This Financial Reform Bill Won't Stop the Next Financial Crisis
Considering that the cost of cash and guarantees to bail out the financial crisis totaled $23.7 trillion, that 0.08% down-payment for the next crisis is a pretty slim cushion. Moreover, while financial reform does force banks to spin off some derivatives businesses, it misses most of the financial crisis's major causes.
When money talks louder than the public interest, you get the best government money can buy. In this case, it's the so-called Dodd-Frank bill, which Senator Christopher Dodd (D-Conn.) and Representative Barney Frank (D-Mass.) pushed through the final negotiations in the wee hours of June 25 so that President Obama could sign it during an Independence Day ceremony.
Dodd-Frank is touted as a way to achieve many objectives:
- Strengthen consumer protection
- Make derivatives trading more transparent
- Create a new process for unwinding failing financial firms
- Make financial institutions stronger to prevent such failures in the future
- Create a 10-member council of regulators, headed by the Treasury Secretary, that will issue early warnings when companies are poised to trigger a financial crisis
Here are the three most prominent compromises:
- Weakened Volcker rule. Former Fed Chairman Paul Volcker wanted banks to stop proprietary trading and investing in hedge funds. That won't happen. Instead, firms will have up to two years to reduce these activities to 3% of their capital.
- Gutted consumer financial protection. A consumer financial protection agency designed to keep citizens from being hoodwinked by financial firms won't oversee one of the major sources of such hoodwinking -- auto dealers. Thanks to their lobbying power, America's18,000 auto dealers will be exempt.
- Sketchy derivatives protection. Derivatives -- whose $1.2 quadrillion in notional value is 20 times global GDP -- will still remain part of banks, albeit in a somewhat more limited fashion. Banks will get to keep trades in interest rates, foreign exchange, gold and silver derivatives. They could even arrange credit default swaps (CDSs), which contributed heavily to American International Group's (AIG) need for a $182.3 billion bailout, as long as they're traded through clearinghouses. Banks can also trade derivatives with their own money to hedge against "market fluctuations." In the end, very little has changed in how banks can use derivatives.
- Demand higher capital requirements. Banks were able to borrow as much as $50 for every $1 of capital during the peak of the latest bubble. That borrowing should be limited to $8, and government should have the power to take immediate action to punish any financial institution exceeding that level. Without tight control of bank borrowing, the cycle of bubbles building and bursting is baked into the system.
- Link banker pay to return and risk. Dodd-Frank does nothing to change the way bankers are paid. People do what they get paid to do, and under the bill bankers will still be able to get enormous bonuses that reward them for putting big deals on the books without having to pay any of the costs if those deals fail. This heads-I-win-tails-you-lose setup ensures that bankers will find new ways to get big bonuses while shifting the costs of their mistakes onto the public. We ought to require banker pay to go in an escrow account for 10 years to be used to cover the costs of deals that go bad.
- End too-big-to-fail. By creating a 10-person interagency committee to warn us of the next big financial crisis, the bill doesn't do nearly enough to prevent huge institutions from causing a sudden collapse of the financial system. The May 6 flash crash that caused the Dow to drop about 1,000 points in 20 minutes remains a mystery more than six weeks later. With markets operating at such lightning speed, we shouldn't derive any confidence that such an early-warning mechanism will work. Instead we should break up the too-big-to-fail financial institutions.