ANOTHER MISSTEP ON THE ROAD TO REFORM / THE NEW YORK TIMES EDITORIAL ( HIGHLY RECOMMENDED READING )

October 31, 2009

Editorial

Another Misstep on the Road to Reform

Draft legislation to regulate too-big-to-fail financial firms hit a wall of well-deserved dissent at a hearing on Thursday in the House Financial Services Committee.

Authored by the Treasury Department and Representative Barney Frank, the chairman of the committee, the proposal broaches a number of essential reforms. Chief among them is the creation of a systemic risk regulator to look for problems that could lead to cascading failures. The regulator would also have resolution authority — the power, if necessary, to seize and restructure critically ill bank holding companies and nonbank financial firms whose failure would pose a systemwide threat.

Such broad authority was lacking during the crisis, leading to the disorderly demise of Lehman Brothers, among other fiascoes. Properly executed, resolution authority would impose losses from a failure on a firm’s shareholders and creditors. That would force discipline on firms that have come to expect taxpayer rescues.

There’s little disagreement over the need for systemic risk regulation and resolution authority. But as lawmakers and witnesses at the hearing pointed out, the proposal is flawed in its choices of who should wield the new powers and how they should be defined.

The proposal would concentrate much of the new power with the Federal Reserve, which is problematic for several reasons. Not only did the Fed fail in its responsibility to identify and stop several of the threats that led to the crisis, it has further damaged its credibility by failing to fully account for how and why those catastrophic lapses occurred. Before Congress grants new powers to the Fed, it needs a full accounting.

The proposal is also weak on certain components of systemic risk management. It proposes to keep secret the name of institutions whose failures would be systemically dangerous, ostensibly to prevent them from enjoying lower financing costs and other advantages that come with implicit government backing. That would be silly if it wasn’t so disturbing. Systemic regulation, done right, should not confer advantages. Rather, too-big-to-fail firms should be subjected to much higher capital requirements so they can better absorb their potential outsize losses. They should also be subject to much stiffer insurance premiums, so the government wouldn’t have to turn to taxpayers to cover the costs of seizing them.

The proposal calls for higher capital, but is vague on specifics. It also would not charge upfront insurance premiums; rather, it would levy an assessment on large firms after one of them had failed. But effective legislation must impose stiff upfront insurance fees and mandate that regulators establish a progressive scale of capital requirements. The riskier the institution, the higher the capital level.

The aim should be to make size and complexity so expensive that financial firms opt to be smaller and more manageable.

Which brings up the last, but by no means least, of the proposal’s flaws. Its premise is that too-big-to fail institutions are an immutable fact of life. They are not. The proposal ignores measures that would control risk by controlling size and complexity, like a ban on proprietary stock and derivatives trading by deposit-taking banks.

Systemic regulation and resolution authority are needed. But the current proposal fails not only in its details but in fulfilling broader mandates for transparency, public accountability and thoroughness. Thankfully, it is only a draft. It can and must be significantly reworked.

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