The Wall Street Reform Bill's Worst Ideas

The financial reform bill corrects many of the problems which led to the financial crisis, but serious problems and risks remain.

The massive financial reform bill which passed yesterday in the Senate offers a complex financial regulatory mechanism with many moving parts. Earlier, I reviewed some of the bills’ better aspects. But the bill also has lots of problems. Five stand out:

1. The newly created “Financial Stability Oversight Council” could emerge as a duplicative and burdensome super-regulator: An entirely new entity, the Financial Stability Oversight Council, will have near total power over the financial sector. With a 2/3rds vote, the council’s ten members -- heads of each major financial regulatory body -- will be able to break up any firm they deem “too big to fail.” This power to carry out a “death penalty” could well turn the Council into a super-regulator that ends up imposing all sorts of other restrictions on every type of financial institution. Since all voting Council members except the Fed chair will generally change with presidential administrations, the new council also represents a massive potential consolidation of power within the executive branch. At best, the Council will find the 2/3rds rule threshold too high to do much of anything. At worst, the Council will be a device for the Washington bureaucrats to micromanage with every nook and cranny of the economy.

2. New “interchange” or “swipe” fee limitations will pad the pockets of big retailers while reducing the perks consumers get from credit cards: Credit card networks cost money to maintain and firms that issue cards impose fees on merchants that accept them in order to recoup the costs of running these payment networks. Many merchants, however, feel that the fees are too high and have gotten Congress to cap them. This, of course, has nothing to do with financial stability and, by cutting off a dependable revenue source for banks, could potentially destabilize some already weak institutions. It’s a bad deal with consumers too. Experience with capped fees in Australia and elsewhere has shown that caps don’t reduce prices for consumers but do result in limitations on credit card rewards programs, free checking, and other consumer perks. The only real beneficiaries of the law will be the stockholders and executives in companies like Target and Wal-Mart.

3. The bill offers no long-term solution for the problems of Freddie and Fannie: The two individual institutions most responsible for the financial crisis -- Freddie Mac and Fannie Mae -- get almost no mention in the bill.  The government had no business playing in the mortgage securitization market in the first place and a truly comprehensive plan to restore financial stability should have included a step-by-step plan for turning all or almost all of the mortgage securities market over to the private sector. The bill doesn’t even try.

4. Creating innovative new financial products will be much more difficult: The Council, new limitations on firm structure, new bars on interrelationships, and even new taxes may promote stability but they’ll also make it hard to innovate. Financial products on the cutting edge -- prediction markets, “true” reciprocal insurance agreements between large companies, “rocket scientist” exchange traded equities that offer hedge-fund like techniques to ordinary investors -- will become a lot more difficult to create and market under the new regime. Although impossible to quantify -- none of the products above are significant economic drivers yet -- the sheer number of “watchers” the new regime establishes will make it hard for them, or anything else innovative, to emerge.

5. The compromise “Volcker Rule” is the worst of all worlds: Former Fed chairman Paul Volcker doesn’t much like the current version of the rule that bears his name and, even among those who think that Volcker headed in the wrong direction, it’s difficult to blame him. Volcker originally proposed a rule that would have banned banks from investing in hedge and private equity funds using their own money. This would have impeded banks’ ability to make money and create new products but, at least, increased their stability. The version of the rule most likely to become law (things are still in flux) puts a cap on the amount that banks can invest in these types of speculative investments. As a result of the cap, large commercial banks will still be able to make these speculative investments while the high minimum investments needed to participate in them will make it hard for upstarts -- which could benefit the most from them -- to do the same. Finally, a handful of larger entities that excel at wealth creation (Goldman Sachs for example) will probably just change their corporate structure to get around the rule.  The resulting changes probably won’t stabilize the financial system at all and, by making it harder for small institutions to get big, may perpetuate the existence of “too big to fail” firms.

Rep. Barney Frank -- the single person who may have had the most to do with the bill’s final form -- has blamed many of the greatest financial problems on “non-regulation” rather than “deregulation.”  He’s right about that. A working financial system cannot exist in the absence of law and the bill represents a good faith effort to update an outdated financial regulatory framework. As written, the bill contains good ideas and bad ideas in roughly equal number. It could surely stand improvement; but, if implemented wisely, will correct some of the problems that led to the financial crisis in the first place.  The risks of overcorrection, however, remain real and, whatever happens, the numerous new agencies and rules created under the legislation will need careful, ongoing scrutiny.