No Big Fix for Global Finance

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Stumbling Blocks

Scariest of all, there is still no procedure for countries to share responsibility for the takeover and resolution of a failing multinational financial firm like Lehman or insurer American International Group (AIG). Another uncontrolled failure today could set off a global domino chain of failures. Says Raghuram G. Rajan, the former chief economist at the International Monetary Fund who currently teaches at the University of Chicago's Booth School of Business: "The difficulty of international dialogue means [establishing a procedure] will take forever, by which time people will have forgotten and something much more diluted will have come out."

International coordination isn't the only stumbling block. The U.S. is moving gingerly even on purely domestic issues. For example, regulating insurance conglomerates like AIG is proving tricky. Under the reorg plan being pushed by Geithner, U.S. insurers would continue to operate under a patchwork of state regulation, though the largest would get additional scrutiny from the Federal Reserve or a committee of federal regulators.

Officials in the Obama Administration also considered consolidating the Securities & Exchange Commission, which oversees the securities market, and the Commodity Futures Trading Commission, which polices futures and commodity markets. But they concluded it would take too much political capital to buck the congressional agriculture and financial committees that split responsibility for the agencies—and that enjoy the campaign contributions that follow the oversight. Now the proposal calls for just one of more than a half-dozen federal financial regulators to disappear.

The Administration's goal of consolidating all financial consumer protection in a single agency—perhaps its boldest proposal—is running into a buzz saw of bureaucratic infighting and industry lobbying. "Our strategy is to kill it," says one lobbyist for the financial-services industry.

Furthermore, banks selling complex derivatives—essentially financial bets—would be free to continue writing "custom" contracts under the Geithner plan. That would sidestep many of the protective mechanisms built into the brand-new exchanges and clearinghouses designed to temper the risk of such instruments.

Praise for Some Reforms

It's not just bank-hating liberals who are concerned. R. Glenn Hubbard, who was President George W. Bush's chief economic adviser from 2001 to 2003 and is now dean of Columbia University's business school, is generally reluctant to interfere in the markets more than necessary. Yet he says he's disturbed by what he sees now. Hubbard favors stronger measures to improve the security and transparency of derivatives trading. "Ironically, the Obama Administration is less tough on Wall Street than many market participants and academics who have recommended reform," Hubbard says.

To be sure, the plans in the works are better than nothing. One clever idea proposed in the Treasury documents is to require financial firms to sell a big issue of bonds that would automatically convert to equity if money were tight. Such securities would relieve the firms of their debt payments and replenish their capital even in panicked markets. Another idea Geithner favors is to force big firms to draw up plans that regulators could use to dismantle the institutions. (One reason Lehman Brothers was so hard to shut down was that it had more than 600 subsidiaries.) And the new capital rules may dissuade banks from collecting deposits while participating in risky trading activities. They would have "no choice" but to separate into "specialized entities," Karen Shaw Petrou, co-founder of consultancy Federal Financial Analytics, predicted in a Sept. 4 report. Douglas J. Elliott, a former JPMorgan Chase (JPM) banker now at the Brookings Institution, generally praises the reforms: "If you believe the single biggest problem was that everyone got careless, then you'll be happier because everyone will have to be more careful."

Trouble is, the reforms are weaker than expected, and they're likely to be watered down even more by the time they're passed. As markets recover, lobbying for laxer regulation will intensify. Already financial engineers are at work on an array of insurance, derivative, and other products designed to exploit loopholes in the new regulatory regimes. Meanwhile, the biggest financial firms have only gotten bigger and harder to control. The Economic Policy Institute notes that the four biggest U.S. banks have about 45% of industry assets, up from around 27% in 2003.

Reform? Yes. Fundamental change? Not by a long shot.

Francis is a correspondent in BusinessWeek's Washington bureau. Coy is BusinessWeek's Economics editor.

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