The Solution Is How They See The Problem

Now that the financial reform bill is in its final state, we finally have a clear look at what lawmakers view as the problems that led to the financial collapse. When the reform process began the approach that would be taken, and which problems in the financial sector would be solved, was far less clear. Essentially there were two options before policymakers, either limit the size and scope of banks or increase regulation and the power of regulators to prevent problems as they occur. The first approach called for hard and clear caps on the size, function, and actions of banks. Paul Krugman called this the “Roman approach”, an approach that would work even without skilled regulators:

“The pre-1980 system was, I’d argue, pretty robust. Bank regulators didn’t have to be all that smart, because the rules were simple — and besides, the large franchise value of banks, the fact that they faced limited competition and were almost guaranteed to be profitable, made bank executives unwilling to take big risks of killing the goose that laid golden eggs.”

This approach highlighted the staggering growth of financial sector profits as part of all profits in the economy, now 41% of domestic profits, and wanted to trim it down to size. Also questioned was the need and usefulness of “financial innovation” that led to ideas like the Credit Default Swap, the Mortgage Backed Security and further back the Long-Term Capital Management failure and the Savings and Loans crisis. Under this approach we have the ideas of capital requirements (not included in the bill but will be dealt with under Basel III), the plain-vanilla mortgage that would have to be offered to all customers (not in the bill), the Volcker Rule or re-imposition of Glass-Stegall (in the bill but in watered down form), and a financial transaction tax (not in the bill).

This was not the approach that Treasury, the Obama Administration or Congress decided to take. While the bill has received deserved criticism as being insufficient to prevent future crises, this has generally been criticism of the approach taken by the bill not its contents. To analogize to the Health Care debate, there were some who proposed that the only way to reform the system to an acceptable level is to have Single Payer health care, a fundamental change of the system. Instead the Administration took a less radical approach to reform and better the existing system in a less disruptive and conservative way. The less intrusive approach of financial reform relied on empowering regulators and giving the Fed as well as Treasury additional powers to deal with a large bank collapse in a quicker, transparent, and routine fashion. Mike Konzcal describes how this approach looks at the problem:

It’s a story where the regulators just needed a bit more power, a little more legal scope, and a greater extension of what jurisdiction the Federal Reserve has in order to rush in and save the day. A story where the Federal Reserve can successfully carry out prompt corrective action, detecting problems early and guiding banks back to health, on an institution with $2 trillion dollars on its sheet. A story where that institution’s off-balance sheet and the warehouse of derivatives it holds are no match for our regulator’s stare. But more importantly, it is a story where the regulators will be able to sweep in during a moment of crisis and keep the financial sector working no matter what.

Here the bill does well, giving Treasury the power to break up big banks or “resolution authority” that is commonplace under the FDIC and to help avoid situations like the Lehman bankruptcy that lead to panic and the seizing up of credit. There is also language in the bill to limit derivative trading to try to prevent some of the most egregious casino like behavior. It also will require regulators to draft new regulations that more closely fits the intricacies of the financial impact – it’s the use of a scalpel instead of a hammer.

So then what does this bill see as the problems that led to the financial collapse? This bill isn’t a harsh lesson to banks, punishing them for their part in causing the financial collapse only to be bailed out by the taxpayer. The bill doesn’t impose anything like the consequences that would have occurred if these banks had been left to fail on their own. But while not a total change this bill represents an ideological shift away from the culture deregulation that we have seen over the last thirty years. The bill is a clear message that continual deregulation, where the free market (or a market dominated by powerful political and economic actors in a world post-Citizens United) is wholly allowed to govern economic activity leads to inefficient outcomes and poses a systemic risk to the economy.