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Slouching toward financial reform—A Commentary by Jonathan Macey ’82

The following commentary was posted on Politico.com on June 17, 2010.

Slouching toward financial reform
By Jonathan Macey ’82

President Barack Obama traveled to Wall Street in late 2009 to tell the financial community that he favored changing government’s traditional approach to dealing with distressed financial institutions.
He wanted a new “resolution authority” — what others would call a new bureaucracy — to operate outside the traditional bankruptcy system. The whole point of the new bureaucracy, Obama said, was to “put an end to the idea that some firms are too big to fail.”

Larry Summers, director of the White House National Economic Council, went even further. He asserted that ending too big to fail is the Obama administration’s “central objective” for financial reform legislation.

Summers calls the new resolution authority the “most crucial” part of the massive new legislative package.

Because the administration lacks much — if not all — Wall Street cred, Obama clearly decided to boost the prospects of financial reform by linking his legislative efforts to the venerable Paul Volcker, former Federal Reserve chairman.

The president probably now wishes he had used some other historical source of credibility — like J.P. Morgan or Henry Morgenthau or Alexander Hamilton or any other financial giant who, unlike Volcker, no longer walks among us.

To hardly anyone’s surprise, the U.S. taxpayer is due to get the new bureaucracy. Actually, we’ll get several new bureaucracies. But too big to fail is still with us — much to the relief of megabanks such as Citigroup and Goldman Sachs.

Meanwhile, no less an authority than Volcker himself, the president’s poster boy for financial reform, just acknowledged what others have been saying for months. Which is that the banking reform bill leaves the discredited too-big-to-fail policy intact — alive and well.

In particular, Volcker says he does not believe that the administration is going to be able to apply its too-big-to-fail policy to what he calls “megabanks.”

Ironically, Volcker may have tried to be supportive of the new legislative efforts when he said on CNBC that the proposed resolution authority appears to be a “workable proposition for anything short of the biggest banks.” He then acknowledged that the legislation is not “workable” for the country’s largest banks.

Of course, the whole reason for the policy is to use it against the biggest banks. That’s why it’s called a too-big-to-fail policy.

Volcker, in essence, said the airplane he and Sen. Chris Dodd (D-Conn.) have designed can work great — as long as nobody wants to fly it.

Too big to fail is bad public policy for many reasons. As we saw during the past financial crisis, the policy is ruinously expensive.

But even when banks don’t fail, the policy produces inefficient outcomes in the financial markets. Market participants can figure out, more or less, which banks are too big to fail — and which are small enough for the government to ignore during times of financial distress.

Clients inevitably will favor the biggest banks over their smaller competitors since the biggest are the ones too big to fail.

Astonishingly, it appears that the final legislation that could emerge from the House and Senate versions will provide yet another government subsidy for the nation’s biggest banks — above and beyond what they already have by virtue of being too big to fail.

According to Massachusetts Democrat Barney Frank, chairman of the House Financial Services Committee, Congress is moving “in the direction” of adopting the proposal of Sens. Carl Levin (D-Mich.) and Jeff Merkley (D-Ore.). This would impose a maximum limit on the size of big banks and would force financial institutions to divest hedge funds and private-equity units.

But the size cap is bad policy. It could ossify the current financial industry structure by preventing other firms from becoming sufficiently large to compete with the current behemoths.

In addition to capping bank size, the new legislation aims to put new limits on financial institutions’ activities.

These institutions would have to get rid of in-house hedge funds and private-equity departments and subsidiaries. They also would be barred from using their own capital to make speculative proprietary derivatives and even stock investments.

This sounds terrific — until you start to wonder how the economy is going to generate the capital necessary to start the businesses that are crucial to stem our rising unemployment.

Unfortunately, not everyone will be able to find a job in one of those new bureaucracies that the bill creates. Perhaps the most outrageous thing about the legislative package that has emerged is that there is not one provision aimed at reforming Freddie Mac or Fannie Mae.

Fannie Mae and Freddie Mac are the government-backed enterprises that buy mortgages from lenders and “securitize them” — meaning that they package them into bonds to sell to investors.
During the financial crisis, the government had to take over these companies because they were too big to fail.

So the lack of reform here only further tarnishes the government’s credibility.

In fact, when it comes to financial reform, the basic problem the government faces is that it lacks credibility in so many areas.

Nobody believes the government when it says that it will end too big to fail — not even Volcker.

And as long as nobody believes the government’s rhetoric, the astronomical cost of its failed policies remains with us.

Jonathan Macey is a professor at Yale Law School who specializes in finance and banking. He is also a member of the Property Rights Task Force at the Hoover Institution.