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Wednesday, July 28, 2010


A new era for U.S. finance

The U.S. Congress on July 15 approved the most substantial reform of the country's financial system since the Great Depression. The measures, put into place to prevent another crisis like the one that slammed the global economy in 2008, have been hailed by supporters as a virtual overhaul of the financial system.

Detractors on the left argue that the moves do not go far enough; opponents on the right claim the bill is another step in the creeping socialization of the U.S. economy and will shrink the flow of funds that has generated economic growth. The overhaul will help insulate the U.S. financial system from future shocks, but it is unlikely to prevent them entirely. That is about all we can expect.

Economists continue to debate the causes of the Great Recession. For some, the chief culprit was the easy credit that flooded the U.S., creating asset bubbles, particularly in real estate. Others insist the problem was not just easy credit, but lending practices that exploited an uninformed public.

Others blame a hugely over-leveraged financial sector that indulged in speculative trades that were so sophisticated that no one understood the risks involved. Yet others finger a regulatory structure that was unable to identify potential problems, asleep at the switch or lacking the authority to take action when it was needed. The new U.S. legislation tackles each of those issues.

First, and perhaps most substantially, the bill expands federal financial regulation beyond its traditional focus on banks and public markets, imposing government oversight on a much wider range of financial institutions. Hedge funds in excess of $150 million will have to register with the Securities and Exchange Commission. A new federal office will monitor — but not regulate — insurance companies, a task that has traditionally been left to the states. And the legislation pushes the $600-trillion derivatives market into public exchanges and clearinghouses, which should make transactions more transparent for the parties concerned and regulators.

Until now, this huge market has been virtually unregulated, permitting banks and financial companies to rack up huge profits — and to risk bringing the entire financial system to its knees when unexpected losses materialize.

The bill creates a council of federal regulators to detect and assess risks to the financial system. Significantly, regulators will also have funds to unwind failed banks and other financial firms without resorting to taxpayer money. Republican opponents of the bill claim that this paves the way for future "bailouts" of the financial system. In fact, it will help regulators avoid both the resort to taxpayer funds as well as yet another bruising fight — as occurred in September 2008 — during which the situation deteriorated dangerously while politicians played to televised audiences. As U.S. President Barack Obama said upon signing the bill into law last week, "because of this law, the American people will never again be asked to foot the bill for Wall Street's mistakes. There will be no more taxpayer-funded bailouts. Period."

To stem the risk of banks getting in over their heads via risky trading strategies, the bill embraces "the Volcker rule," named after former Federal Reserve Chairman Paul Volcker, which limits the amount of money that banks can invest in hedge funds and other trading vehicles. This will keep banks from making speculative bets with government-backed money.

Finally, the bill creates a Consumer Financial Protection Bureau, which will address the predatory practices that banks sprang on uninformed — and sometimes informed — consumers. The new agency will be housed in the Federal Reserve and will try to ensure that ordinary citizens are not victimized by unscrupulous lenders. The regulator will try to end the abusive practices that allowed lenders to bury hidden fees and penalties in pages of fine print that accompany every financial document.

The entire package of legislation reverses the decades-long deregulation process in the U.S. that unleashed the power of finance, but also injected new fragility into the financial system. It transforms the relationship between the federal government and the finance industry. Whether it succeeds in protecting the U.S. — and the world — from another crisis is an open question.

While the new consumer authority has the authority to protect ordinary citizens, much depends on the rules and regulations that it will write. The body has to have a powerful head, a motivated staff, and the integrity to protect itself from the industry it is designed to oversee. If it lacks any of those elements, then its promise will be squandered.

While the new council of regulators is intended to anticipate the risks that could cause a crisis, authorities have a poor record of being able to see into the future. Like generals, they are often tempted to fight the last war rather than prepare for the new and unexpected.

As always, the hardest task will be resisting the siren song of easy money. There is something to the Republican complaint that the new financial regulations will slow the economy. But it was precisely the ease with which money was circulated that led to easy credit, the asset bubbles, the speculation and the inevitable crash.

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