What Problems Were Solved by Financial Reform Legislation?

Jul.18.10 | About: iShares U.S. (IYF)

I was on a conference call this morning with Michael Barr, the Assistant Treasury Secretary for Financial Institutions, talking about the Wall Street reform bill. His remarks on Elizabeth Warren have already been well covered elsewhere, so I want to focus on his remarks about the legislation itself.

The call opened with his summary of the most important things in the bill, and then we were allowed to ask questions. In his opening remarks, the first thing Barr mentioned was that the legislation would end the too big to fail problem. So I wanted to ask him:

What does Treasury see as the one or two biggest problems in the financial sector that contributed to the crisis, and how does this legislation solve those problems?

More specifically, would it be fair to say that Treasury views the TBTF problem as the most important problem that needs to be solved in the financial sector? Is it also fair to say that the legislation has everything Treasury requested to deal with this problem?

Unfortunately, in another episode of "the dumb things I do," I hit #1 instead of *1 (twice after it didn't work on the first round of questions) so I didn't get my question in the queue. Next thing I knew, the call was over. I had sent an email asking for the right code during the call (even though I was the problem, I knew it was *1 but kept punching the wrong buttons). I was told later to submit the question by email, but haven't received a reply.

I hope I do get an answer so I can confirm this: Too big to fail was the main emphasis of the initial presentation, and I got the impression that this was, in fact, the main problem that Treasury thought needed to be solved. Further, from the triumphant nature of the presentation and what was said about how the legislation coincided with the Treasury reform proposal that was put out some time ago, I also got the impression that Treasury believes it got everything it asked for to solve the too big to fail problem.

Regulators believe they now have the authority to force troubled banks into a resolution process, something they didn't have before, and that they can do so in a way that won't disrupt the banking sector and create even bigger problems. But regulators won't know if this will actually work until they try it, and that's the problem. When it comes time to try this for the first time on a financial sector teetering on the edge, will regulators be willing to risk endangering the entire system to try this out? Regulators are not going to let the system crash on their watch if they can help it, and if that means abandoning resolution plans in the heat of the moment, they won't hesitate to do so.

My view is that we should expect that bailouts will occur, and that firms understand this (or at least give this outcome a meaningful probability in their risk assessments). That gives financial institutions operating under this type of implicit guarantee an advantage over other firms, and it encourages the build-up of excessive risk. Maybe resolution authority will work, and I hope it does, but we should assume that it may not work and take the appropriate precautions, one of which is strict regulations on the amount of risk firms can take on. Unfortunately, the legislation does not do enough to limit risk-taking, particularly -- though not exclusively -- its failure to place adequate limits on leverage.