Why Financial Reform Is Stalled

That is the title of a 3-1-2010 WSJ article by PETER J. WALLISON (p. A 25). You can read it by clicking here. The brief synopsis is:

"Partisan gridlock is not the reason. The administration's plans are flawed, and they're encountering resistance from both sides of the aisle in Congress."

Here are the key exerpts:

"The administration appears to have begun its regulatory reform effort with the idea propagated by candidate Barack Obama that the financial crisis was caused by deregulation. There was never any evidence for this. The banks, which were in the most trouble, are the most heavily regulated sector of the economy and their regulation has only gotten tighter since the 1930s."

"So we have the spectacle of Paul Volcker, having recently persuaded Mr. Obama to back the idea of restricting proprietary trading by banks or bank holding companies, telling a puzzled Senate Banking Committee he can't really define proprietary trading but knows it when he sees it."

"The Fed had been regulating the largest banks and bank holding companies for over 50 years—among the very companies that would be considered systemically important—yet it failed to see the risks they were taking or the impending danger.'

"Wouldn't designating particular companies as "systemically important," and subjecting them to special Fed regulation, signal to the markets that these companies were too big to fail?"

"..."the administration says all large and "interconnected" financial firms in crisis should be dealt with by a government agency, rather than by a judge in bankruptcy proceedings.

The term "interconnected" is important here. It implies that when one large firm fails it will carry others down with it, causing a systemic crisis. But that is clearly not the lesson of Lehman. Although the company went suddenly and shockingly into bankruptcy, none of its large financial counterparties failed."

"To be sure, there was a freeze-up in lending after Lehman. But that episode demonstrated the power of moral hazard—the tendency of government action to distort private decision-making. After Bear Stearns was rescued by the Fed in March 2008, market participants assumed that all companies larger than Bear would be rescued in the future. As a result, they did not take the steps to protect themselves against counterparty failure that would have been prudent in a panicky market. When Lehman was not rescued, all market participants immediately had to review the credit standing of their counterparties. No wonder lending temporarily froze."

"And it is clear creditors will be treated far more favorably in a government resolution process than in a bankruptcy.

To understand why this is true, consider the administration's reasons for preferring a government resolution process. The claim is that large, interconnected firms will drag down others when they fail. The remedy for this is to make sure their creditors and counterparties are fully paid when the takeover occurs."

"Creditors will realize that by lending to large companies that might be taken over and resolved by the government, their chances of being fully paid are better than if they lend to others that might not."

"...as creditors increasingly assume that large firms will be rescued, the too-big-to-fail phenomenon will grow, not decline."