Financial hall monitors
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HAVING forked over hundreds of billions of dollars to bail out financial institutions, American taxpayers deserve a regulatory system that curbs the industry’s worst excesses and minimizes future risks to the public coffers. Yet the far-reaching proposal that President Obama announced last week falls short in crucial ways. Institutions that had been too big to fail remain too big to fail, and dangerously mysterious derivative securities remain as dangerous as ever.
Ambitious in scope, the plan would subject major financial firms to regulations even if they don’t fit the definition of traditional banks. It calls for more cooperation among the alphabet soup of regulatory agencies, more public scrutiny of sprawling financial companies, and new compensation practices that align financial managers’ pay with the long-term interests of their companies. And a new Consumer Financial Protection Agency - a version of an idea often advanced by Harvard Law School professor and congressional bailout overseer Elizabeth Warren - would presumably restrict the unsustainable mortgages that played so great a role in the current financial mess.
But the plan does not deal adequately with two other major factors in the crisis: the use of derivatives so murky that many firms did not understand what they were buying and selling; and the gargantuan size of some financial firms, such that their failure would threaten the entire economy. The Obama plan would take steps to make derivatives markets more transparent but, by some accounts, would not discourage firms from using even the most complex instruments.
Furthermore, the administration also takes it as a given that some financial institutions are too big and too interconnected to be allowed to collapse. Last year, the Treasury and the Federal Reserve decided on an ad hoc basis which firms to bail out; Obama’s plan essentially defines a whole category of companies that are too big to fail, and it grants the Federal Reserve the authority to regulate such giants and step in to stabilize them if necessary.
But there’s no guarantee that such an intervention will be well-timed. Worse, defining some firms as too big to fail sets up perverse incentives; their investors and employees will always know that the government will come to their rescue.
The sigh of relief on Wall Street that greeted Obama’s plan is a clear signal that it will not radically restructure an overgrown financial sector. In the middle years of this decade, the industry’s detours into exoticism and opacity generated huge profits and led to huge salaries for its managers. But it also put the global economy at grave risk, and Obama and Congress must not miss the opportunity to set the sector right.
