Where Dodd's Financial Overhaul Seems Likely to Miss the Mark

Senator Chris Dodd (D.-Conn.) is retiring from office this year. And that pending departure helps to free him from the need to kowtow to financial services firms that give so generously to politicians and lobbyists who shape the rules that oversee their industry, including the size of financial execs' bonuses. But Dodd's soon-to-be-unveiled proposal appears to have a fatal flaw: It enshrines the notion that it's good to have financial firms that are Too Big to Fail (TBTF).

According to The New York Times, Dodd's idea for overhauling financial regulation includes four key elements:

  • Give shareholders a voice. It would allow shareholders advisory votes on executive pay and let them nominate public company directors through company proxy ballots.

  • Protect consumers. It would create a consumer financial protection agency (CFPA) whose director would be appointed by the president and would write rules pertaining to "mortgages, credit cards, payday loans and a wide range of other financial products."

  • Reduce the Fed's power. It would strip the Federal Reserve of the power to oversee bank holding companies with assets below $50 billion while entrusting it "to regulate systemically important nonbank financial institutions."

  • Create a systemic risk council. It would create a council headed by the Treasury Secretary and including representatives of the Fed, the CFPA, the Federal Deposit Insurance Corp., the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Federal Housing Authority and the insurance industry to uncover, seize and dismantle large financial firms on the brink of collapse.

Dodd's plan will face opposition from all sides, but he's now thinking about his legacy. So, I believe that this is what he really would like to see happen instead of bestowing a collection of gifts to potential supporters. However, I also think that the first three elements are little more than window-dressing.

How so? Giving shareholders a voice might release some steam from those who are angry, but the shareholder votes would be nonbinding. The CFPA isn't going to substitute for consumers' need to take the time to read contracts before they sign them. And changing what the Fed regulates just shifts the deck chairs among Washington's regulatory agencies.

An Alphabet Soup of Regulators

The biggest problem with Dodd's proposal is that it's likely to fail to preemptively dismantle any institution whose collapse could put the world's financial system at risk. His proposal enshrines TBTF institutions and creates an alphabet soup of regulators who would spend so much time fighting among themselves that they probably won't even notice if one of these financial volcanoes is about to erupt.

After the Great Depression, the Glass-Steagall Act separated the businesses of commercial and investment banking. This led to the breakup of the biggest financial institutions and kept them from getting too big. To keep another financial collapse from happening, we need to dispense with the flawed idea that TBTF is a viable concept as long as it's properly regulated.

Instead, we need to replace that bad idea with one that worked until Glass-Steagall was repealed in 1999: Every financial institution ought to be Too Small to Cause Systemic Collapse (TSTCSC).