When the Senate returns from spring break on Apr.Â 12, the debate over banking regulation will command the center ring. The political press will track, in excruciating detail, the trapeze act of Banking Committee Chairman Chris Dodd (D-Conn.) as he reaches for the elusive 60th vote needed to push his bill past a GOP filibuster. The clowns on both sides will emit their reliably windy rhetoric: Republicans claiming that the legislation will invite more outrageous bailouts, Democrats that this bureaucratic reshuffle will fend off the next financial cataclysm.
The whole depressing circus will be beside the point. There's one clear issue at the heart of regulatory reform—one obvious measure that lets you know whether the bill is worth the price of admission—and the Dodd legislation ducks it. What's missing are strong rules forcing banks to raise capital and liquidity levels. Such restrictions would be a real buffer against the sort of risk-taking that fueled our recent crisis.
Instead of building this buffer, the Senate will argue about issues that amount to little more than elaborate distractions. First, the Dodd bill would create a consumer protection agency to prevent home loan and credit card abuses. Republicans, echoing JPMorgan Chase (JPM) CEO Jamie Dimon and his cohorts, attack the plan as hostile to capitalism. Dodd has compromised by sequestering the watchdog within the bank-friendly Federal Reserve. Look for him to offer more cosmetic changes to tempt GOP crossover votes.
Additional consumer protection makes good sense. But fabricating a brand-new agency smacks of symbolism. Existing regulatory bodies already have all of the powers that would be invested in any new agency. With or without a reform bill, if the White House put real cops on the banking beat, we would see real enforcement. If we get the sort of do-nothing crews we've had since Ronald Reagan, rearranging the seating charts won't make much of a difference.
Capital and Liquidity Requirements
The other fake debate will focus on proposals to enhance Washington's authority to put to rest troubled financial giants—a less traumatic "do not resuscitate" procedure for the next Lehman Brothers. The Democrats want to give regulators more tools to liquidate endangered Wall Street Goliaths without the panic sparked by Lehman's abrupt Chapter 11. Republicans, warning that their mollycoddling foes are encouraging taxpayer giveaways, argue that ordinary bankruptcy court is sufficient. Again, the argument seems tangential. In the midst of a future meltdown—God help us—politicians aren't going to risk either the liquidation of interconnected financial institutions or another Chapter 11 train wreck. As long as we allow the leviathans to get too big to fail, they will be, well … too big to fail. We will rescue them to prevent worldwide depression. That, predicts Douglas J. Elliott, a former investment banker who is now at the Brookings Institution, will likely lead to "the same type of stumbles and traumas as we just went through."
Which brings us to the issue that deserves attention but will be largely absent from the Capitol Hill theatrics: capital and liquidity requirements. Capital is the investment in a financial institution that doesn't have to be paid back to anyone. When a bank's assets—say, exotic real estate-backed securities—fall suddenly in value, its capital provides a bulwark against disaster. In the last debacle, too many Wall Street institutions lacked sufficient capital. They were too highly leveraged. Since 2007, U.S. banks have boosted cash reserves and raised $519Â billion of capital at the urging of regulators, Bloomberg News reported last month. As memories of the crisis fade, however, those stockpiles will diminish—unless someone sets tough rules. As a chastened Alan Greenspan told the Financial Crisis Inquiry Commission on Apr.Â 7: "The primary imperatives going forward have to be increased risk-based capital and liquidity requirements on banks and significant increases in collateral requirements for globally traded financial products."
In lamentably vague terms, the Dodd bill authorizes regulators to impose stricter mandates for bank capital. It also requires more stringent standards for liquidity, the supply of cash or easily sold holdings. More capital and liquidity means less risk, but also less profit on a per-dollar-invested basis. That's why bankers inevitably try to whittle down stores of capital. They warn that if you force them to keep more cash they will lend less, and they are right—but the argument is a red herring. Having a bigger capital buffer makes lending less cyclical; it allows banks to keep writing loans even in bad times. A 1999 analysis by the Basel Committee on Banking Supervision concluded that while certain sectors such as real estate seem to be cooled by higher capital standards, experts "have been rather less successful at identifying an impact at the aggregate economy level." It added that "by promoting financial stability, their overall effect on economic growth may be positive."
Shrink the Too-Big-to-Fail Institutions
Simon Johnson of MIT's Sloan School of Management contends in his new book, 13 Bankers, that higher capital standards aren't enough. He wants to shrink the too-big-to-fail institutions until we can afford to let them collapse without fear or favor. Johnson and co-author James Kwak propose strict caps that would force banks to shed assets if they want to place bets like casino gamblers. Anti-bailout Republicans should agree. "If there are no financial institutions that are too big to fail," Johnson maintains, "there will be no implicit subsidies favoring some banks as opposed to others. Creditors and counterparties will play their necessary role of ensuring that banks do not take on too much risk."
Shrinkage makes sense. It's also far beyond what Congress is willing to mandate. The Dodd bill doesn't even include specific numbers for capital requirements; that's left to the regulators. Granted, if Democrats had tried to set hard capital levels, Wall Street's lobbying army would have intensified its campaign to blow up the bill. That would have been a battle worth having, however—and a better use of political ammunition than the coming skirmish over a consumer protection agency. Even if Dodd prevails, we won't know whether future regulators will set aggressive capital and liquidity rules.
Any meaningful action on capital and liquidity will have to play out internationally. Without global standards, Wall Street would set one jurisdiction against another in a game of regulatory arbitrage. So when the financial reform show wraps up in Washington, it will move to Switzerland, where the Basel Committee sets standards for 27 countries and territories. That's the forum where later this year we'll see whether the Obama Administration intends to take bold steps to challenge the Wall Street oligarchy.
It won't be easy. Bloomberg reported in March that amnesiac European bankers are already complaining that Basel shouldn't limit risk to a degree that slows money flows into their economies. If the Basel negotiations do produce tough guidelines, the White House will have to summon the fortitude to enforce them at home. That would be a circus worth watching.