Time to get real on financial reform

Democrats and Republicans in the Senate are getting closer to striking a deal on a proposed overhaul of financial regulation, increasing the likelihood that a bill will become law this year. That’s the good news. Still in doubt, though, is how well lawmakers have learned the lessons of the Wall Street meltdown that sent the economy reeling in 2008. The Republicans’ rhetoric suggests that they cling to a revisionist view of that recent history, or that they remain in denial about the fundamental failure of the market to protect itself against the financial industry’s worst instincts.

One repeated complaint by critics of the Senate bill is that it would “institutionalize” bailouts rather than ending them. The bill, they argue, would implicitly guarantee big banks and their creditors by creating special rules for companies whose failure would jeopardize the entire system. That’s like saying higher fines for speeders promote the sale of faster cars.

The point of the added scrutiny is to address the systemwide risks that led to the last bailout. Lawmakers’ two goals should be to give companies strong incentives to limit how large, indebted and interconnected with other financial institutions they become, and to make clear that struggling companies will not be kept afloat. The Senate bill would give regulators important new powers to dissolve failing nonbank financial firms, just as the Federal Deposit Insurance Corp. can take over collapsing banks. But to remove any suggestion of federal rescue, lawmakers should restrict the power of the Treasury Department and the Federal Reserve to help weakened borrowers.

A second criticism of the bill is that regulating financial derivatives such as credit default swaps would hinder innovation, raise the price of credit and drive dealmakers offshore. But the explosion in unregulated derivatives this decade made it impossible for investors and regulators to tell just how risky many banks had become, while also tying too many companies’ fates together. That was another important factor in the meltdown and the subsequent bailouts. Lawmakers should treat the derivatives problem the same way they address other weaknesses in the system, by requiring more transparency and greater margins for safety.

Pushing more derivatives contracts into clearinghouses would ensure that both sides hold up their ends of the deal, and having them trade on public exchanges would promote competition among the banks that arrange the contracts — to the benefit of the companies that rely on derivatives to minimize their risks. Banks shouldn’t be barred from setting up customized contracts, but if they do they should be required to keep larger capital reserves.

Both Republicans and Democrats recognize that the current financial regulatory system contributed to the latest Wall Street collapse. And neither side wants to have to vote for another bailout, so there are good political reasons for them to come to an agreement on a bill. But before the Senate can come up with a bipartisan plan for more effective regulation that punishes failure instead of coddling it, the GOP is going to have to acknowledge the gaps in oversight that led us to this point.