Monday, May 24, 2010

What's Wrong with the New Financial Regulation Legislation?

by Richard Crews
As a result of the near-collapse of the U.S. (and world) financial systems in 2008, Congress is putting together the strongest, broadest regulation legislation since the 1930s. This legislation will go a long way toward stabilizing the financial industry. It increases the level of funding institutions will be required to hold, and increases visibility and regulation of their activities. But the new legislation has problems.

(1) Previously trillions of dollars in derivatives representing bets that the system would fail--bets that turned financial difficulty into catastrophe when things started to go awry--were hidden from view. Now they must be traded out in the open on an exchange. BUT certain kinds of derivatives that are used to hedge fluctuations in interest rates and commodity prices are exempted from this requirement. This exemption could be manipulated to cause serious problems.

(2) Bank regulators were lax; also, they often did the bidding of the banks they regulated. This has been addressed to a certain extent, BUT under the new system smaller banks still choose their own regulators.

(3) Some financial institutions became "too big to fail," that is, so big that their collapse would jeopardize the entire financial system--they had to be bailed out. There were debates about how to deal with this, BUT the problem has not been addressed effectively.

(4) A new, stronger consumer protection agency has been created, one that would, for example, restrict banks from lending to borrowers who clearly could not pay back the loans made to them. BUT the authority of this agency has been limited to banks with more than $10 billion assets. Small banks and non-banks are not covered.

(5) Credit-rating agencies that determine the riskiness and therefore the price of loans were both chosen by and paid by the institutions they rated, and were therefore inclined to give distorted favorable ratings. Rating agencies will now be chosen by an "independent" board. BUT it is uncertain how "independent" this board will be. Moreover, the fees are still paid by the banks being rated.

In general stronger legislation was favored by Democrats but opposed and diluted by Republicans under intense lobbying from some of their major contributors such as the U.S. Chamber of Commerce, the Business Roundtable, the payday lending industry, and the National Automobile Dealers Association.