Opinion: Will Financial Reform Work? It Depends

(July 16) -- In speaking about the financial regulation bill he will soon sign, President Barack Obama said that the bill "will prevent a financial crisis like this from happening again." This is oversimplified -- there is no way to prevent every crisis and this bill doesn't come close. In leaving Fannie Mae and Freddie Mac untouched, for example, the legislation fails to address a key factor behind the recent crisis.

Still, there are elements of the bill that will help prevent future crises even as other parts are likely to have unintended negative consequences.

An important innovation is the systemic risk council that will empower federal regulators, notably the Federal Reserve, to gather information from any firm that poses a threat to the financial system. This will help avoid the situation in which no regulator had responsibility for policing the AIG subsidiary that took enormous housing-related risks. Banks also will be required to hold more and higher-quality capital, meaning that shareholders will have extra money at stake before anyone looks to taxpayers for a bailout.

Also helpful for avoiding future crises are provisions in the bill that increase transparency by moving some derivatives trading onto exchanges and clearinghouses. This will help market participants and regulators spot potential risks that are now largely hidden from view.

The snag is that not all derivatives can or should be traded on exchanges -- some are so customized that they cannot be shoehorned into a poorly fitting regulatory system. The provision of the bill to dislodge some derivatives trading from banks is ill-conceived and will raise costs for users of commodity-related derivatives, such as farmers. Also poorly-considered is an attempt to change the way banks organize their internal trading, which will add costs but not reduce risk. These parts of the bill reflect the Obama administration's unfortunate lack of courage to stand against harmful but politically attractive provisions that don't actually solve a problem behind the crisis.

A further disappointment is that the bill doesn't do nearly enough to reduce the chance of future government bailouts or address the issue of "too big to fail."

The legislation provides the executive branch with so-called non-bank resolution power to take over a troubled firm that poses a risk to the financial system. The government could put money into the next Lehman Brothers and thus make some people better off as a result. Taxpayers eventually will be made whole, but the essence of a bailout is the intervention. The bill lets the executive branch start writing checks and will have government officials rather than the market choose winners and losers.

Perhaps worst of all is that this ability for the government to undertake bailouts gives firms an incentive for riskier behavior and thus makes future bailouts more likely rather than less.

The new consumer protection agency could be a force for good if it increases consumer information and education and cracks down on banks' abusive practices. But one can easily imagine a headline-loving agency head tilting at imaginary risks, while leaving American families and firms with the downside of less lending at higher interest rates.

This highlights the fact that the ultimate impact of the bill depends on how it's implemented by regulators who are given enormous new powers to interfere in the financial system.

We have outstanding and well-meaning people in the financial regulatory agencies, but these same regulators already had considerable authority to gather information and act upon it, and yet didn't stop the last crisis.

There are helpful aspects to the financial regulatory reform bill. But despite President Obama's assertion, it is hard to imagine that giving government officials more power will prevent crises from happening again.

And it would be ironic if the negative impacts of the bill in terms of reduced lending start to affect the economy over the next two years, leading to slower growth and job creation that shows up in 2012 just as the president faces re-election.

Phillip Swagel is visiting professor at Georgetown University's McDonough School of Business. He served as assistant secretary for economic policy at the Treasury Department from 2006-2009.