Financial Re-Regulation and Democracy

As always, the “devil is in the details,” and financial-sector lobbyists have labored hard to make sure that the new regulations’ details work to their employers’ benefit. As a result, it will likely be a long time before we can assess the success of whatever law the US Congress ultimately enacts.

But the criteria for judgment are clear: the new law must curb the practices that jeopardized the entire global economy, and reorient the financial system towards its proper tasks – managing risk, allocating capital, providing credit (especially to small- and medium-sized enterprises), and operating an efficient payments system.

We should toast the likely successes: some form of financial-product safety commission will be established; more derivative trading will move to exchanges and clearing houses from the shadows of the murky “bespoke” market; and some of the worst mortgage practices will be restricted. Moreover, it looks likely that the outrageous fees charged for every debit transaction – a kind of tax that goes not for any public purpose but to fill the banks’ coffers – will be curtailed.

But the likely failures are equally noteworthy: the problem of too-big-to-fail banks is now worse than it was before the crisis. Increased resolution authority will help, but only a little: in the last crisis, US government “blinked,” failed to use the powers that it had, and needlessly bailed out shareholders and bondholders – all because it feared that doing otherwise would lead to economic trauma. As long as there are banks that are too big to fail, government will most likely “blink” again.

It is no surprise that the big banks succeeded in stopping some essential reforms; what was a surprise was a provision in the US Senate’s bill that banned government-insured entities from underwriting risky derivatives. Such government-insured underwriting distorts the market, giving big banks a competitive advantage, not necessarily because they are more efficient, but because they are “too big to fail.”

The Fed’s defense of the big banks – that it is important for borrowers to be able to hedge their risks – reveals the extent to which it has been captured. The legislation was not intended to ban derivatives, but only to bar implicit government guarantees, subsidized by taxpayers (remember the $180 billion AIG bailout?), which are not a natural or inevitable byproduct of lending.

There are many ways of curbing big banks’ excesses. A strong version of the so-called Volcker Rule (designed to force government-insured banks to return to their core mission of lending) might work. But the US government would be remiss to leave things as they are.

The Senate bill’s provision on derivatives is a good litmus test: the Obama administration and the Fed, in opposing these restrictions, have clearly lined up on the side of big banks. If effective restrictions on the derivatives business of government-insured banks (whether actually insured, or effectively insured because they are too big to fail) survive in the final version of the bill, the general interest might indeed prevail over special interests, and democratic forces over moneyed lobbyists.

But if, as most pundits predict, these restrictions are deleted, it will be a sad day for democracy – and a sadder day for prospects for meaningful financial reform.

Copyright: Project Syndicate, 2010.
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