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Chris Dodd's Cloudy Crystal Ball

March 29, 2010

By Nicole Gelinas

Sen. Chris Dodd, D-Conn., wants to legislate clairvoyance, requiring financial regulators to see the future perfectly and prevent it before it happens. His financial reform bill, which he released last week, shows that Washington hasn't learned the lesson of the financial meltdown: humility.

Dodd seems to think that the financial industry failed because Washington lacked the necessary powers to collect and analyze data that would allow them to foresee and predict crises.

To fix this problem, he would expand the bureaucracy. Among his proposed agencies are a Financial Stability Oversight Council (FSOC) to “identify potential threats to the financial stability of the United States” and neutralize them. It could break up a big financial institution that poses a “grave threat to financial stability.” The Office of Financial Research (OFR) and the Research and Analysis Center (RAC) would support it, enjoying nearly unlimited access to Wall Street’s raw material to “monitor, investigate and report on changes in system-wide risk levels.”

No central authority can predict the future, though.

Dodd wants financial stability, for example, so it may seem logical to create an FSOC. But the Federal Reserve has long had this implicit role. Its explicit mandate is to protect the dollar's value and to maximize employment. It cannot do those things without financial stability.

The Fed has long held ample power to do this job. If then-Fed Chairman Alan Greenspan had perceived a looming crisis a decade ago but felt powerless under existing law to avoid it, he had such clout that he could have gone to Congress and requested the authority. Instead, Greenspan freely surrendered some of the Fed's power, counseling Congress in 2000 to forbid the regulation of over-the-counter derivative securities, the kind that insurer AIG ( AIG - news - people ) would use over the next decade to achieve its insolvency.

The Fed failed to prevent the future not because it was inept, stupid or corrupt. It failed because it thought that it was doing the job Dodd wants the FSOC to do: seeing the future.

As Greenspan says in a new paper, called The Crisis, “given history, we believed that any declines in home prices would be gradual. Destabilizing debt problems were not perceived to arise under those conditions.”

Policymakers believed, too, that Wall Street firms, armed with cutting-edge modeling technology, would monitor themselves and each other to avoid losses, obviating the need for old-fashioned capital and trading rules on new derivatives.

Voices warned of risks--but they were in the minority. In a bubble, more people are over-exuberant than not. The new Financial Stability Oversight Council would not escape this fact.

It would also fall victim to politics. Imagine that the Fed and other agencies had restricted all but the plainest-vanilla mortgages back in 2000, when, as Greenspan notes, “we were aware of … some highly irregular subprime mortgage underwriting practices.” The regulators would have tempered the bubble--but the politicians wouldn't have seen it that way. Instead, they'd have accused bureaucrats of roping off citizens from the American dream.

It must be tempting for Greenspan to agree with Dodd that the problem was the wrong kind of bureaucracy. Such a conclusion would leave the ex-maestro off the hook.

Instead, Greenspan says, “the notion of an effective 'systemic regulator' as part of a regulatory reform package is ill-advised ... . [F]orecasters as a group will almost certainly miss the onset of the next financial crisis, as they have so often in the past, and I presume any newly designated 'systemic regulator' will also.”

The way to protect against an unknowable future is through rules that don't require “unachievable specificity in regulatory fine-tuning,” in Greenspan's phrase. That means applying consistent, predictable rules to finance, protecting the economy from financial-industry disaster no matter what happens.

How? The biggest financial crises arise from too much debt. Borrowers and lenders, ensconced in a bubble, fail to see the need for cash as a cushion against error. When the bubble bursts, it leaves behind so much debt that it bankrupts the financial industry.

To protect the economy from this unchanging but unpredictable history, we don't need an FSOC, or the OFR and RAC that would support it. Instead, existing regulators should move toward consistency in their borrowing limits--requiring a financial institution to put a consistent level of cash down behind any debt security or derivative instrument, even if the government thinks the investment is perfectly safe, as it did with mortgage securities.

Further, existing regulators should wean financial companies off their reliance on the cheap overnight debt that they borrow from global markets to fund their investments. Dependence on these markets makes the economy's credit stores too vulnerable to mania and panic. Regulators could require firms to put down greater cash cushions proportionate to this borrowing.

These rules would encourage the most important regulation of all: market discipline. Individual companies would still fail to meet their obligations, but they would not bring down the entire financial system in the process. Only when investors know that the economy has some cash cushion against financial-company failures will they understand that such failures are possible and protect themselves accordingly.

Dodd's bill would encourage the opposite: more complacency. If the Financial Stability Oversight Council decrees, for instance, that firms such as Citigroup ( C - news - people ) and AIG don't pose a “grave threat” to the financial system, the firms can't pose a grave threat to their own investors, the markets will think.

Instead of adding to Dodd's 1,336-page bill, Washington should repeal the 2000 law that forbids existing regulators to set consistent rules for all derivatives instruments. Then, Washington should tweak the bankruptcy code so that, for example, financial firms can go bankrupt without giving their creditors the right to pull their derivatives contracts, destabilizing the financial world.

We need politicians and regulators to implement simple rules that don't require faith in omniscient, micro-managerial government planning.

Original Source: http://www.forbes.com/2010/03/29/chris-dodd-financial-reform-economy-opinions-contributors-nicole-gelinas.html

 

 
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