If it has proved difficult for the federal government to deal with the long-term effects of the financial crisis, it is proving no less difficult for it to deal with the causes of the crisis.

The regulatory problems that led to the collapse of credit markets, though not particularly mysterious, are complicated, and solving them will be complicated too. Predictably, the financial industry is fiercely opposed to any measure that might limit its profits. In the first half of 2009, it spent $42 million to lobby against proposals that would force banks, investment firms, and credit-card companies to change the way they do business. Republicans in Congress, as well as a few Democrats, are opposed on principle (or at least in theory) to any change that would increase the federal government’s involvement in the private sector. Against all evidence, and every reasonable analysis, they still say it was too much regulation, rather than too little, that crippled the financial system.

Fortunately, most House Democrats have ignored them. Last month they approved a bill that would help prevent Wall Street from again endangering the U.S. economy in reckless pursuit of short-term profits. The legislation would create a consumer financial protection agency to crack down on predatory lending practices. It would regulate some of the “over-the-counter” derivatives that turned a slump in the residential real-estate market into a deep recession. Investors would be allowed to sue credit-rating agencies that endorse dubious securities, and shareholders would have a say about how bank executives are compensated. The bill also provides federal regulators with more control over companies deemed “too big to fail,” while establishing a $150 billion fund, paid for by the same companies, to cover the costs of dismantling them if they do fail. The White House has welcomed the new bill, though Treasury Secretary Timothy Geithner has hinted he wants some changes made to it before it becomes law. The Senate is about to begin work on its own version of the legislation.

Geithner is right that the House bill could be improved, though not by being weakened. A few additional measures, all of them opposed by industry lobbyists, would help keep Wall Street from taking advantage of investors and taxpayers.

First, Congress should require that all complex derivatives—and not only those traded between financial firms—be bought and sold on an open market; that way all customers can compare what they are being charged with what others are being charged for the same, or similar, financial products. This would help to correct an asymmetry in information that has allowed unscrupulous dealers to fob overpriced securities off on the managers of pension funds, among others. Credit-default swaps, which Warren Buffett has described as “financial weapons of mass destruction,” should be tightly regulated, and available only to those whose assets they insure. One can’t take out a fire-insurance policy on someone’s else’s house; there’s no reason one should be able to take out default insurance on someone else’s assets.

Second, capital requirements (the amount of money a bank must hold in reserve) should depend not only on the amount of risk to which a bank exposes itself, but also on its size. The failure of a large bank is a much greater threat to the economy than the failure of a small bank, and regulations ought to reflect this fact. Congress might also consider limiting the size of banks by limiting the amount of liability they can undertake. Since the phrase “too big to fail” was coined, some of the biggest banks—Bank of America, Wells Fargo, and JPMorgan—have become even bigger, and thus more dangerous.

Finally, mutual-fund and money managers should no longer be required to rely on rating agencies paid by the companies whose bonds they rate. David Segal of the New York Times has aptly compared this arrangement to “a restaurant paying a critic to review its food, and only if the verdict is highly favorable.” The Senate should revisit the idea of creating an independent credit-rating agency, one that doesn’t profit from endorsing as many securities as it can.

It is time to turn indignation at what happened on Wall Street into prudent reform. Many in the financial industry are hoping that the country’s economic misery will distract the American public from its original outrage at the policies and practices that bred the misery. The public and its elected representatives must disappoint them.   January 5, 2010

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Published in the 2010-01-15 issue: View Contents
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