Reform We Can Believe In

Prudent homeowners recovering from pest or water damage remove all compromised material before they rebuild. Similarly, surgeons prepare wounds for sutures by excising diseased tissues and sterilizing the damaged area. Nonetheless, as the US struggles to restart its economy, we're not identifying what caused the financial crisis or cleansing compromised institutions.

In 2007, the global housing bubble burst as prices fell and defaults grew. There had been related growth in the financial services sector, particularly in non-standard banking activities - the so-called "shadow" banking system. When the real estate market collapsed, the related financial services failed, dragging down the conventional banking system, which stopped lending money. On September 15, 2008, the Lehman Brothers investment bank filed for bankruptcy, causing a global financial panic. On September 18th, then Secretary of the Treasury Paulson presented an outline of a bank bailout plan to Congressional leaders. On October 3, 2008, Congress authorized $700 billion to shore up banks.

More than a year after the collapse of Lehman Brothers, the root causes of the meltdown remain unclear. Writing inThe New YorkerJames Stewart noted: "Today, it is widely accepted that the failure of Lehman was indeed a disaster. Its unintended and unforeseen consequences - the run on money-market funds most of all - could arguably have been avoided."

On June 15, 2009, the Obama Administration unveiled a program forfinancial regulatory reformthat has been poorly received. Writing in theNew York ReviewJeff Madrick noted: "Offering little more than a wide-ranging summary of existing regulatory proposals, [Obama's program] did not attempt to analyze why the crisis occurred or was so intense; nor did it identify in any detail the rules or regulations that were lacking that might have prevented the crisis." (On September 18th, a bipartisanFinancial Crisis Inquiry Commissionbegan its work "pursuing the truth, uncovering the facts, and providing an unbiased, historical accounting of what brought our financial system and our economy to its knees.")

Despite the fact that many questions about the financial crisis remain unanswered, the Obama Administration has promoted regulatory reform, which is being pursued by the House Financial Services Committee, chaired by Barney Frank, and the Senate Banking committee, chaired by Christopher Dodd. Thus the Administration finds itself in the position of the homeowner who rebuilds upon a foundation of uncertain integrity. In the meantime, according to Madrick, "much of Wall Street has already returned to the aggressive practices that were widespread before the crisis, including high levels of compensation and the creation and trading of risky derivative contracts."

There are three common-sense elements of financial reform that progressives should insist on. Given the fact that there was so much confusion at the time of the financial crisis - Wall Street and Washington's "best and brightest" didn't understand what was going on and made serious mistakes - it's obvious that the US financial system has grown too complicated. Therefore, the first reform should be to simplify it.

The Obama proposal advocates bringing all parts of the banking system - regular as well as "shadow" activities - under regulation. That's a good first step. The proposal suggests making the Federal Reserve responsible for managing "systemic risk;" the situation that occurs with "too big to fail" financial institutions, -- such as Citigroup -- that are so large that their failure jeopardizes the financial system. That's a bad idea. The Fed didn't get high grades for their behavior in the financial crisis; they waited too long to respond to the housing bubble. Instead there should be an independent council established to manage systemic risk: that's the path Barney Frank is promoting.

A basic problem that must be fixed is the growth of bank holding companies: banks that accept deposits and also engage in investment banking and brokerage activities. These mega-banks were prohibited in the originalGlass-Steagall Actbut permitted when part of the bill was repealed in 1999. It's time to go back to the original intent of Glass-Steagall and eliminate the behemoths that played a major role in precipitating the financial crisis.

The second common-sense action should be to regulate derivatives, contracts that permit financial services firms to buy and sell securities with little capital. (One form, "credit default swaps," brought down insurance giant AIG.) Warren Buffett famously called derivatives "financial weapons of mass destruction."

The Obama proposal makes derivative trading more transparent but a better idea would be to ban them entirely. Derivatives have become so byzantine that Wall Street executives do not understand their consequences. Why make the market so complicated?

The third common-sense action should be to regulate compensation for Wall Street CEOs, traders, and all those involved in the current system that encourages speculation (ultimately) at public expense. A recentIPS reportfound that "the CEOs of the 20 financial industry firms that received the largest bailouts were paid nearly 40 percent more last year than other CEOs at Standard & Poor's 500 companies." The bailout CEOS were paid 430 times more than their average workers. It's time for strong action such as a cap on executive compensation.

It makes no sense to rebuild America's financial institutions upon a foundation that is fundamentally flawed. The Obama Administration must promote a bolder program of reform or the meltdown will recur.