, interconnected firms will drag down others when they fail. The remedy for this is to make sure their creditors and counterparties are fully paid when the takeover occurs. That's why the Fed made Goldman Sachs and others whole when it rescued the insurance giant AIG. It's also what distinguishes a government resolution process from a bankruptcy, where a stay is imposed on most payments to creditors when the bankruptcy petition is filed.

Creditors will realize that by lending to large companies that might be taken over and resolved by the government, their chances of being fully paid are better than if they lend to others that might not. Thus a resolution authority will enhance moral hazard not reduce it--and as creditors increasingly assume that large firms will be rescued, the too-big-to-fail phenomenon will grow, not decline. In the end, a resolution authority becomes, in effect, a permanent Troubled Asset Relief Program.

The image of partisan gridlock standing in the way of sensible financial regulation is wildly misleading. Twenty-seven Democrats in the House voted against the Barney Frank bill that mostly mirrored the administration plan. Democrats and Republicans in the Senate Banking Committee revolted against the first bill offered by Chairman Chris Dodd. That bill adopted most of the administration's flawed ideas.

Now Mr. Dodd is trying to negotiate a Plan B. But the longer he channels the White House, the longer it will take to get a bill that both Democrats and Republicans can support.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies.

Photo Credit: iStockphoto/Larry Cole

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