Four Ways to a Better Finance Bill

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Democrats say their financial regulation plan will vastly reduce the odds of a future crisis and ensure that taxpayers won’t ever again have to pay for banks’ sins. Skeptics worry — and with good reason — that the White House and Congress are being a little too confident.

Financial crises are complex beasts. Even after they’re over, people have trouble agreeing on exactly what caused them.

So the Obama administration and Congress were smart to avoid the magic bullet trap: the wishful idea that one sweeping solution, like breaking up the banks, could prevent the next crisis. Their goal instead has been to improve financial regulation in dozens of ways, making it harder for tomorrow’s regulators to do as poor a job as yesterday’s.

But as the House and Senate begin merging their separate bills into a single bill, they still have a chance to make some important improvements. Here are four issues to watch in coming weeks:

DERIVATIVES They’re easy to hate and hard to understand. Derivatives are contracts that allow people to make bets, be it on the price of corn, the future of interest rates or a pool of subprime mortgages.

Their economic purpose is that they allow companies to hedge risk. If soaring fuel prices have the potential to bankrupt an airline, it can buy a derivative that pays off if prices jump. Southwest Airlines did exactly this a few years ago.

Unfortunately, many investors used debt to buy their derivatives. When the value of the derivatives fell, the investors had little margin for error. The fact that most deals were done privately — rather than through a clearinghouse, with prices everyone can see — made the situation worse by creating uncertainty.

The House bill would force some trades into a clearinghouse but would allow far too many exemptions. The Senate bill is stronger. It’s probably too strong, in fact. It effectively bans many big firms from trading the most lucrative type of derivatives. That’s not so different from a ban on subprime mortgages, which, of course, also helped cause the crisis. Both derivatives and subprime mortgages can play a useful role. They just need to be closely watched.

The Senate rule, however, does have a silver lining. Wall Street lobbyists have devoted so much energy to fighting the ban that they have not had as much time to fight other (better) parts of the bill that they also dislike — like the Senate’s clearinghouse.

CONSUMER PROTECTION Why didn’t any government agency prevent banks from issuing mortgages that homebuyers obviously could not repay?

There were two main reasons: the responsibility for doing so was spread across a handful of agencies, and the most important of those agencies, the Federal Reserve, has never been good at protecting consumers.

So both the House and Senate would create a new consumer watchdog for credit cards, mortgages and other financial products. In the House version, the watchdog is a separate agency. In the Senate version, it is housed inside the Fed — which is less than ideal, given the Fed’s history of deferring to banks. But it’s not a disaster, because the Senate was careful to create an independent budget for the group and let the White House appoint its director.

As Elizabeth Warren, the law professor who developed the watchdog idea, told me, “The consumer agency in the Senate bill is strong, but there is no margin for error.” You can expect lenders, ranging from big banks to car dealers, to try to weaken the agency during House-Senate talks.

FED CREDIBILITY The Fed still has accepted almost no responsibility for its mistakes during the housing bubble. “Like other regulators, there were some things we could have done, at least with hindsight,” Ben Bernanke, the chairman, recently said. “But we had neither the mandate nor the tools to be the financial system’s supercop.”

Reading that, you might think that the bubble was evident only in retrospect and that, regardless, the Fed was powerless to stop it. That’s simply not the case. A fair number of people did recognize the bubble as it was inflating. The Fed’s leaders, by contrast, went out of their way to claim real estate was not in a bubble.

Imagine if Mr. Bernanke and Alan Greenspan had used their bully pulpit to point out how high house prices were relative to rents or incomes. Or imagine if they had cracked down on delusional mortgages, as their consumer protection powers gave them the authority to do — and as they finally did only after the bubble burst.

Despite the Fed’s failures, Congress is giving it vast new powers, largely because there is no better alternative. Most important, the Fed will decide how much debt banks can take on, a standard that will help determine how well they weather the next crisis. Yet neither the Fed’s leaders nor President Obama, who reappointed Mr. Bernanke, has explained why we should believe the Fed has learned from its errors.

Congress can do better. The Senate bill calls for an audit of the Fed’s actions during the crisis (which were, in fact, pretty heroic). Why not expand the time frame to the run-up to the crisis? The Senate would also create an independent unit inside Treasury, the Office of Financial Research, that could identify problems even if the Fed did not.

The more checks and balances on the Fed, the better the odds of avoiding another crisis. Fool me once, right?

BAILOUTS No matter how much those odds are reduced, however, they won’t be eliminated. Banks will get in trouble again, just as they have for hundreds of years. The government may then need to prop up a bank to avoid another panic.

The Senate bill — which is likely to win on this point, because the White House agrees — would cover the costs of any such bailout by collecting money later from surviving banks. The House would collect fees up front and place them in a fund. Both approaches have their problems. The House’s fund seems too small, and the Senate’s after-the-fact fee may not be so easy to collect after a crisis has passed.

A better approach is a permanent tax on banks, based on how much debt they have and how risky their holdings appear. This has the double advantage of discouraging risky behavior while also making sure taxpayers are made whole. And if banks end up paying more in taxes than they eventually need in bailouts, that’s O.K. They have enjoyed plenty of subsidies and plenty of bailouts over the years.

A bank tax will not make it into this bill. But Congressional leaders have said they may take up the issue later this year. As flawed as the Senate bill is on this issue, it at least does not get in the way of a future tax.

It’s worth remembering that whatever bill Congress passes will not be the last word on financial regulation. How well the Fed and other agencies carry out the law will matter greatly, and Congress will probably need to pass other, albeit smaller, bills in the future.

“This bill isn’t remotely perfect, but I think it gets us two-thirds of the way to where we ought to be,” said Douglas Elliott, a Brookings Institution finance expert. “In the real world, that’s pretty good.”

Here’s hoping the House, the Senate and the White House can get a little further — say, three-quarters of the way to perfection — in the next few weeks.

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