President Obama’s speech on Wall Street last week signals that a year after one of the worst financial panics in U.S. history, financial reform is on its way. Though reform will not prevent all future crises, it will make them less frequent and less likely to pose the same lethal threat to the economy.
That reform is necessary almost goes without saying. The financial system issued trillions of dollars in bad loans over the last decade – loans unlikely to be repaid under even the best of circumstances – creating the fodder for the subsequent financial panic and Great Recession. Its legal merits aside, the recent Securities and Exchange Commission suit against Goldman Sachs Group Inc. brings into sharp relief all that we feared about the financial system: that it has become opaque, conflicted, and dysfunctional.
Yet the system can be redeemed, and must be for the current economic recovery to evolve into a self-sustaining expansion. Credit is the mother’s milk of growth; without credit, the economy cannot flourish and may even slide back into recession. And credit cannot flow freely without a well-functioning financial system.
Odd as it may sound, the U.S. financial system is also one of our biggest global advantages. The Italians make great sunglasses, the Russians make excellent vodka, but Americans make the best financial products. Not always, as the financial meltdown has made clear, but in most times our financial system has done an admirable job of taking what little saving we do and using it to finance the investment needed to power the most productive economy on the planet.
To revive our financial system, however, trust needs to be restored. Unless those who lend money as well as those who borrow it believe they are getting a fair shake, credit won’t flow, at least not at reasonable cost. Trust is particularly important to attract global investors to buy U.S. bonds, stocks, and other financial products. With so many Treasury bonds to sell to fill our gaping budget deficit, we need global investors to have full faith in our system.
Financial reform can start to accomplish this, for example, by taming the wild and woolly derivatives market, putting trading on exchanges where transactions can be monitored and regulated. Private or over-the-counter derivatives trading is where much of the current smoke is coming from, including the Goldman Sachs suit. Regulation is also necessary to ensure that investors have the financial wherewithal to meet the obligations they make in these deals.
Under the proposed reforms, the Federal Reserve will monitor risk and enforce standards of prudence across the entire system. Under the current framework, each regulatory agency – and there are many – is responsible for only a specific corner of the markets. No one asks whether the system as a whole is taking on too much risk. The Fed won’t be a perfect overseer – nothing could be – but expanding its authority to step in before the system begins to crack would help.
The proposed reform also includes a new agency to ensure that financial products are safe for consumers. It would be to financial products what the Food and Drug Administration is to pharmaceuticals. Loans and investments have become complex enough to warrant such consumer protection, and nowhere in the current regulatory patchwork are consumers and their well-being the primary focus. Worries that such an agency could stifle useful financial innovation are legitimate but are trumped by concerns that consumers are being ripped off too often.
A more arcane but equally important job of reform is defining what to do with troubled financial institutions. New rules will lay out when and how such firms should be fixed, dismantled, or, under extreme circumstances, taken over by government. There will always be some institutions too big to fail; it is impractical to think we can impose enough restrictions to eliminate this risk. If we tried, U.S. banks would be taken over by larger global competitors, and the too-big-to-fail risk would move outside our control.
Financial reform has many moving parts, and not all of it will work out as intended. I would have done a few things differently. But given the complexity of the problems, policymakers appear to be taking a worthy shot at reform. Our financial system is on the road to redemption, and eventually to becoming again the envy of the world.