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Financial Reform's Uncertain Promise

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
May 21, 2010

Financial Reform's Uncertain Promise - financial-reforms-uncertain-promise


Politically, the Senate's financial reform bill is a victory for President Barack Obama, who now seems likely to sign his second major piece of legislation--the first being health reform. Substantively, the Senate bill could be significant or insignificant, depending on how it is implemented. Its main provisions are likely to mitigate financial risk without solving the threat posed to the ultimate insurers of the system--governments and taxpayers.

The Senate bill would create a Financial Stability Oversight Council of regulators chaired by the Treasury secretary. In theory, this council will search out pockets of potential instability in markets and insist that financial firms cut their exposure before they suffer catastrophic losses. But it is not at all clear that regulators will be able to anticipate catastrophes successfully, and even less clear that they will have the authority to force financiers to retreat at the right time. The nature of bubbles is that most people don't think they are bubbles as they're inflating. Ordered to leave the dance while the music is still playing, banks will protest vociferously. Since they won't be able to prove that the music will stop imminently, regulators may back down.

The same uncertainty applies to another of the bill's provisions, which aims to drive derivatives trades onto exchanges. This reform is good in theory: The huge volume of off-exchange trades has the effect of tying financial institutions into a cat's cradle of interdependence, so that failure at one could bring several others down. But the efficacy of this reform could be undermined by a concession in the Senate bill. Non-financial firms will be allowed to continue trading off exchange, or "over-the-counter." If this loophole leads to the rise of large "non-financial" derivatives houses, the systemic risk posed by derivatives will merely have been displaced.

The Senate bill also provides for a "resolution authority." Government will be given the power to seize control of a large institution if its impending failure poses a risk to other players. Acting like a bankruptcy court, the government would then wipe out shareholders, fire executives, and close down the business in an orderly fashion. But it is not at all clear that this mechanism will prove effective in a crisis. The government already has a resolution mechanism for deposit-taking banks, the Federal Deposit Insurance Commission. In the mayhem after the Lehman Brothers failure, the Treasury balked at following the FDIC's procedures for fear of panicking investors further.

In the end, two things are certain. Financial markets consist of uncertain promises about an unknowable future, and so will always be unstable. And the causes of the next financial crisis will not be the same as the causes of the last one.

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