Flawed Financial Bill Contains Huge Surprise: Simon Johnson

On the face of it, financial reform appears to have failed.

To be sure, there will be a new consumer agency charged with protecting people against financial products. Given the way financial companies treated people during past decades, even those who aren’t generally enthusiastic about regulation think this is a good idea.

Yet with regard to the heart of the matter -- the kind of systemic risk that almost caused another Great Depression in late 2008 -- all the high-profile ideas in the Dodd-Frank bill turn out to be damp squibs.

The Volcker Rule -- aiming to limit banks’ use of their capital in risky activities -- was watered down by the administration almost as soon as it was introduced in January and has now been negotiated down to almost nothing. Banks will still be able to take big bets with their own capital, as long as the deals don’t look like traditional proprietary trading.

The Lincoln Amendment, targeting undercapitalized derivative trading and about which there was tremendous emotion in recent months, has been greatly diluted. Undercapitalized derivative positions, broadly defined, were at the heart of the matter in 2007 and 2008. This is the common thread that runs from the failure of funds backed by BNP Paribas SA in the summer of 2007 through the demise of Bear Stearns Cos. in the spring of 2008 and into the cataclysm that American International Group Inc. became a few months later.

Small Change

Yet the final bill does almost nothing to change realities on the ground. Even JPMorgan Chase & Co., the giant of over-the- counter derivatives trading, apparently claims that it is already compliant with the new rules.

The Treasury Department will get the much vaunted “resolution authority” that will in effect allow the Treasury (and the Federal Reserve) to take over and manage the liquidation of any financial firm. This essentially allows a Federal Deposit Insurance Corp.-type closure process for bank holding companies and other entities that do not have insured deposits and therefore aren’t covered by the FDIC.

But this authority applies only to firms whose operations are entirely domestic. It doesn’t apply to those that do any type of global business because there is no cross-border resolution mechanism and no prospect that the G-20 will even take up such an idea.

None of the big financial firms will be affected by this legislative outcome. And Treasury Secretary Timothy Geithner’s approach of “let us raise capital standards” doesn’t seem to have legs. Congress was told to not legislate minimum capital requirements and has duly obliged.

Letting Others Decide

But the administration seems intent on deferring to the Basel Committee, which has in mind that no bank or similar institution needs Tier 1 capital of more than 10 percent, less than Lehman Brothers Holdings Co. had immediately before it failed. (Lehman had 11.6 percent, according to the public record.)

Scouring all 2,400 or so pages of the bill, which has now passed the House and awaits final passage in the Senate, it is hard to find anything that will substantially change how Wall Street operates.

And yet there is one item that is more than a surprise -- in fact, its presence in the final bill is quite stunning.

This is what is known as the Kanjorski Amendment, after Congressman Paul Kanjorski, chairman of the House Subcommittee on Capital Markets, part of the House Financial Services Committee.

Big Shift

In essence, Kanjorski proposed that a group of 10 federal regulators be given the explicit power to break up big financial firms when they pose systemic risk. Not only that, the wording of the bill makes it clear that these regulators now face the expectation that they will use these powers.

This is a big shift in responsibility, away from the Federal Reserve, which implicitly had all kinds of emergency powers but would never have taken such action.

Who are the Kanjorski 10? This is the systemic risk council, which includes the treasury secretary (as chairman), the chairman of the Federal Reserve’s Board of Governors, the director of the new consumer protection agency, the head of Federal Housing Finance Agency, the chair of the National Credit Union Administration board, an individual who will represent insurance regulators and representatives from the each of the four standard federal regulatory agencies.

If two thirds of the council’s members agree (i.e., 7 out of 10), then a financial company can be subject to a variety of restrictions, up to and including the requirement that it divest itself of particular activities or more generally break up.

‘Grave Threat’

The criteria for an intervention here are broad, with the key condition being defined clearly and quite sensibly as “a grave threat to the financial stability of the United States.”

This is not, of course, the same thing as a legislative requirement that megabanks be subject to a hard size limit -- in effect breaking up the largest six banks -- in order to reduce system risk. That idea was put forward by Democratic Senators Sherrod Brown and Ted Kaufman. It received impressive support on the Senate floor, but ultimately failed, 61-33.

The Kanjorski Amendment wasn’t a surprise. It is an entirely reasonable reaction to the too-dangerous-to-fail experience of 2008-2009. The surprise here is that the bank lobbyists weren’t able to get it taken out or entirely watered down. The supermajority decision-making at the level of the risk council might seem like a weakening from the original Kanjorski proposal, but it also helped keep political support for what is, at its heart, a very radical idea.

(Simon Johnson, co-author of “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown,” is a professor at MIT’s Sloan School of Management, a senior fellow at the Peterson Institute for International Economics, and co-founder of BaselineScenario.com. The opinions expressed are his own.)

To contact the writer of this column: Simon Johnson at sjohnson@mit.edu

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