Not Much Financial System Reform We Can Believe In

EBR believes that the administration has made a substandard start at financial system reform. Here are some first comments.

1. The administration wants to give the Fed more powers. However, the Fed more than any one institution enabled this mess. What is needed instead is to oversee the Fed better to verify that it can fulfill its current role. We should also ban such nonsense as letting Alan Greenspan serve 16 years as Fed Chairman. Au contraire, consider limiting the Fed Chair to one 3-6 year term. Also, since the House of Representatives creates all spending proposals, let the House nominate the incoming Fed chairman, let Congress approve him/her, and let the White House have veto power. That might take away the Nixonian and Bushbama approach to the Fed, which is that it is an affiliate of the Treasury Department.

This proposal is a disaster. We must recall that no-one owns the Federal Reserve Bank. It controls our money but answers to no one. It has no stockholders. It is too powerful as it is.

2. The President wants the power to simply dismantle financial companies whose failure would, in the opinion of the powers-that-be, harm the financial "system" - whatever that actually is. Just think 0f the potential for political abuse. The message would be: play ball, or we will shut you down. After the company has been shut down, what good would it do to show that the company was sound, after all?

A much better solution is Nassim Taleb's: do not allow any company to be big enough to threaten the stability of the world or the U. S.'s financial system should it fail. Small is beautiful.

A related solution is that the banking system should be a small utility-like cog in the wheel, processing payments and making low-risk loans. All the gambling should be done by uninsured entities that are free to succeed or fail without involving taxpayers.

3. The administration wants to regulate all sorts of complex derivatives. One cheer for that. But what it will not do is simply ban the toxic ones, such as "credit default swaps", that simply add costs to the system and distort incentives. Failing that, there is no proposal to ban systemically important financial companies from owning these sorts of securities. One thing we have learned is that regulation cannot or deliberately will not keep up with the pace of financial "innovation".

4. Mr. Obama wants to strengthen the Community Reinvestment Act. The premise is that banks must invest in communities where they gather deposits.

Let's forget about ethnicity and ask whether this proposal is sensible. Consider the many small towns that dot Pennsylvania and the West. They were built in, say, the 1800s to service mines and factories that no longer exist. But the houses and roads exist, so the towns live on, generally shrinking. No sensible investments can be made there, as the towns are likely going to continue to shrink away absent an unexpected boom. No pensioner living in the town wants to lend money to the local bank to invest in the town; the depositor wants the deposited funds to make loans in growing areas where the loan opportunities are greater, prices of assets are trending upward rather than downward, people are moving in rather than out, etc.

The CRA makes no sense. Sure, lenders should not discriminate on the basis of skin color, religion or the like, and laws could be strengthened in that field should they be insufficient at present. But the upshot of the CRA may simply be to deprive small towns of a bank branch that otherwise would be happy to gather deposits and provide routine banking services, but sees no loan opportunities in the town. Beware unintended consequences.

5. Mr. Obama has now spoken of a need to rush a bill through to passage. Given how favorably disposed toward the debt culture the President has said he is, the best thing would be for Congress to give the White House proposal a very, very long and careful look. Whatever is passed needs to make Democrats happy when they are out of power as well as when they are flexing their muscles. The idea of making the unaccountable, imperial and often incompetent Fed increasingly powerful seems especially antithetical to the populist roots of the current party in power.

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