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Financial Reform Still Within Reach

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
April 26, 2010

Financial Reform Still Within Reach - financial-reform-still-within-reach


Criticized for the drawn-out struggle to get health reform, the Obama administration and its congressional allies are determined to secure financial reform quickly. On Monday, April 26, barely a month after the breakthrough on healthcare, the Senate staged its first attempt to move ahead with its overhaul of Wall Street. The fact that Democrats narrowly failed to secure the sixty votes they needed to advance debate on financial reform legislation does not change the bottom line. The president and his allies believe this is the moment to get something passed. They are likely to be vindicated.

Both parties in the Senate are already close on two key elements in the reform package. They agree on the need for a bankruptcy-type solution for large financial institutions that would theoretically make taxpayer bailouts less necessary. And they agree on the case for an enhanced consumer finance watchdog that would prevent financial firms from selling excessively risky products to unsuspecting households.

That leaves two issues on which Republicans and Democrats do not yet agree: the regulation of derivatives and the creation of a $50 billion bailout fund.

The battle over derivatives should be possible to resolve, because it is more a fight over degree than over principle. Both sides agree that the risks posed by derivatives should be reduced: Users of derivatives should set aside more capital as a buffer against a potential loss, and more of their trades should go through well-capitalized central clearing houses. Senator Blanche Lincoln (D-AR), the top Democrat on the Agriculture Committee, has produced a bill that would go further: It lays down that swaps trading, which allows firms to spread risks (e.g., from currencies and interest rates), should be moved out of taxpayer-backed banks and into separate companies. This provision would reduce the danger that swap-related losses could wipe out banks' capital; it would be costly for banks to implement and Republicans will not go along with it. But many Senate Democrats would be happy to soften the Lincoln measure, so bipartisan compromise should be possible.

The battle over the $50 billion bailout fund also seems resolvable. Senate Minority Leader Mitch McConnell (R-KY) has charged that the creation of such a fund "will lead to endless taxpayer bailouts of Wall Street banks." But the financial crisis proved that there can be endless taxpayer bailouts in the absence of a bailout fund. Because McConnell's objection is mainly symbolic, it should be possible for the Democrats to give him what he wants, perhaps while retaining the useful idea of a bank tax. By aiming the tax at the largest lenders that pose the most systemic risk, Congress can reduce the dangerous power of too-big-to-fail institutions.

Of course, the fact that compromise seems possible does not mean it is assured. But given the public appetite for a clampdown on financial risk, the Obama administration seems set to get some sort of reform package.

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