Issue of the week: Overhauling financial regulation

While the nation is focused on congressional Democrats’ attempt to take over the health-care industry, said Investor’s Business Daily in an editorial, two New England liberals are readying legislation “that would squeeze the life from the whole economy.” Rep. Barney Frank of Massachusetts and Sen. Christopher Dodd of Connecticut, the Democrats’ point men for financial regulation, hope to create “an über-regulatory body” that would regulate banks, insurance companies, hedge funds, and any other financial firm deemed to be “systemically critical” and therefore “too big to fail.” This “monster” of an agency would have final say over the fate of troubled firms and could even order healthy companies to exit businesses deemed too risky. But “with politics comes favoritism,” and bailouts and preferences will inevitably go to favored firms. Such far-reaching regulation would be sure to “breed corruption, loopholes, lobbying, and the very kind of perverse incentives and distortions in the market” that led to Fannie Mae and Freddie Mac’s backing $1 trillion in bad loans.

If only the Democratic plans were that ambitious, said Mike Konczal in The Nation. On the contrary, the regulatory agency proposed by Frank and Dodd wouldn’t be strong enough to stop tottering financial firms from threatening the entire system. To be sure, Democrats want to create a mechanism through which “failures are cleaned up in an orderly and nondisruptive fashion.” But nothing in the plans would stop a financial firm from becoming so big and complex in the first place that its failure would set off a cascade of failures at other firms. Nor do the proposals offer any way to head off a failure except through a bailout—at taxpayers’ expense.

Too bad the Democrats didn’t heed Paul Volcker’s advice, said Bill Fleckenstein in Moneycentral.com, MSN’s financial website. The former Federal Reserve chairman has analyzed the financial crisis with “a large dose of common sense” and reached the conclusion that the meltdown could have been averted if we had stuck with the banking system that “worked for 60-odd years before it was dismantled in 1999.” Under the old system, banks were restricted to taking deposits and making loans. In return, the federal government insured their deposits and stepped in to rescue them if they were about to fail. Firms that wanted to take bigger risks by trading securities and derivatives were free to do so, but if their speculation blew up in their faces, the government wouldn’t help them. If Democrats really wanted to safeguard the financial system, they’d restore the wall between banking and trading.

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If only it were that simple, said Steve Goldstein in Marketwatch.com. Commercial banks like Washington Mutual and Wachovia didn’t go bust because they were speculating in securities. They failed at mortgage lending, their bread-and-butter business. By the same token, Lehman Brothers and Bear Stearns “were precisely the kind of investment banking–only institutions” that Volcker now champions. That didn’t prevent their failures from endangering the entire financial system. By all means, let’s try to ensure that institutions that fail don’t “take others down with them.” But “putting up arbitrary barriers” around banking activities won’t accomplish that.