A Shot in the Arm

As I write these words, the U.S. Congress has just completed its historic health care overhaul and now turns its full attention to the nation’s financial regulatory system-which in medical terms suffers from advanced arteriosclerosis, and last year experienced a near-fatal heart attack. The early word out of Washington seems to be that regulatory reform won’t be tarred by the same partisan ugliness we saw in the health care debate-even though the Senate Banking Committee reported out a reform bill introduced by Sen. Chris Dodd, the Connecticut Democrat who chairs the committee, over the objections of the committee’s 10 Republican members.

Haven’t we seen this movie before?

Still, there may be good reason to believe that regulatory reform will find an easier path through Congress than health care reform did. Ameri-cans remain bitterly divided over the wisdom of such a drastic restructuring of our health care system, but there seems to be strong populist sentiment in favor of cracking down on the banking industry and “Wall Street,” which has become an euphemism for the complexity of today’s global capital markets. That alone may temper the mood of congressional Republicans, who clearly were emboldened by the strong public opposition to health care reform.

Regulatory reform may still fail, but it’s more likely to fail because of the breadth and depth of the proposed changes-Dodd’s bill would impose the most drastic change on financial regulation in the U.S. since passage of the 77-year-old Glass-Steagall Act-than because of partisan politics. The proposed changes in Dodd’s measure are so sweeping that there’s something in it for everyone to hate.

The House of Representatives, under the forceful leadership of Rep. Barney Frank, passed its own comprehensive reform bill last December by a narrow 223-202 vote. But the balance of power is more closely calibrated in the Senate, which probably means that Dodd will be the driving force behind any reform law that finally makes it to President Obama’s desk. Even if the political environment is more favorable for financial reform, Dodd will have to compromise with enough Senate Republicans to put together the necessary majority to win passage.

Dodd’s bill-which is more easily characterized by what it doesn’t propose to change-would, among other things, bring an end to the sotto voce policy of Too Big to Fail, create a new consumer protection agency inside the Federal Reserve, and eliminate the OTS in a broad restructuring of the bank regulatory agencies.

It’s impossible at this point to predict what a new financial reform law would look or taste like once it has emerged from the congressional sausage-making factory, but there are two things that I hope are included in its provisions. For many bankers, the creation of a new consumer protection agency-which would operate independently of the banking agencies-is an anathema. The House bill would establish this new agency as a stand-alone entity, while Dodd’s measure would situate the agency inside the Federal Reserve-although it would still operate independently.

The subprime mortgage crisis occurred in part because there was no marketplace cop with the power to crack down on the abusive and dangerous practices of nonbank mortgage originators-including mortgage brokers-who largely operate outside the authority of federal regulation. As our financial services industry has expanded in recent decades, much of that expansion has occurred outside the tightly controlled banking sector. Unfortunately, the regulation of nonbank financial companies has not kept pace with that market’s expansion. For bankers who oppose the creation of a consumer protection agency, I would argue that the potential occurrence of another future crisis like the subprime debacle-where smart operators exploit the nonbank sector’s relative lack of regulation-is the far greater danger.

Dodd’s measure would also give the Federal Reserve the authority to oversee “systemically important” financial companies that traditionally have operated outside the control of federal safety and soundness supervision. The poster child for this growing phenomenon is AIG, now better known as a purveyor of the infamous credit default swap. AIG’s swap portfolio grew so large that it could have made last year’s global economic crisis even worse had the company failed and defaulted on all those contracts, which forced the Fed to bail the insurance company out even though it had no explicit authority to do so.

The shadow banking system, as this nonregulated financial sector is sometimes called, has now grown so large that it can no longer be allowed to play by a different set of rules than traditional banks. Considering how bleak everything seemed last year during the darkest days of the global economic crisis, I think we have gotten away lucky. To not profit from such a near-death experience would be tragic.

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