Walls for Wall Street

Posted April 28, 2010, at 5:49 p.m.

With each quarterly report showing the economy is recovering, the impetus for reforming the U.S. financial sector is dissipating. A proposal working its way through the U.S. Senate, which would rebuild safeguards tailored to the 21st century financial industry, must not be neutered by pro-banking lobbyists.

Senate Republicans who oppose the bill in its current form, including Maine’s Olympia Snowe and Susan Collins, are right when they assert that there is one chance to get this right. But the way to get it wrong would be to weaken the safeguards. Just as weeds find a way to grow in cracks in a side-walk, the financial industry will find a way to exploit loopholes in regulations. If the reforms are not concrete, 10 years from now a new, unheard of term will enter the lexicon as quickly as “credit default swap” became a household phrase in 2008.

The key components of Sen. Chris Dodd’s bill make sense, given what we know of the causes of the great recession. Those causes include: investment products that were too far removed from a real value (e.g., credit default swaps); the lack of protection for consumers who borrowed too deeply on home equity, and the lack of self-imposed restraint for the banks making those risky loans; the ability of commercial banks to invest their funds in the stock market (which had been banned in 1933, but legalized again in 1999); and financial institutions that grew “too big to fail.”

Robert Reich, labor secretary in the Clinton administration, argues that Sen. Dodd’s bill does not go far enough. Three key components are missing, he writes on his blog. He recommends requiring that derivatives — those bets on the future value of an investment — be traded on an open exchange where sellers have to disclose the details of what they are offering, and where both buyers and sellers have enough capital to cover losses. Reich also wants the Dodd bill to restore the wall between commercial banks and investment banks (the resurrection of the 1933 Glass-Steagall Act).

And last, he wants the reform bill to cap the size of banks at $100 billion in assets.

“The current bill … creates a process for winding down the operations of any bank that gets into trouble. But if several big banks are threatened, as they were when the housing bubble burst, their failure would pose a risk to the whole financial system, and Congress and the Fed would surely have to bail them out,” Mr. Reich writes.

Sen. Snowe doesn’t want the bill to include a $50 billion bailout fund, paid by banks, because it could “encourage banks to resume risky behavior.” Sen. Collins also worries the $50 billion fund for winding down financial institutions threatening the system would pose a “moral hazard.”

In the end, it comes down to putting limits on a growing economy, something both parties are loathe to do. But an economy that grows too fast, like an overheating nuclear reactor, can have calamitous consequences. Tightening regulations later will be as difficult as rebuilding a dam during a flood. The Dodd bill should move forward, not be filibustered into oblivion.

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