Rushing to Pass Financial Reform Won't Help Anyone

There is absolutely no truth in the rumor that Goldman Sachs was behind the oil spill in the Gulf of Mexico. It is true, however, that only a disaster of monumental proportions – and only the oil industry -- could have diverted the country’s attentions away from Wall Street’s most vilified player. It is never fun to be on the front page; Lloyd Blankfein, though doubtless as fond of seagulls as the next fellow, must be breathing a little easier.

Indeed, the financial community – and the country -- should be relieved that the tussle over financial regulations has taken a back seat to the Gulf catastrophe and also to the Times Square terror incident. Perhaps as the limelight dims, we can hope for a bill that actually makes sense, as opposed to one that creates juicy political headlines. Under the glare of populist outrage and partisan gamesmanship, common sense was abandoned as Senator Chris Dodd pushed to pass a bill – any bill. He had already knuckled under to colleague Blanche Lincoln’s proposal that banks spin off their derivatives operation, even though that particular measure was opposed by the Obama administration and by most informed analysts. If the purpose is to gain greater oversight of derivatives trading, taking that function away from much-regulated banks and throwing it to the “lightly regulated” hedge fund industry is like trying to trying to improve your view by knocking down the walls of your house. It solves one problem but raises several others.

Over the weekend FDIC head Sheila Bair wrote a letter to Senators Dodd and Lincoln arguing against the spin-off of operations that she says involves some $294 trillion in notional amount of derivatives. She makes the excellent point that the portion of that total represented by the riskiest credit derivatives – at the heart of the AIG collapse -- is only $25.5 trillion; the balance is made up of OTC instruments used to hedge against future movements in interest rates. Making it more difficult for banks to prudently protect themselves against sudden shifts in the credit landscape would, as Bair points out, be extremely damaging. At the end of the day, we want the banks to be stronger, right?

On that point, Bair echoes various trade groups who have argued that forcing banks to create affiliates to handle OTC derivatives would require them to divert capital to such activities – capital which would perhaps otherwise be used to expand loan activity. That is clearly against the country’s interests since credit remains tight, especially for small businesses, the work horses of our domestic economy.

Moreover, Bair points out that pushing derivatives operations out into the so-called “shadow” world of hedge funds and foreign banks not under the supervision on the FDIC would reduce, rather than increase, the opportunities for regulators to anticipate problems brewing in the sector. Also, hedge funds tend to operate with higher degrees of leverage than banks, altogether not a path to reduced systemic risk. Bair argues “A central lesson of this crisis is that it is difficult to insulate insured banks from risk taking conducted by their non-banking affiliated entities.” Creating more such entities – especially charging such operations with one of the more risky operations on the Street – flies in the face of prudent reform.

There will indeed be a financial regulation bill. It is unlikely to win any awards for coherence or serious “reform” in my view, for much the same reasons that the health care bill fell short. In the health care fight, established interests played too large a role, and the status quo reigned supreme. No one wanted to upset how Medicare compensates doctors, why most of us have so little “skin in the game,” how soaring health care costs are inextricably linked to the increased obesity of the country, why insurers don’t compete across state lines, how fear of lawsuits drives medical outlays higher or any of the other tough – really tough—issues. The point was to get a bill through, and that they did.

The situation in financial reform is analogous. The Dodd proposals do little to streamline the warren of regulatory authorities that oversee financial firms, little to rein in the use of excessive (and, yes, dangerous) leverage, and nothing to change the manner in which the ratings agencies are compensated. There is also no fix for Fannie and Freddie – the ongoing hole in the taxpayer’s wallet. Making real changes would pit regulator against regulator and threaten Congressional jurisdictions– a fight that would make the NFL look like flower children. Sheila Bair, as protective of her turf as anyone on the horizon, declaims the “damage regulatory arbitrage caused our economy.” She’s right, and the bill that was supposed to fix the mess has added a whole new agency – to protect consumers. It is, as the French would say, to laugh.

Liz Peek is a financial, political and social columnist. She is a frequent contributor to the Fox Forum. For more, visit

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