Can Obama's financial reforms address today's mess?

The Obama administration is beginning to pull back the curtain on its sweeping plan to prevent future financial crises. But it's the current crisis that's causing controversy.

Are the big banks healthy again, economists and analysts ask, or are they just artificially and unsustainably propped up? The question is key because the economy will have a hard time recovering if investors have no confidence in the financial system (see: US stock markets September '08 to March '09.)

First, the optimists: "The odds are vanishingly small that any of the [stress] tested banks will actually report losses in the coming seven quarters even close to the losses that the stress case implies," wrote hedge-fund manager Thomas Brown in a blog for Bankstocks.com. "Forecasters who’ve taken to using the stress case as their base case for the banks (Goldman, this means you) are meaningfully underestimating banks’ profitability for the next two years."

His reasons, among others, are that: 1) rising unemployment doesn't accurately signal rising commercial loan losses; 2) banks have already begun cleaning up their problem loans; and 3) early cycle defaults produce the greatest losses, which the banks have already put behind them.

Have things changed?

Pessimists argue that the banks' situation has changed little, aside from the government's extraordinary assistance.

"What really seems to have happened is not that one policy or another fixed the sector. It’s not even the total effect of them that renewed confidence," wrote John Carney in a blog at Clusterstock. "Rather, it’s a kind of meta-policy, a shadow program that repaired things. And that policy is that the government will do whatever it takes to prevent the collapse of a major financial institution. There will be no more Lehmans. Failure is not an option."

The problem with that is that if big banks can't fail then markets can't price their risk and bank managers are, essentially, flying blind. What's troublesome is how to unwind the government's implicit guarantee. If government stepped in once in times of extraordinary trouble, wouldn't it step in again if things really got bad?

White House weighs in

The Obama administration understands the challenge. Writing in a Washington Post editorial Monday, Treasury Secretary Timothy Geithner and National Economic Council Director Lawrence Summers identified the issue as one of five key problems that regulatory reform must address.

They propose "a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system." That authority would only be used in extraordinary circumstances, "but it will help ensure that the government is no longer forced to choose between bailouts and financial collapse."

Will those new rules – even if Congress adopts them – deal with the current conundrum? Optimists and pessimists differ. Ultimately, markets' confidence in the administration's moves may well decide.

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