U.S. President Barack Obama's April 22 speech urged Congress to move forward on reforming the financial system. But following passage of the House bill in December, several recent proposals in the Senate and a hotly contested Securities and Exchange Commission case against Goldman Sachs have intensified debate on the reforms' details and overall direction.
Senate Democrats pushed forward (Politico) with a procedural vote to formally consider the bill, ratcheting up pressure on both parties to reach a bipartisan deal that would salvage their reputations ahead of mid-term elections. But Democratic lawmakers are still mulling whether the Senate bill (PDF) should include the Obama administration's January proposal (NYT) to levy a $90 billion tax to limit banks' size and risk-taking. Many Republican senators oppose the inclusion of a $50 billion fund to streamline the dissolution of systemically risky firms, arguing it would encourage bank bailouts. Financial industry titans--including Goldman Sachs, Morgan Stanley, and JP Morgan Chase--are also wary of the Senate Agricultural Committee's push (Reuters) for tougher regulations of the $450 trillion market for credit default swaps and other derivatives. Some Democratic lawmakers say (BusinessWeek) these measures are more pressing in light of the SEC's derivatives-related fraud charges against Goldman. Meanwhile, other analysts argue the Senate bill fails to address other key problems destabilizing the financial system, including bank size, stronger leverage and liquidity requirements, and tax loopholes.
The SEC case--which alleges that Goldman defrauded investors by failing to disclose key information about the sale of so-called "synthetic" derivatives--has divided analysts on several fronts. Some argue the case highlights omissions in the laws that govern financial firms' conduct. According to CFR Senior Fellow Benn Steil, a regulatory system that relies solely on rule-making allows "companies with good lawyers [to] avoid violating the rules while clearly violating the spirit of the rules."†By contrast, he says "principles-based systems state broader principles--for instance, you cannot mislead investors--and leave more scope for the regulator to determine ex post whether a specific action was misleading." A more principles-based system might entail future prosecutions by the SEC and private lawyers of cases like Goldman's, a move the agency appears intent (WSJ) to pursue.
There is also concern (WSJ) that the SEC overstated its case for political gain. The Hoover Institution's Tunku Varadarajan agrees (DailyBeast) that the case highlights a gulf between rules and contextual reality. But he also cautions legislators against the dangers of overstepping. "The law might become a mere handmaiden of morality, especially when morality takes on a populist tinge," he says. Congress should pass some version (WashPost) of the regulatory package in the Senate, notes CFR's Sebastian Mallaby, but "the premise for more regulation is that the regulators will behave responsibly. Let's hope the SEC remembers that."
The case also highlights Congress's heated tussle (Politico) over which over-the-counter derivatives belong on regulated exchanges. "The more we can get finance into standardized contracts that are easier to understand, the less we're going [to] face situations where investors don't know what they're doing and get taken advantage of," says Mallaby. Difficulties in prosecuting the case could strengthen calls to narrow the SEC's authority in overseeing investor protections and regulating increasingly complex trading techniques. Under the current Senate bill, the agency--whose reputation has suffered (WSJ) from failing to catch several prominent fraud cases--would not lose power. The Obama adminstration's proposed 'Volcker rule'--which seeks to curb banks' propietary trading and private equity and hedge fund investing--could get a boost, too.
Also at issue is whether the Obama administration's proposal to curb banks' size goes far enough. The current proposal, which Democratic lawmakers may wrap into the Senate bill, would prevent the country's largest banks from getting bigger. But MIT's Simon Johnson argues their current size should be reduced, since the six largest banks have grown since the financial crisis as a result of the bailout. "There are simply no social benefits to having banks with over $100 billion in total assets," he said in a recent blog post.
Corporate tax reform is another missing element of the current Senate bill. "An enormous amount of financial market activity--in particular, securitization and leverage--is driven by the vastly favorable treatment of debt over equity," says CFR's Steil. While the Senate bill includes leverage limits, some argue the effectiveness of caps like these hinges on enforceability and other countries following suit. A recent Squam Lake paper, for example, says liquidity requirements for prime brokerages in Britain and elsewhere should be "at least as restrictive as current U.S. requirements" to prevent a "race to the bottom." But whether other countries would embrace new U.S. regulatory standards remains to be seen. IMF Managing Director Dominique Strauss-Kahn has said (WSJ) Washington's push for immediate domestic reforms could impede† international consensus on the matter.
In this New York Times blog, economist Paul Krugman discusses six theoretical views underpinning the various financial reform proposals.
Frank Partnoy, the former SEC chief accountant, says (Economist) the SEC's Goldman case shows how litigation can fill the gaps that regulation misses.
The Economist discusses the political challenges of achieving bipartisan support for financial reform.
In this Financial Times op-ed, six heads of large Canadian banks discuss problems related to global regulators enforcing different standards on capital and bank leverage.
This CFR Backgrounder outlines the Obama administration, Senate, and House proposals on financial regulatory reform.