A User's Guide to Financial Reform

We explain why other changes are more important than protecting consumers or cutting banker pay.

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Attentive citizens can be excused for feeling like they've overdosed on reform from Washington. The healthcare overhaul was bitter and exhausting, energy and education reform are kicking around, and we haven't even started the mother of all Washington battles: entitlement reform.

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But fixing the financial system is awfully important, kind of like fixing your car after the front end has been mangled in a crash. Like healthcare reform, the dickering over new financial rules involves competing proposals from various Congressional committees, intense lobbying, and hyperbolic pronouncements from the affected industries. But unlike healthcare, there's widespread agreement that the system is broken and that the main practitioners—Wall Street financial firms—need to be reined in. That means final legislation might come by summer, with less partisan bickering than usual and maybe even a few Republican votes. Who knows, the government might even come up with something that benefits its citizens.

Finance can be extremely arcane—one reason Wall Street wizards have been able to bamboozle regulators along with ordinary consumers. But the basic principles of reform aren't that complicated. Here's a crib sheet outlining the main issues, plus some handicapping on which types of reforms are most important, and the likely outcomes:

Take-over authority for big, failing firms. Importance: High. Since the 1930s, the FDIC has been able to take over failing banks, effectively preventing runs or contagions that could paralyze the financial system. But the FDIC's authority doesn't extend to non-bank firms that have a significant role in the economy—which turned out to be a huge hole when the system melted down in 2008. No government agency had the authority to take over Lehman Brothers or AIG, for example, which left the government with poor choices as the firms collapsed. The resulting ad hockery—letting Lehman collapse, while hastily orchestrating a deeply flawed bailout of AIG—prevented a depression, but still nearly froze the credit markets while leaving taxpayers saddled with ownership of tar-baby firms. The only worse outcome would probably have been doing nothing at all.

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The financial system has stabilized, but there's still no coherent plan for how to handle "systemically significant" institutions like hedge funds, private-equity firms, insurance companies, or other corporations with big financing arms if there's another meltdown. Simply allowing huge, failed firms to go through bankruptcy could shut down the credit markets, since banks, fearing a domino effect, would call in loans and hoard cash. Financial reform bills in the Senate and House of Representatives would each deal differently with the problem. The final outcome will probably give some branch of government, such as the Federal Reserve, new authority to take over failing non-bank firms, run them as necessary, and dismantle them in a more orderly way than simply splitting up the remnants in bankruptcy court. One of the toughest questions is who should pay for the damage incurred along the way. A fair outcome would force maximum losses on stock and bond holders, but taxpayers might still have to bear some costs of a takeover.

Policing derivatives. Importance: High. Derivatives are invented securities such as futures contracts, collateralized debt obligations, and credit-default swaps that are related to real assets or events but have no inherent value of their own. They have legitimate uses, such as allowing airlines to hedge against wild swings in energy prices, so they can better control costs. But derivatives are also unregulated, which allows speculators to place huge bets on various parts of the economy in secret, which can amplify real problems and occasionally produce disastrous results. Congressional reform proposals call for regulating derivatives on exchanges, the way stocks and commodities are regulated. Hedge funds and financial firms oppose this, because it would shine light on one of the shadiest parts of the financial system and cut into profits for the most privileged firms. But it's hard to argue against transparency, which is why some regulation of derivatives looks likely.

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Preventing firms from getting too big. Importance: Moderate. If firms weren't so huge, they might be able to fail without threatening the collapse of the whole financial system. So logic suggests that more smaller banks would provide better stability than a few humongous banks. The problem is, the financial meltdown actually concentrated more financial assets in fewer firms, as weak outfits like Bear Stearns, Washington Mutual, Wachovia, and Merrill Lynch were taken over by healthier rivals. That made the "too big to fail" problem worse, not better. Some critics would like to see financial powerhouses like Citigroup, Bank of America, and JPMorgan Chase broken up into smaller operations. But that would remake an industry that's just settling down after a spate of profound turmoil. What seems more likely is stricter bank oversight meant to prevent huge banks from foundering in the first place.

The "Volcker Rule." Importance: Moderate. Financial firms like Goldman Sachs and Morgan Stanley earn a small fraction of their income these days from lending money or providing services to clients. The big bucks fueling rich paychecks at those firms come from speculating and trading with their own money. The problem with that is that firms designated as commercial banks enjoy special privileges, like government-backed deposit insurance and access to cheap government funds, meant to support their role as lenders—not provide an advantage that helps line their own pockets.

Former Federal Reserve Chairman Paul Volcker, a key Obama advisor, argues that banks shouldn't be allowed to trade for their own benefit. But the proposal is controversial because it would force many of the nation's biggest banks to spin off their most profitable business lines, possibly killing jobs and sending lucrative business overseas, where rules are more lax. Obama says the Volcker Rule is a high priority, but Congress is lukewarm at best. A compromise might allow banks to keep doing their own trading, but impose tougher rules governing the risks they're allowed to take. If the rules are tough enough, some banks may decide on their own to spin off their trading desks and disconnect them from more staid banking operations.

Better consumer protection. Importance: Moderate. The Obama administration and some Congressional Democrats say that a new Consumer Financial Protection Agency is one of their top priorities. Such an agency would concentrate oversight of mortgages, credit cards and other financial products in one organization, instead of spreading it around. Protecting consumers has strong stump appeal, but the idea has flaws. There are already several agencies that have a similar role, and while creating a new agency, Obama has called for eliminating just one of the old agencies. So his plan would expand government—not popular at the moment—without making clear how it improves government. Plus many states have consumer-protection agencies that are supposed to do the same thing. And a variety of businesses are lobbying to be excluded from the CFPA's jurisdiction, which could leave a confusing patchwork of semi-protections. Democratic negotiators could end up backing away from this idea in exchange for concessions from the banking industry and their supporters on other top priorities.

New banking regulators. Importance: Low. House and Senate proposals would both reorganize the apparatus for regulating the financial industry. But the problem has never really been organization—it's been lax enforcement of rules that already exist. Some reformers want to take power away from agencies deemed weak, which might make sense, except that all of Washington essentially looked the other way for years while the financial industry racked up reckless profits and gradually destabilized itself. Reorganizing regulatory bodies might improve things at the margin, but it won't diminish the natural political pressure to keep the booze flowing when the party's going strong. Still, expect Congress to fiddle with the regulatory structure and pronounce it a grand improvement.

Regulating pay. Importance: Low. It's a hot-button issue, but exorbitant pay for bankers and CEOs isn't something Congress or the Obama administration really wants to police. Even Democrats are uncomfortable dictating what private-sector workers should be allowed to earn. And while huge salaries for a few at the top clearly reflect an imbalance in incomes, inflated paychecks are more a symptom of the problem than the cause. There's one exception: Most reformers agree that executive pay should be closely linked to the company's long-term performance, not to deals that generate short-term windfalls but could blow up down the road. Still, new rules seem likely to go no further than giving shareholders a stronger say in the pay of the people running the company. It was good to be CEO before, and it still is.