Hooray! Financial reform is here! Right? Well now that the health care reform bill is done and gone, Congress can turn their attention to the financial reform suggested by Senator Chris Dodd. Some of the main highlights of the bill are designed to both protect consumers and the integrity of the financial system are: a consumer protection agency, ending too big too fail, providing an early warning of systemic risk threats, increasing the regulation of financial instruments, increasing oversight of the Federal Reserve, as well as having other investor protections and regulatory powers over the system.
The consumer protection agency that Sen. Dodd envisions is designed to centralize the authority of many already in existence. His reasoning is very sound.
“The economic crisis was driven by an across-the-board failure to protect consumers. When no one office has consumer protections as its top priority, consumer protections don’t get the attention they need. The result has been unfair and deceptive practices being allowed to spread unchallenged, nearly bringing down the entire financial system.”
I agree that there were abusive practices in the housing market and that more should have been done to protect the consumer. Protecting the consumer would have in turn protected the financial system by preventing reckless loans. One thing I am not too sure about is the Office of Financial Literacy. Its intention is very constructive and for most people it will be beneficial. But what about many of the people that were harmed in the last wave of bad loans? Are they going to benefit from an Office of Financial Literacy? If this is not an active agency and aggressively ensuring that people are able to understand regulation than it is a worthless government entity.
The next highlight is one I am particularly interested in: managing systemic risk.
“The economic crisis introduced a new term to our national vocabulary – systemic risk. In July, Federal Reserve Governor Daniel Tarullo, testified that “Financial institutions are systemically important if the failure of the firm to meet its obligations to creditors and customers would have significant adverse consequences for the financial system and the broader economy.”
In short, in an interconnected global economy, it’s easy for some people’s problems to become everybody’s problems. The failures that brought down giant financial institutions last year also devastated the economic security of millions of Americans who did nothing wrong – their jobs, homes, retirement security, gone overnight.”
Managing systemic risk is incredibly hard. Everyone thought that there was no housing bubble or a large scale financial crisis until it was too late to do anything about it. This is the trouble with attempting to control systemic risk. An analogy I like very much is… put the from in boiling water and he jumps right out, but put him in the pot and bring the water to a boil around him and he will slowly boil to death. This is very much like the situation we were in, nobody knew we were in a problem until they saw the evidence. The attempt to predict the direction of the economy is big money and many firms are already attempting to do this. I like the ability to break up overly complex banks as well as ending too big to fail. The idea that one financial institution is such a liability to the system as a whole that the whole thing could topple is ludicrous and it’s long overdue that there should something that equalizes the playing field. Capitalism was built on this ideal and we are playing somewhere in between which is no good for anybody.
This area of regulation is the crux of attempting to manage the economy (or systemic risk). What happens when someone sounds the systemic risk alarm? How will the market respond? Right now the only one with the power to affect the market with their statements is the Federal Reserve. When Alan Greenspan sounded the “irrational exuberance” alarm, the markets responded briefly before plowing toward new highs. What power will this agency have with the markets? If this comes into being it will be interesting from a regulatory standpoint and will instantly be on the top of my news list. The need for an agency that is dynamic is essential and if this agency is given the freedom to act in an environment where flexibility is key than it might have a shot at being useful
How tired did you get of hearing that something was “too big to fail?” It seemed like everything met this mysterious criteria. Banks, car manufacturers…. everything. Too big to fail essentially meant that in today’s economy, businesses were so large and interconnected that allowing them to fall into bankruptcy would have devastating effects on the entire economy. With the failure of Lehman Brothers (one institution) the economy experienced extensive turmoil. Can you imagine what would have happened if other banks and companies failed? Chaos right?! Well we’ll never know for sure because the powers at be believed that it would be too tumultuous to handle. This is exactly why it needs to be addressed in the financial reform bill. Dodd’s reasoning:
“As long as giant financial firms (and their creditors) believe the government will prop them up if they get into trouble, they only have incentive to get larger and take bigger risks, believing they will reap any rewards and leave taxpayers to foot the bill if things go wrong. Since the crisis began, a number of financial institutions previously considered “too big to fail” have only grown bigger by acquiring failing companies, leaving our country with the same vulnerabilities that led to last year’s bailouts.”
Overall the bill addresses several areas of concern. The bill is long and there are several places where you can go to get a solid understanding:
As I always say… get informed!
