Financial Reform Will Definitely Work After Regulators Figure Out How to Make It Work

Worried about the next economic meltdown? Don't get your hopes up. Congress' new scheme to prevent the next economic crisis isn't more of a plan to say that they're against economic crises—and figure out how to stop it later:

"I would say that nothing in this bill would have prevented the previous crisis — the one we are working our way through right now," said William Isaac, former chairman of the Federal Deposit Insurance Corp. "And it clearly won't prevent the next crisis."

The law sets broad guidelines for the existing patchwork of regulators—including  the Federal Reserve, Securities and Exchange Commission and Commodity Futures Trading Commission — and establishes bodies to oversee consumer protection and monitor "systemic risk."

Those regulators have been tasked with writing the specific rules of the road governing limits on risk-taking by financial firms and previously unregulated trading.  Other provisions are supposed to make it easier to liquidate large institutions that pose a risk to broader financial system. A new consumer protection bureau is supposed to guard against lending abuses.

But it will take years before the impact of the law is known. That's because most of the specific regulations have yet to be written.

"The devil is in the details: There are a lot of unanswered question that were thrown to regulators," said Jay Brown, a professor of corporate and securities law at the University of Denver. "The reason it was thrown to regulators is because there are no answers. So for example: What's too big to fail? Nobody knows the answer to that."

But the regulators will figure it out, right? After all, they were so effective in the last crisis. Er. I mean…

Under the new law, banks and other financial institutions will be overseen by a council of  regulators. That group will be charged with identifying the kinds of "systemic" risks that spun out of control in the collapse of Bear Stearns and Lehman Bros. in the financial panic of September 2008.

But there's little to be gained by entrusting that task to the same regulators who failed to spot the causes of the panic the first time, said Isaac, the former FDIC head.

"If a bank went to the regulators and said, 'We've got a good idea: we're going to put our lending officers in charge of risk management,' that bank would be put out of its misery immediately," said Isaac. "That's what the government just did. It put the regulators in charge of assessing their own performance. It's a very bad system."

How about the big banks? At least we're not going to continue to favor them taxpayer-funded advantages, right?

The new law also sets up different rules for big banks—those with more than $10 billion in assets—and the rest of the industry. That means a handful of banks will continue to enjoy "too big to fail" status—complete with an implicit government guarantee that lowers their borrowing costs and gives then a competitive edge, according to Hurley.

"It enshrines for the foreseeable future that there are two parts of the financial system," he said. "There are the six largest banks, which account for about 60 percent of the financial system, and then there is everybody else, from regional banks down to credit unions. The top six get a subsidy in the form of lower borrowing costs. And everybody else pays for it."

For three more reasons why the new financial reform law won't work, check out Reason.tv.