Federal Judiciary

Thinking Bigger on Financial Reform -- By: Duncan Currie

In a recent article, I discussed three financial-reform ideas that Republicans should champion: (1) the one-page mortgage form designed by American Enterprise Institute scholar Alex Pollock; (2) the sweeping overhaul of government housing giants Fannie Mae and Freddie Mac sponsored by Rep. Jeb Hensarling (R., Texas); and (3) the innovative risk-mitigation strategy conceived by economists Oliver Hart of Harvard and Luigi Zingales of the University of Chicago, who recommend implementing new capital requirements along with a market-based trigger mechanism linked to credit-default swaps.

While none of these specific proposals can be found in the legislative blueprint released by Senate Republicans last week, the GOP plan would impose tougher controls on Fannie and Freddie, and would compel the Federal Reserve to introduce new contingent-capital rules. It would also establish, among other things, a new resolution authority with strict bans on creditor bailouts; tighter limits on the Fed?s emergency lending powers; a three-person Council for Consumer Financial Protection, made up of the chief of the Federal Deposit Insurance Corporation, the comptroller of the currency, and the Fed chairman; a Council of Financial Regulators to monitor market stability and address risks or crises; a more transparent regulatory framework for over-the-counter derivatives; new underwriting standards for residential mortgages; and a new organizational structure at the Securities and Exchange Commission.

On some issues, the broad strokes of the Republican plan are similar to those of Sen. Chris Dodd?s vaunted financial-reform bill, though the details differ significantly. The Dodd bill moved a step closer to passage last week, after the Connecticut Democrat promised to adjust certain language and Republicans ended their filibuster of a procedural motion. As the debate continues, here are four more ideas the GOP should advocate robustly -- or at least inject into the conversation.

(1) Improving the credit-rating agencies (CRAs). Commentators left and right have blasted the CRAs for botching their job prior to the housing crash. But how should we seek to fix them? Columbia Business School economist Charles Calomiris has proposed forcing the CRAs to deliver quantitative ratings rather than letter grades. If the agencies were required to provide specific numerical estimates of risk probability, he argues, they would offer more meaningful information and also have stronger incentives to make accurate assessments.

This idea is well worth adopting. But CRA reform should go much further. The root problem, says Council on Foreign Relations economist Benn Steil, is that the agencies have effectively become ?gatekeepers to the capital markets,? which ?gives them enormous power.? Their exalted status is the product of federal laws and rules that should be revamped. Indeed, Steil urges a wholesale deregulation of the CRAs. This would depoliticize them, nullify their role as gatekeepers, and promote a more competitive credit-rating environment. It would be ?a long process,? says Steil, and should be initiated as soon as possible.

(2) Mandating ?living wills.? There is no question that some large financial institutions (such as Citigroup) have become so mind-bogglingly complex that nobody can explain precisely how they would be dismantled in the event of a crisis. The Dodd bill would preemptively require big firms to submit a ?living will,? otherwise known as a wind-down plan or a ?funeral plan.? This ?would be extraordinarily helpful,? says Steil. Stanford economist John Taylor agrees, and suggests adding a living-will provision to the federal bankruptcy code.

Wind-down plans would constitute a roadmap for sensible regulatory intervention and reduce the threat of knee-jerk bailouts. They are an essential element of any Wall Street reform legislation, as Republicans have acknowledged: The GOP alternative to the Dodd bill would obligate the new Council of Financial Regulators to ?study the use of . . . living wills and provide those studies to the Federal Reserve so that they can be used to develop new rules.?

(3) Measuring systemic risk. It is profoundly difficult to identify which firms are systemically important, partly because the entire notion of ?systemic risk? is quite subjective. In early September 2008, many experts did not believe Lehman Brothers was systemically significant. (Those experts were not necessarily wrong: What made Lehman?s demise so cataclysmic was the widespread expectation -- fostered by decades of government-backed rescue packages -- that Washington would not let it collapse. When federal authorities decided to change course from their longstanding bailout policy amid severe financial turmoil, the markets panicked.)

Taylor advocates launching a bipartisan commission to collect and study data on counter-party relationships, establish quantitative measures of systemic risk, and make recommendations to Washington. Ideally, he says, the commission members would be Wall Street veterans and/or trained financial analysts. While it is impossible to construct a perfect operational definition of systemic risk, we should certainly aim to forge a better definition than the hopelessly nebulous one we have today.

(4) Fixing tax distortions. As Steil notes, U.S. financial companies are given huge tax incentives to securitize their assets, because the tax treatment of debt capital is far more favorable than that of equity capital. He points to a 2005 Congressional Budget Office study, which calculated the effective tax rates on debt-financed corporate capital income (negative 6.4 percent) and equity-financed corporate capital income (36.1 percent). The difference between the two was a whopping 42.5 percentage points. By putting debt and equity capital on a more level playing field, we would discourage excessive securitization.

Of course, financial institutions that benefit from the current arrangement would lobby against changing it. But if federal lawmakers are serious about tackling the causes of high leverage ratios, they must address the distorting impact of our corporate-tax regime.

-- Duncan Currie is deputy managing editor of National Review Online.

Full post as published by Bench Memos - National Review Online on May 04, 2010 (boomark / email).