The Verdict on Regulatory Reform Awaits the Test of a New Crisis

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Byline: Harry Terris

After a bitter political fight, and a series of prototype proposals that straddled two administrations, the most sweeping overhaul of financial regulation in generations took concrete shape in the thousands of pages of legislation that President Obama signed into law in July. Meanwhile, the recasting of international oversight standards is proceeding with uncharacteristic speed in Basel.

Is the world safer?

The answers varied from "yes" to "maybe" when panelists on an American Banker roundtable met this month - but the final verdict will have to await the next crisis, they said, when the capacity of new safety measures and mechanisms to minimize the damage will truly be put to the test.

Alan Blinder, a professor at Princeton University and former vice chairman of the Federal Reserve, characterized regulatory reform as an attempt to end an epoch "of wild, unregulated cowboy finance." The Dodd-Frank Act established the bases for stronger capital levels, systemic regulation, consumer protection and resolution of complex entities ("a polite word for euthanasia"). "We didn't have much of any of those before," he said, "and now, presumably, going forward we'll have a lot."

Though Hal Scott, the director of the Program on International Financial Systems at Harvard Law School, saw "a potential for this to have a large impact," he emphasized the uncertainty about how the law will be implemented; precise capital standards and many other issues are as yet undetermined.

"It's clear that there will be more consumer protection than there was in the past, and that's good," he said. But simply more disclosure - as opposed to controls over prices and products - would probably not be "much of a departure from the past, given what the Fed already was going to do."

Blinder, who also is a senior adviser at Promontory Financial Group, said the scale of the damage after the next crisis will be the ultimate measure of the law's effectiveness - answering whether factors like simplification and transparency in derivatives, vigilance by "the systemic-risk oversight apparatus," a stronger capital regime that withstands complacency during healthier economic times and broader resolution powers "can contain the potential virulence of the contagion."

Asset bubbles cannot be eliminated, and interconnectedness is a basic feature of the financial universe, Blinder said. But the goal of the legislation is to minimize "the collateral damage when the bubble, whatever it is, bursts. This stands in great contradistinction to the system that we're getting out of, which seemed designed to maximize the collateral damage."

Scott argued that important interim grades can be assigned based on the quality of approaches selected to address intractable issues like controlling financial institutions' exposures to each other, which is "easier said than done."

"We've got a lot to work out," he said. "I don't know that anybody's got a good answer for the increase in correlation of risk across financial institutions."

New resolution powers established by the law have created a "process in which we can do things that we could not do before," he said, but in practice much remains unresolved.

Gail Fosler, the president of the strategic advisory firm GailFosler Group LLC, said that one gauge of success would be the achievement of a smaller financial sector. The industry grew and simultaneously stayed "as profitable as one that had, implicitly, sort of monopoly powers back 30 years ago," before deregulation.

"The financial sector is meant to be an intermediary," said Fosler, formerly the president of the Conference Board Inc. "It should have limits on what is a sustainable level for the sector to grow to, and it should have reasonable profitability, but not profitability that sort of mirrors almost monopoly profits."

Blinder said higher capital ratios, "several more layers of regulatory compliance" and, for the giant Wall Street players, a move toward standardized exchange-traded derivatives will "take some of the profit out, and that should result in a smaller financial sector. …