Financial Regulation: Preventing Another Crisis

The Financial District in lower Manhattan i i

The Financial District in lower Manhattan at sunset. Economists say reforming financial regulations should be a top priority for President-elect Obama. Mario Tama/Getty Images hide caption

itoggle caption Mario Tama/Getty Images
The Financial District in lower Manhattan

The Financial District in lower Manhattan at sunset. Economists say reforming financial regulations should be a top priority for President-elect Obama.

Mario Tama/Getty Images

Memo To The President

In this occasional series, NPR will follow the transition from one administration to another through a series of stories, conversations, commentaries and essays that will outline the many issues and challenges facing the new occupant of the White House. From a broken military to a troubled economy to a National Park Service in need of a major overhaul — we'll provide the briefing paper, the options and the obstacles.

Given the huge problems facing the U.S. economy, Barack Obama may be wondering why he ever wanted to be president. Failing auto companies and rising unemployment are just a couple of the daunting challenges for the new administration.

Getting the economy growing again will obviously be "job one" for President Barack Obama, says economist Dean Baker of the Center for Economic and Policy Research.

But, Baker says, reforming the failed regulatory system can't wait, either, so he says he'd start his memo to Obama like this: "Mr. President, the financial industry is ordinarily tremendously powerful politically. At this moment, they're vulnerable. We have to take advantage of this political opportunity that exists now."

At the top of Baker's list of reforms is shrinking the size of the financial industry, which ballooned to account for 30 percent of all U.S. corporate profits in 2004. But much of that profit, says Baker, came through speculation using exotic financial instruments — which ultimately backfired, causing the financial crisis and torpedoing the underlying economy. To shrink the system, he proposes a tiny tax on financial transactions to discourage speculation.

"We want a financial industry that makes loans available to people to buy homes, start businesses [and] expand businesses," says Baker. "We don't want one that engages in all sorts of exotic financial speculation, which is what we have now."

Martin Baily, chairman of the White House Council of Economic Advisers during President Clinton's second term, sees it differently. He opposes reforms that would discourage Wall Street's innovation and expansion.

"This has been a very good sector for the U.S. in terms of employment, in terms of exports [and] in terms of profits," says Baily. "And we don't want to kill this golden goose, but obviously we have to find a set of reforms that make it less vulnerable."

Baily, now a senior fellow at the Brookings Institution, suggests that a watchword for Obama's financial reform agenda should be "transparency." A case in point is the huge $55 trillion market for credit default swaps, financial instruments that are essentially insurance policies for investors who lend money to corporations. That market is completely unregulated now.

Baily would move it out of the shadows and onto public exchanges, so that regulators and investors could see the risks companies are taking. That would make regulators more effective, he says.

"And those people whose money is at stake can see more clearly the risks that they are taking," Baily says.

Baily also urges more training and better pay for regulators and higher capital requirements, so that firms have the ability to absorb losses.

Peter Wallison of the American Enterprise Institute would take a very different tack in reforming the financial system.

"The problem centers on and comes from the housing policies of the United States," says Wallison. "And if you want to prevent this from happening again, you should change those policies."

Wallison says the crisis wouldn't have happened if Congress hadn't pressured banks to make loans to low-income borrowers through the Community Reinvestment Act. In his view, that began to erode the quality of home loans throughout the financial system and led to the subprime mortgage crisis.

"The government encouraged the making of loans in the United States that were much weaker in terms of their quality than had ever happened before," says Wallison. "And it's those loans, those very poorly underwritten, very poor quality loans that are the source of the problem we're facing."

Wallison, who served in Ronald Reagan's Treasury Department, says he'd be surprised if President-elect Obama gave much attention to a memo he might write on financial reform. But he says if the White House and Congress want to continue to help low-income people buy homes, they should be providing direct help — for instance, by providing downpayment assistance rather than forcing banks to loosen their underwriting standards.

Many disagree with Wallison's assessment of the financial crisis. They blame Wall Street banks, not the government's effort to promote homeownership for low-income people.

In the end, the timing and content of financial reform may not be decided by the Obama White House. Both houses of Congress have already started writing legislation. The new president and his team may have to run to catch up once they take office.

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