Monday, June 28, 2010

A Bank Overhaul Too Big To Hail- A Wall Street Commentary

The local media has been playing up Paul Kanjorski's role in bank reform. It's a love fest that is smack dab out of Ed Mitchell's playbook. In an effort to educate the people of PA's 11th Congressional district I am publishing in full an article by Peter Eavis that was printed in the Wall Street Journal, Saturday/Sunday, June 26-27, 2010. It paints a much different picture.

In democracies, the people are said to get the laws they deserve. But if American taxpayers had formulated a financial-overhaul bill, it likely would have looked very different from what will be known as the Dodd-Frank Act.

Of course, Congress and powerful interests always water down legislation to meet their own ends. The outcome for financial overhaul, however, is particularly relevant for taxpayers who spent and pledged hundreds of billions of dollars to bail out the system.

The act's biggest failing: It does little to solve the too-big-to-fail problem that caused such trouble in the crisis. If any of the 10 largest banks, whose $10.4 trillion in assets are equivalent to nearly 80% of gross domestic product, hit serious trouble, the government would have to step in to prevent a systemic meltdown.

True, the overhaul tries to protect taxpayers in rescues, but it also enshrines the bailout architecture, and thus the too-big-to-fail distortions.

There was never any real chance that bank size would be reduced to the point where they would be made small enough to fail. But there was some hope that parts of the overhaul—like the "Volcker rule," which focused on scaling back proprietary trading, and the Blanche Lincoln amendment, which aimed to force derivatives-trading risk out of federally insured lenders—would at least cut banks' riskiest activities. But both Volcker and Lincoln were softened in the face of lobbying.

The bill leaves much of the responsibility for avoiding further banking crises on regulators. Although the banking system and economy became unstable in part under the Federal Reserve's oversight, the central bank has retained huge responsibilities under the overhaul. How it and other watchdogs interpret the new rules and how proactively they use their new powers to head off problems will decide how safe the system really is.

An example of this is derivatives. The way to make sure banks hold sufficient capital against these instruments is to get as many as possible traded through clearinghouses and on exchanges. The banks likely will resist that, arguing many of their trades are nonstandard and don't qualify for clearing. Or they may claim the trades are being used to hedge their own risks, and therefore can be kept out of the separately capitalized affiliates resulting from the Lincoln amendment.

It is in those gray areas, and others such as defining what constitutes proprietary trading, that regulators will have to stand firm. Given how critical the performance of regulators is to making the overhaul work, someone also needs to make sure the Fed and other bodies are doing their job.

Congress is well-placed for that task, and, after failing to serve up a first-rate overhaul, it needs to deliver.

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