Financial Regulation: Preventing Another Crisis A lack of oversight, transparency and accountability in financial markets led to the worst crisis in decades. Economists weigh in with advice for President-elect Barack Obama on revamping regulations for Wall Street.

Financial Regulation: Preventing Another Crisis

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Of course it's not just the automakers in trouble. There is a lot of talk about changing the way that financial companies do business, since they were at the heart of the crisis. In the latest report in our series "Memo to the President-elect," we decided to focus on ways to reshape the financial system with the aim of preventing such turmoil in the future. NPR's John Ydstie reports.

JOHN YDSTIE: Getting the economy growing again will obviously be job one for President Barack Obama, says economist Dean Baker of the Center for Economic Policy Research. But, Baker says, reforming the failed regulatory system can't wait either. So he says he'd start his memo to Mr. Obama like this.

Dr. DEAN BAKER (Co-Director, Center for Economic and Policy Research): Mr. President, the financials industry is ordinarily tremendously powerful politically. At this moment, they're vulnerable. We have to take advantage of this political opportunity that exists now.

YDSTIE: 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.

Dr. BAKER: We want a financial industry that makes loans available to people to buy homes, start businesses, expand businesses. We don't want one that engages in all sorts of exotic financial speculation, which is what we have now.

YDSTIE: 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.

Mr. MARTIN BAILY (Senior Fellow, Economic Studies, Brookings Institution): This has been a very good sector for the U.S. in terms of employment, in terms of exports, in terms of profits. 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.

YDSTIE: Baily, now a senior fellow at the Brookings Institution, suggests that a watchword for President Obama's financial reform agenda should be "transparency." Take 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.

Mr. BAILY: And those people whose money is at stake can see more clearly the risks that they are taking.

YDSTIE: Baily also urges more training and better pay for regulators, and higher capital requirements so 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.

Mr. PETER WALLISON (Resident Fellow in Financial Policy Studies, American Enterprise Institute): The problem centers on and comes from the housing policies of the United States. And if you want to prevent this from happening again, you should change those policies.

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

Mr. WALLISON: 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. And it's those loans, those very poorly underwritten, very poor quality loans that are the source of the problem we're facing.

YDSTIE: 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 argues if the White House and Congress want to continue to help low-income people buy homes, they should offer direct help - for instance providing down payment assistance, rather than forcing banks to loosen their underwriting standards.

Many people 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 begun writing legislation. The new president and his team may have to run to catch up once they take office. John Ydstie, NPR News, Washington.

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