The flaws of financial reform

The House reform bill has already been passed, but the more influential bill written by Senator Dodd and the Banking Committee still faces debate in the Senate. It is crucial, for the sake of US financial stability and that of the world, that some of the bill’s shortcomings are recognized and remedied.

Today sees the publication of a think piece I have written in reaction to what I believe are two flawed elements of US financial reform bills. The US financial services sector is the largest and most important in the world, many global leaders in investment banking are based and chiefly regulated in the USA. What happens to institutions of the size of JP Morgan Stanley, Goldman Sachs, Citigroup and Lehman Brothers can, as we have seen, have enormous consequences for the financial systems and economies of the world.

It is beyond dispute that reform is necessary, and a diagnosis of the events that caused the crash comes to bear on the proposed reforms. It is my view that at the heart of the crisis was an incentive problem, whereby certain firms where effectively marked as too big to fail, their profits privatised and losses socialised. This is not capitalism; it is neither economically efficient nor morally acceptable and government reforms must reflect the need to establish the appropriate market incentives in finance.

Both the Senate and House bills ostensibly aim to resolve the ‘too big to fail’ problem, but propose reforms that are at best a waste of time and at worst potentially damaging to the financial system. Most alarmingly, Senator Dodd’s reform bill, currently working through the Senate, establishes the principle that the FDIC (Federal Deposit Insurance Corporation) may draw funds from the government to help liquidate banks in a crisis. It is argued that this measure enshrines the principle of a taxpayer bailout, qualifying the legislation as a Bailout Bill.

The legislation shows no commitment to competitive markets in the sector by bestowing the advantage of a potential preferable liquidation on the larger financial firms in case of failure and by failing to ‘break up’ the largest firms as a first port of call. In doing so, it is argued, the bill could cement the fundamental incentive problem, increasing systemic risk and the probability of future large bailouts by the treasury effectively with taxpayer dollars.

While the two reform bills do too little in relation to solving the central incentive problem at play, it is argued that there is an overreaction in the direction of ‘alternative investments’. The regulatory proposals are likely to be futile in this field, as well as being unnecessary.

The House reform bill has already been passed, but the more influential bill written by Senator Dodd and the Banking Committee still faces debate in the Senate. It is crucial, for the sake of US financial stability and that of the world, that some of the bill’s shortcomings are recognised and remedied.

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