Here's a Republican Idea for Financial Reform

Duncan Currie is the deputy managing editor of National Review.

While liberals have been demanding stronger consumer protections, many conservative tea-partiers have been railing against the Troubled Asset Relief Program (TARP) - which, lest we forget, was signed by President Bush. Indeed, the populist anger comes in different flavors; and in the wake of revelations about alleged fraud at Goldman Sachs, that anger may intensify.

Does this mean the public will rally behind the 1,336-page financial overhaul devised by Senate Banking Committee chief Chris Dodd (D., Conn.)? Not necessarily. Republicans can make a good case against the Dodd bill. The key is to explain that their skepticism is rooted, not in a desire to insulate Wall Street from tighter regulations, but rather in a desire to preserve financial soundness and shield taxpayers from future corporate bailouts. They can credibly argue that Dodd's legislation would perpetuate the "too big to fail" (TBTF) dilemma and lead to more government-funded rescue packages.

With all 41 GOP senators opposed to the current version of that legislation, the White House has been urging Democrats to scrap the proposed $50 billion resolution fund, which would be supported by the largest financial companies and used to wind down failing institutions. Yet, as NR has editorialized, removing the liquidation fund would not close the loopholes that threaten to transform Dodd's resolution authority into a bailout machine. Moreover, by establishing a Financial Stability Oversight Council to monitor and tackle "systemic risk," the bill would allow federal authorities to classify a non-bank financial firm as "systemically significant" (i.e., TBTF) and have it regulated by the Federal Reserve. "Under the Dodd plan," Clive Crook writes in National Journal, "many big financial firms would indeed be declared too big to fail."

The bill suffers from other flaws. Writing in the Wall Street Journal, American Enterprise Institute (AEI) scholar Peter Wallison and University of Pennsylvania law professor David Skeel point out that the Federal Deposit Insurance Corporation is simply not equipped to manage the closure of enormous non-bank financial entities. As for launching a new consumer watchdog inside the Fed, AEI scholar Alex Pollock believes this would be "a bureaucratic nightmare."

A Fed-housed consumer unit wouldn't really be part of the central bank, says Pollock; it would effectively be a stand-alone agency (which is what President Obama has wanted all along) funded by Fed profits. The Consumer Financial Protection Bureau outlined in the Dodd bill would have an independent director, an independent budget, independent rule-writing ability, and enforcement authority, though its rulings would be subject to appeal by other regulators. The fear is that such a bureaucracy would reduce consumer credit options and hamper economic growth. There are also legitimate concerns that Dodd's corporate-governance provisions would boost the clout of labor unions and other politically active interest groups while doing very little to help smaller shareholders.

As they wrangle over these issues and others (such as derivatives and proprietary trading), Republicans have an opportunity to champion some basic, common-sense reforms of their own. Here are three suggestions.

(1) A one-page mortgage form. Pollock, a former president and CEO of the Federal Home Loan Bank of Chicago, has been advocating his one-page mortgage form since 2007. The form would clearly and concisely show prospective borrowers how their mortgage payments relate to their income, and would be accompanied by a two-page glossary defining various technical terms. It has received praise from none other than Elizabeth Warren, chair of the TARP Congressional Oversight Panel.

Ideally, says Pollock, the mortgage-lending industry would adopt the one-page form voluntarily. Failing that, he would like to see it enacted into law. Republicans should promote it as a simple way to increase mortgage literacy and enhance housing-market efficiency.

(2) Revamping Fannie Mae and Freddie Mac. It's widely acknowledged that the two government-sponsored enterprises (GSEs) - which have been in federal conservatorship since 2008 - played a major role in pumping up the subprime bubble, yet Dodd's legislation does not address their future status. Republicans should continue highlighting this omission and challenge Democrats to support robust GSE-reform language.

Rep. Jeb Hensarling (R., Texas) has introduced a measure (the "GSE Bailout Elimination and Taxpayer Protection Act") that would set a two-year expiration date for the current GSE conservatorship, after which Fannie and Freddie would enter a three-year transitional phase culminating with the abolition of their government charters and subsidies. (While in transition, they would be subject to steeper capital requirements and stricter curbs on their mortgage activities.) The GSEs would become normal private-sector mortgage lenders. They would no longer enjoy taxpayer largesse or government bailout guarantees.

"Housing-finance inflation was at the center of the financial crisis, and the GSEs were at the center of housing-finance inflation," Pollock told the House Financial Services Committee last week. He lauded the Hensarling bill for delineating "an orderly transition" sequence that would yield a world without GSEs, noting that such a transition would be made easier by the fact that "Fannie and Freddie are not now GSEs. They are government housing banks, owned for the most part and controlled entirely by the government." Pollock also touted legislation spearheaded by Rep. Scott Garrett (R., N.J.), the "Accurate Accounting of Fannie Mae and Freddie Mac Act," which would stipulate that the two mortgage giants be included in the federal budget.

(3) Implementing new capital requirements. As Yalman Onaran of Bloomberg News recently observed, the Dodd bill does not contain "rules to ensure that banks keep enough cash-like assets when credit disappears." While the legislation would authorize federal regulators to establish new capital requirements, it lacks any specific recommendations. In the latest issue of National Affairs, economists Oliver Hart of Harvard and Luigi Zingales of the University of Chicago describe an innovative approach.

Briefly, Hart and Zingales would force big financial firms to safeguard their systemically important obligations by carrying two layers of capital, the second of which "would allow for a market-based trigger to signal that a firm's equity cushion is thinning, that its long-term debt is potentially in danger, and therefore that the financial institution is taking on too much risk." The trigger mechanism, whose activation would prompt a regulatory response, is somewhat complex, but Hart and Zingales persuasively show that their proposal could be implemented "without causing any serious hardship to financial institutions or the larger economy, without costing taxpayers much (if anything at all), and without requiring much in the way of new legislation."

The Hart-Zingales plan would combat the excessive leveraging we saw prior to the financial meltdown. As Council on Foreign Relations economist Benn Steil emphasized in a March 2009 report, "Thirty-to-one leverage ratios are far too dangerous to tolerate going forward, particularly now that so much moral hazard has been injected into the markets by repeated government bailouts and debt guarantees."

Taken together, the three ideas discussed above would hardly constitute a full-scale alternative to the Dodd bill. But they deserve a prominent place in the ongoing debate, and Republicans should seek to advance them.

(The opinions expressed in this commentary are solely those of the author.)
By Duncan Currie:
Reprinted with permission from National Review Online