The Details Matter And Obama’s Got Them All Wrong

In his speech before Wall Street executives in New York on Thursday, President Obama pledged several times that the Democrats’ bill for financial reform will “put an end to taxpayer bailouts.” The bill won’t accomplish this important goal until Congress ditches the first 274 pages – the two sections that would create a “financial stability oversight council” and an “orderly liquidation authority.”

The financial stability oversight council, which Obama supports, will have a daunting task — in the bill’s words — to “identify risks to the financial stability of the United States” and “to respond to emerging threats to the stability of the United States financial markets.”

Problem is–no institution, whether it’s a government agency, or a big bank, can be confident that it can predict the future. This issue isn’t theoretical. Say we had this “Financial Stability Oversight Council” today. Would the council say that big banks should hold bigger “down payments”– non-borrowed money — against, say, investments in U.S. Treasury bonds? After all, the next financial crisis to hit the globe could be a government debt crisis.

But the bondholders who provide money to the big banks will take comfort that a brand-new regulator is looking out for them — or, at least, they’ll pretend to. Really, they’ll be thinking that the government’s approval of big banks means that everyone else is investing in these banks, too — which means, in turn, that the government will have to bail everyone out to avoid a systemic crisis.

This expectation will make it impossible for the new regulator to do its other job: “to promote market discipline, by eliminating expectations on the part of shareholders, creditors, and counterparties … that the government will shield them from losses.”

Why leave any room for debate here, especially when Congress doesn’t need to? We have a system for financial-firm failures: the FDIC controls bank failures and the bankruptcy code controls investment-firm and other financial-company failures.

The reason that the system doesn’t work anymore is that for the past two decades, Wall Street has overwhelmed the system with too much borrowing and financial instruments like “credit-default swap” derivatives, which spread more risk than the FDIC and the bankruptcy code can manage.

Instead of changing the system, let’s fix these things so they no longer overwhelm the system. Congress should direct regulators to set strict limits on borrowing across financial firms and instruments — no matter how big the firms are, how “safe,” or risky they seem. Congress, too, must require derivative securities to trade on public exchanges, where regulators can limit borrowing, and where the public can see volume and pricing information, just like in the stock market.

On borrowing limits, the bill put forth by Dodd, which Obama supports, fails. Regulators could continue to set borrowing limits arbitrarily. On derivatives, Democrats are getting better — and Republicans, too, need to join them to make sure neither side threads in loopholes that make any new rules irrelevant.

Making these two straightforward, simple fixes are the only measures that will accomplish Obama’s promise “that taxpayers are never again on the hook because a firm is deemed too big to fail.”

Nicole Gelinas, author of “After The Fall: Saving Capitalism From Wall Street – and Washington,” is a contributing editor to the Manhattan Institute’s City Journal.