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Congress Didn't Learn Anything From the Financial Crisis

Dodd bill hands more power to failed regulators and guarantees "too big to fail" bailouts

Anthony Randazzo
May 4, 2010

Voting is expected to begin today on Sen. Chris Dodd’s (D-CT) financial reform bill as the Senate takes up debate on amendments to the gigantic piece of legislation. Some of the amendments have broad bipartisan support (i.e. rating agency reform). Some of the amendments, though vitally necessary, are dead in their tracks (i.e. reform for Fannie Mae and Freddie Mac). It is almost unconscionable that Wall Street regulatory reform would ignore addressing the main causes of the crisis, however, the Dodd bill does just that.

At its core the proposed legislation gives even more authority to the regulators who failed taxpayers. It fails to deal with the “too big to fail” problem. And does not promote efficiency in the market. Fixing these three problems wouldn’t make the Dodd bill perfect, but it would go a long way towards instituting real reform.

Everyone would agree that putting former Lehman Brothers CEO Richard Fuld back in charge of Lehman, reversing the bankruptcy filing, and handing him $1 trillion in assets would be a bad idea. Yet, the Senate confirmed the reappointment of Federal Reserve Chairman Ben Bernanke—member of the Fed board of governors since 2002 and proponent of the low interest rates that fueled the housing bubble. And now the Dodd bill proposes expanding Bernanke's and the Fed’s authority, basically making it the sheriff of the whole economy.

The Dodd bill would establish—similar to the bill passed in the House—an oversight council to monitor the market and assure any future meltdown is averted. Ironically, this increases authority for the very same regulators who missed the housing bubble. It misplaces trust in regulators as capable of stopping the next crisis and ignores an essential lesson from the crisis: regulators are not perfect and we should not fully depend on them to keep us safe.

In these ways, the Dodd bill is continuing a philosophical failure that was a partial cause of the market meltdown. As Cato Institute’s Gerald O'Driscoll writes, "The idea that multiplying rules and statutes can protect consumers and investors is surely one of the great intellectual failures of the 20th century. Any static rule will be circumvented or manipulated to evade its application.”

Perhaps even worse, the Dodd bill does not put an end to "too big to fail." Instead, the current version of the legislation includes a provision to create a pile of money to pay any short-term financial commitments of a failed institution to ensure credit flows don’t dry up. With today’s highly interconnected market, a few unpaid bills could significantly slow down operations in the marketplace, as they did in 2008. But in what should sound alarm bells in the halls of Congress - there hasn’t been a lot of push back on the proposed bank tax to create this bailout fund. That is because banks will happily trade a small tax for the promise of bailouts. Too big to fail remains government policy.

Interbank lenders will also be happy with this provision because it reduces counterparty risk. Right now firms are being very careful about who they lend to because if an institution goes under, who knows when they’ll get their money back. But with the government bailout fund there to save the day, lending will flow much more freely. This distorts an important market signal and makes it difficult for investors to know if a bank is having financial difficulty.

The Dodd bailout fund also grants regulators wide discretion in determining when, and what, banks would get shut down if perceived to be a systemic threat. The problem is that this overly broad authority will create confidence problems in the marketplace. One of the main problems during the meltdown was a lack of confidence in regulatory authority, as the Fed and Treasury made erratic decisions. There should be an objective standard for insolvency that is known to the market so that firms can assess their own activities to gauge what regulatory action might be taken against them, and so that market participants will know what the government plans to do in the case of a struggling firm. A clearly ordered, more rapid bankruptcy process would be preferable to the Dodd bill.

Finally, instead of promoting market efficiency, the Dodd bill opens more doors for fraud and risk taking. The increased compliance rules and overall transfer of authority over decision making in markets away from the private sector—such as consumer safety restrictions on certain products instead of letting investors make decisions for themselves about what is safe—will introduce even more government bureaucratic terror into the financial sector.

One loophole, according to former Housing and Urban Development official Mark Calabria, would roll back existing consumer protections, and start allowing real estate agents to collect kickbacks for steering homebuyers to “special services.” Senate Majority Leader Harry Reid (D-NV) has complained about Wall Street lobbyists, but apparently has failed to see the National Association of Realtors rent-seeking around the place too.

By making the system more complicated and attempting to regulate every concern, the Dodd bill introduces new incentives to find ways to get around the rules. This happened with Sarbanes-Oxley in the wake of the Enron and Worldcom scandals, and the Dodd bill would make the same mistake.

For all of its errors, the Dodd bill is, sadly, still the least destructive of the different versions of financial reform offered to date. But if there is to be real reform, some significant amendments will be necessary. The banks shouldn’t be subjected to punitive taxes, and they shouldn’t have the opportunity to lean on the government’s promise of bailout for cheaper access to credit. Most importantly, both sides of the political aisle should be able to find a way to end the era of "too big to fail."

Anthony Randazzo is director of economic research at Reason Foundation.


Anthony Randazzo is Director of Economic Research


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