Stephen Foley: A day to celebrate: America ushers in a more robust financial system


US Outlook: Every finickity detail in the US Senate's 1,500-page Wall Street reform bill is worth billions of dollars. Every sentence is a potential loophole through which the beginnings of the next financial crisis might be threaded. The political debate has raged for so many months, and over so many topics, that it has been a while since anyone has stood back and taken in the big picture.

And the big picture is this: If these laws had been in place in the US a decade ago, we would not have had the financial crisis of 2007-09.

No institutions would have been too big to fail. The human misery of a housing market crash and recession would have been much lesser. And governments around the world wouldn't have had to shoot the public finances to pieces to sort out the mess.

The bill, as passed late on Thursday night, ushers in a new era of powerful regulation in the US, pulling the business of financing the economy back in from the shadows.

But it is far, far from being the final word. Many important details have to be hashed out in a process that reconciles the bill with an earlier version passed by the lower House of Representatives. And the attention of Wall Street's lobbyists has already shifted to more opaque, and arguably more important, debates going on in international bodies such as the G20 and the Bank for International Settlements.



What is financial regulation actually for? To my mind, it has two fundamental aims, against which all the coming reforms should be judged. It should reduce the chances of stupid lending decisions in periods of economic exuberance, and it should reduce the chances of a devastating panic when those periods of exuberance ends.

Against these fundamental principles, the US reforms score well, and point a direction that other major financial centres, London included, will be wise to follow.

Central to both aims is the need to bring the "shadow banking system" under the purview of regulators, so that the credit needs of the economy are not being met by a panoply of organisations, from hedge funds and insurance firms, that don't fall under traditional banking laws. The Federal Reserve is getting the power to oversee systemically important firms of all stripes, not just banks. Good.

We know that it was a collapse of underwriting standards on US residential mortgages that rotted the foundations of global finance from 2005 onwards, and the reforms coming will make that a lot harder. A new consumer protection bureau will set rules for such lending, so Americans will need more than a pulse to get a loan – unlike in 2006 – and loan sharks will get their comeuppance.

The flood of toxic loans into the Wall Street securitisation machine will also be staunched by new rules requiring loan originators to hold a portion of the risk of default on their books. Lenders are once again required to care if their borrowers can pay back the loans they take.

As for panics, the opacity of the banking system, the interconnectedness of major financial institutions and the sheer size of the biggest players all turned the 2007 bust into the 2008 panic, and forced the government here to put $700bn of taxpayer money on the line to bail out the banks.

Ending "too big to fail" has become the mantra for reformers, and this bill does that, because it reduces the consequences of failure. The bankruptcy of Lehman Brothers froze the financial markets; in future, a resolution authority will wind down failed firms slowly, according to a predetermined plan, punishing the creditors that fuelled its risk-taking activities, and recouping any short-term government financing for the wind-down with a levy on other financial firms. To reduce the risk of a taxpayer revolt that would endanger even the short-term financing, hopefully provisions in the House bill that pre-fund this resolution authority with a tax on banks will make it into the final law.

I've never followed the logic of the so-called "Volcker rule", after former Fed chairman Paul Volcker, who proposed banning proprietary trading by deposit-taking banks, or the Senate bill's provision that banks' derivatives desks be spun off. Both will have to be fleshed out as the bill is married with the House version in the coming weeks, and it seems we will end up with a version of the former, while the latter is ditched as impractical. Banks must be allowed to hedge their own positions if they are to properly service their clients.

More important, credit default swaps and numerous other exotic derivatives will soon have to be traded on exchanges, rather than between financial institutions directly, which will pull apart the spaghetti of inter-relations that helped to spread the panic of 2007-09. Under these rules, when an AIG goes down in future, we will know precisely who it is going to take down with it: no one. Opacity, Public Enemy No One in the recent crisis, is dramatically lower in this new era.



So this is a good moment to celebrate a big advance. Public anger is justifiable. Public cynicism is not. The politicians do get it, and the US is closer to a safer financial system. Will these laws prevent future crises? No. You can't abolish greed or fear; we will find ingenious ways to stoke manias and unleash panics. But the new regime in the US is more robust, and, with overseers in charge of the system as a whole, more flexible, too.

Attention turns now outside the US borders. The world's super-power has acted; now it must work to ensure that other jurisdictions come up to the same standards.

A bank tax – to fund regulation and to reflect the guarantees that governments offer their banking systems – has to be agreed at the level of the G20, to prevent financiers upping and leaving for alternative jurisdictions. The BIS's new Basel banking rules, which will vastly increase the capital requirements imposed on banks, should be written and implemented quickly. There is so much work still to do.

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