Financial Reform: Will We Even Have a Debate?

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Baseline Scenario

Financial Reform: Will We Even Have a Debate?

by
Simon Johnson

The New York Times reports that financial reform is the next top priority for Democrats.  Barney Frank, fresh from meeting with the president, sends a promising signal,

"There are going to be death panels enacted by the Congress this year - but they're death panels for large financial institutions that can't make it," he said. "We're going to put them to death and we're not going to do very much for their heirs. We will do the minimum that's needed to keep this from spiraling into a broader problem."

But there is another, much less positive interpretation regarding what is now developing in the Senate.  The indications are that some version of the Dodd bill will be presented to Democrats and Republicans alike as a fait accompli - this is what we are going to do, so are you with us or against us in the final recorded vote?  And, whatever you do - they say to the Democrats - don't rock the boat with any strengthening amendments.

Chris Dodd, master of the parliamentary maneuver, and the White House seem to have in mind curtailing debate and moving directly to decision.  Republicans, such as Judd Gregg and Bob Corker, may be getting on board with exactly this.

Prominent Democratic Senators have indicated they would like something different.  But it's not clear whether and how Senators Cantwell, Merkley, Levin, Brown, Feingold, Kaufman, and perhaps others will stop the Dodd juggernaut (or is it a handcart?)

This matters, because there is more than a small problem with the Dodd-White House strategy: the bill makes no sense.

Of course, officials are lining up to solemnly confirm that "too big to fail" will be history once the Dodd bill passes.

But this is simply incorrect.  Focus on this: How can any approach based on a US resolution authority end the issues around large complex cross-border financial institutions?  It cannot.

The resolution authority, you recall, is the ability of the government to apply a form of FDIC-type intervention (or modified bankruptcy procedure) to all financial institutions, rather than just banks with federally-insured deposits as is the case today.  The notion is fine for purely US entities, but there is no cross-border agreement on resolution process and procedure - and no prospect of the same in sight. 

This is not a left-wing view or a right-wing view, although there are people from both ends of the political spectrum who agree on this point (look at the endorsements for 13 Bankers).  This is simply the technocratic assessment - ask your favorite lawyer, financial markets expert, finance professor, economist, or anyone else who has worked on these issues and does not have skin in this particular legislative game.

Why exactly do you think big banks, such as JP Morgan Chase and Goldman Sachs, have been so outspoken in support of a "resolution authority"?  They know it would allow them to continue not just at their current size - but actually to get bigger.  Nothing could be better for them than this kind of regulatory smokescreen.  This is exactly the kind of game that they have played well over the past 20 years - in fact, it's from the same playbook that brought them great power and us great danger in the run-up to 2008.

When a major bank fails, in the years after the Dodd bill passes, we will face the exact same potential chaos as after the collapse of Lehman.  And we know what our policy elite will do in such a situation - because Messrs. Paulson, Geithner, Bernanke, and Summers swear up and down there was no alternative, and people like them will always be in power.  If you must choose between collapse and rescue, US policymakers will choose rescue every time - and probably they feel compelled again to concede most generous terms "to limit the ultimate cost to the taxpayer" (or words to that effect).

The banks know all this and will act accordingly.  You do the math.

Once you understand that the resolution authority is an illusion, you begin to understand that the Dodd legislation would achieve nothing on the systemic risk and too big to fail front.

On reflection, perhaps this is exactly why the sponsors of this bill are afraid to have any kind of open and serious debate.  The emperor simply has no clothes.

Simon Johnson, former chief economist of the International Monetary Fund, is a professor at the MIT Sloan School of Management, a senior fellow at the Peterson Institute for International Economics, and a member of the CBO’s Panel of Economic Advisers. He is a co-founder of The Baseline Scenario.

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