Closing in on financial reform

What happened

Re-energized by the Obama administration’s fraud lawsuit against Goldman Sachs, Senate Democrats this week neared passage of an ambitious financial-reform package aimed at preventing a repeat of the market meltdown of 2008. The main bill would set up a consumer protection agency within the Federal Reserve to police lending and credit card practices and require big banks to boost their capital cushion against losses. Companion legislation would sharply limit the now largely unregulated trade in financial derivatives—the complex contracts that function as bets on the direction of the prices of stocks, mortgages, and other assets. Derivatives based on bad mortgages were a significant contributor to the financial panic that nearly caused a collapse of the financial system in 2008. Democrat Blanche Lincoln of Arkansas has proposed barring large commercial banks, such as Citigroup, JPMorgan Chase, and Bank of America, from trading virtually all derivatives. Her bill would also require firms trading derivatives to do so on an exchange, where they’d be monitored to gauge the deals’ transparency and the traders’ financial soundness.

Senate Republicans, who last week were threatening to filibuster the entire financial-reform package, changed their tone after Democrats accused them of protecting the banking industry from reform, and began negotiating for changes in the legislation. “I think we’re going to get there,” said the Banking Committee’s ranking Republican, Sen. Richard Shelby of Alabama. “I’m optimistic.’’ If the legislation passes, it would have to be reconciled with a less stringent House measure passed last December.

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What the editorials said

“We hope Republicans stick together,” said The Wall Street Journal. The Democrats’ bill is just another package of “ill-understood reforms whose main achievement will be to make Wall Street even more the vassal of Washington, and do little to reduce financial risks.” Since the Democrats seem determined to pass something, the Republicans’ best option is to reduce the damage to free markets that this tangle of new regulation is certain to cause.

The GOP’s resistance to tough legislation is baffling, said the San Francisco Chronicle. “After the last two brutal years, can anyone be on the side of the status quo?” For two decades, financial markets were deregulated, leading to the crisis that nearly plunged this country, and the world, into another Great Depression. That’s why it’s absolutely vital to crack down on derivatives trading, said the San Jose Mercury News. The derivatives market has swelled to $600 trillion, and has been largely conducted “behind closed doors,” exposing big commercial banks—and the rest of us—to excessive risk.

What the columnists said

A funny thing happened to financial reform on its way through the Senate, said Noam Scheiber in The New Republic. Most reform bills get watered down as they approach passage, but the fraud suit against Goldman has emboldened Democrats to make their legislation even more “hawkish.” With Republicans “ready to crumple,” Banking Committee Chairman Christopher Dodd, who’s shepherding the main bill through the Senate, believes “he can strike a deal in exchange for only a handful of cosmetic, face-saving concessions.”

One concession sought by the GOP wouldn’t be cosmetic, said Nicole Gelinas in National Review Online. And that’s eliminating a $50 billion emergency-liquidation fund that the Democrats’ bill also proposes setting up. Democrats deny that this fund would constitute another “bailout” in waiting, since the banks would fund it themselves through taxes, and it would supposedly be used for the orderly liquidation of a failing bank. But it’s a mistake to tell financial firms that their fall will be cushioned if they gamble and lose. “Free-market discipline” is the best regulator.

All this talk about reform ignores one simple fact, said Frank Partnoy in the Financial Times: “Regulators will never keep pace with financial innovation, and bankers run circles around even the most well-intentioned rules.” The Goldman case reminds us that “the threat of litigation” is still the most effective way to get the banks’ attention. Smart, well-paid bankers are old hands at outmaneuvering their less well-compensated counterparts at the regulatory agencies. But “Wall Street cannot outrun a judge.”