Don't Trust the Regulators

Article excerpt

Byline: Ezra Klein

Financial reform can't be left to those who failed us before.

Here's my problem with the financial-regulation package that Sen. Chris Dodd has proposed: it hands the very regulators who failed us in 2005 and 2006 and 2007 and 2008 the responsibility for saving us next time. If you tried to work backward from the bill to an account of the meltdown that produced it, you'd come up with something like "We have a wise and brave class of regulators who did not have quite as much information or power as they needed to stop the financial crisis."

Anyone who remembers Alan Greens-pan and Ben Bernanke dismissing the housing bubble knows that's not quite right. But regulator failure is a fact of life, or at least of bubbles: it's pretty much in the definition of a bubble that the relevant regulators don't believe there is a bubble. Otherwise they'd pop it. The trick is building protections that work even when the people in charge don't realize they're needed.

The most successful example of this is federal deposit insurance. Be-fore the Great Depression, bank runs were an all-too-common occurrence. There were dozens in the years leading up to 1929. FDR's response wasn't to create a Commission on Bank Runs tasked with watching banks and stepping in to insure their deposits if they got into trouble. He insured all consumer deposits. It didn't matter whether the chairman of the Federal Reserve thought your bank was playing nice. Your money was safe even if he got it wrong.

If you want proof of how well it worked, ask yourself this: did you line up outside your bank to close your account after Lehman collapsed?

The corollary today is capital requirements. When Lehman went down, its leverage was at about 30:1. That means it had borrowed $30 for every dollar it had in assets. Leverage that high does a few things: First, it gives the bank more money to take risks, which banks like because it means higher profits. Second, it means that the bank has less money to pay back creditors if a bunch come calling at once, making failure more likely. Third, it means that if the bank does go down, it does more damage to the system be-cause there are more people counting on the bank's paying them back.

Keeping capital requirements at manageable levels is financial regulation's strongest tool. …