The Great Reces­sion was brought on, in large part, by risk-​​blind behav­iors by banks, finan­cial firms and insurers. Today, as Europe’s own debt woes cast doubt on the sus­tain­ability of the U.S. eco­nomic recovery, Con­gress is debating a finan­cial reform package to pre­vent such melt­downs in the future. Assis­tant Pro­fessor of Finance and Insur­ance Karthik Krishnan dis­cusses the high­lights of the reform leg­is­la­tion, the dif­fer­ences between the Demo­c­ratic and Repub­lican approach and the like­li­hood of passage.

How would pro­posed leg­is­la­tion seek to pre­vent the con­flu­ence of fac­tors that led to the melt down?
The pro­posed law for the US finan­cial system has three impor­tant fea­tures in terms of how future crises may be pre­vented: First, there will be a finan­cial sta­bility over­sight council that will have the job of mea­suring the level of risk that any finan­cial or non-​​financial entity may impose on the overall economy. This will ensure that the type of bailouts required for large and com­plex finan­cial firms like AIG because of their impact on the rest of the economy (i.e., too big to fail) will be less likely.

Second, the bill seeks to pre­vent banks from engaging in pro­pri­etary trading activity as well as investing in risky assets such as hedge funds and pri­vate equity funds (known as the “Vol­cker rule”). The effect of the crisis was mag­ni­fied when banks stopped lending even to cred­it­worthy bor­rowers, in part because of the heavy losses they suf­fered on their invest­ments and the resulting loss of con­fi­dence between finan­cial insti­tu­tions. Pre­venting banks from making overly risky bets may have the effect of keeping banks liquid at a time when liq­uidity is important.

Third, com­plex finan­cial instru­ments known as deriv­a­tives will be reg­u­lated, which will make them easier to under­stand and give us a better idea of where risks are being concentrated.

Both polit­ical par­ties are putting forth bills requesting more reg­u­la­tions and more con­sumer pro­tec­tion. How they are they dif­ferent? Are there better approaches that nei­ther bill takes?
The pro­posals of both major polit­ical par­ties are sim­ilar in many dimen­sions, including cre­ating sys­temic risk reg­u­la­tory bodies, insti­tuting the so called “Vol­cker rule” to pre­vent banks from investing in very risky invest­ments, and reg­u­lating derivatives.

The dif­fer­ences seem to be in terms of the reg­u­la­tion of Freddie Mac and Fannie Mae (Repub­li­cans pro­pose stronger reg­u­la­tion of these agen­cies), how strong a con­sumer pro­tec­tion agency will be (Repub­li­cans give such agency weaker reg­u­la­tory powers), and how much power the Fed­eral Reserve is given (Repub­li­cans do not pro­vide more authority to the fed). Recent devel­op­ments sug­gest that Democ­rats and Repub­li­cans are merging their ideas into a single package and the final bill will con­tain com­po­nents of both packages.

One impor­tant problem that is not com­pletely addressed in either pro­posal is how to immu­nize the U.S. economy so that the impact of inter­na­tional shocks such as the Greek debt crisis will have a smaller impact. Con­ta­gion, i.e., the spreading of finan­cial prob­lems else­where in the world to all parts of the world is a big con­cern in an inter­con­nected global economy. Any sys­temic risk council will also have to con­sider the risks of inter­na­tional invest­ments made by U.S. investors and vice-​​versa to reduce the impact of inter­na­tional finan­cial crises on the U.S. economy.

Who should be reg­u­lated and what authority is best suited to oversee this mon­u­mental task?
The simple rule should be: Can an institution’s action have an impact large enough to affect the overall economy? If the answer is yes, such insti­tu­tions should be reg­u­lated and reg­u­lated effec­tively. There is already quite a bit of con­sensus on who gets reg­u­lated: large banks, rating agen­cies, and hedge funds. Reg­u­la­tion can be tricky in that too little can create the kind of crisis that we just went through, and too much can neg­a­tively impact the com­pet­i­tive­ness of the finan­cial industry. So, there needs to be a bal­ance.
The ques­tion of who should reg­u­late these firms is a tougher one, and one answer is: who­ever is in the best posi­tion to mon­itor and assess the risks taken by finan­cial firms and the effect of such risks on the economy.

Who should pay for bailouts in the future if an industry is in trouble? Was it advis­able for tax­payers to bear this burden in recent past?
The hardest part about assessing gov­ern­ment inter­ven­tions is to know what would have hap­pened had such an inter­ven­tion not occurred. In my mind, this was a nec­es­sary step to sta­bi­lizing the economy and unfreezing the credit mar­kets. The bailout had the effect of unlocking the credit mar­kets so that money started flowing through the economy. Without such an inter­ven­tion, and I can only guess, busi­nesses would not have been able to get loans, con­sumers would not have been able to obtain credit, and eco­nomic activity would have plum­meted fur­ther still, cre­ating a much worse reces­sion than the one that we just experienced.

There is no doubt in my mind that taxpayer-​​funded bailouts will not end and will be at least a small part of gov­ern­ment inter­ven­tion policy. We cannot pre­vent, using any law, the unknown from hap­pening next. The tax­payer will be on the hook for at least some level of finan­cial sup­port and this will be true for not just the finan­cial industry. Two things will ensure this: First, a changing polit­ical sce­nario in which, at some point in time, busi­ness friendly politi­cians with little memory of the past will come to power and who will insist on weak­ening any poli­cies that are imple­mented as a result of reforms; and second, the inherent unpre­dictability of the mag­ni­tude and the source of the next crisis.

Will a $50 bil­lion fund that is being pro­posed really be enough to cover the costs the next time asset values decline? What is the right number? Where is the next crisis going to come from? The answer is, nobody knows. Reg­u­la­tion is usu­ally reac­tive, and rarely proactive.

Do you think reform leg­is­la­tion will pass?
I think it will. Polit­i­cally, there is sig­nif­i­cant pres­sure on Con­gress to punish, or at least, restrain Wall Street. What kind of reform will pass and which pro­vi­sions remain in the final bill still remains to be seen. I think the common ele­ments of the Demo­c­ratic and the Repub­lican pro­posals, such as the sys­temic risk reg­u­lator, restric­tion of pro­pri­etary trading, and enhanced trans­parency for deriv­a­tives will go through.