Financial reform, at the most fundamental level, is designed to keep the markets from imploding in both the long and short term.  Hopefully we can all agree that after the hardships of the last two years, any reasonable cost to lower the risk of future catastrophe is worth it.  Enter from stage left and right the two versions of financial regulatory reform that have been sculpted by our esteemed legislative bodies.  There is plenty to be excited about with the progress these two groups of cantankerous banterers have made in a very short while (short only by their standards).  Unfortunately, as I wrote a month ago, the incentives that exist in our marketplace will show how full of holes this regulation actually is.

As an example, in the Senate bill they have an altered version (Merkley-Levin) of the Volcker rule endorsed by President Obama.  Not only has the Volcker Rule been watered down, it simply doesn’t exist in the version the House pushed through.  This, of course, is because the House bill was constructed prior to Obama’s endorsement of Volcker.  Regardless of the name under which this idea (restricted prop trading) ruminates and takes form in the final version of the bill, there will be significant issues.

Try to tell a banking exec to stop trading activity because Congress feels it is detrimental to shareholders.  On what planet would he decide to listen?  There is a reason that congressmen sit where they do, and investment bankers choose another seat.  All Congressmen are not created equal, and most do not understand the complexities of the markets that they are assigned to regulate.  The only way that Congress can hope to convince bankers to listen to regulations is to approach them with a big stick.  There aren’t even any twigs to speak of in this financial reform.  

Ambiguities in the wording of the bill mean that, once again, financial regulators will have too much room for interpretation.  Therefore, the incentive remains for any profitable firm to find a way around any regulations and a blindfold/lollipop for any regulators.  They will simply conduct the same type of activities under a different name.

Having said all that, these are the options moving forward. 

1. Proceed as planned - use the regulations in the current versions of the bills and reconcile any differences.  This is what will happen.  It is the easiest solution, it brings more reform to Wall Street than was there previously, and it provides a convenient peg for congress to hang their hats on in the coming elections.  This is a political solution, plain and simple.  It avoids addressing some of the most pressing issues in this situation (incentive to cheat the system, banks that are too big to be allowed to exist, predatory financial practices and no explicit powers to enforce the regulations).

2. Reenact the Glass Steagall act - this is far from a perfect solution.  The nature of the market is very different from the one that existed when this bill was effective.  Also, there would be considerable pain in migrating from the integrated markets that people enjoy today to the ones that would exist after a reincarnation of this act was implemented.  This has been on the minds of economists over the last year, but it is still debatable what parts of this legislation would be reasonable to enact in today’s markets.

3. Chop banks into smaller pieces - this is an idea that will probably never gain any momentum, but it has merit.  Everyone has heard of the idea of “too big to fail,” but what about “too big to exist?”  The problem with these super banks is that their layers of risk vary so much in depth and complexity that there is no way for a CEO or a team of executives to manage the company.  Value at risk (VaR) was a misleading idea designed to provide comfort that these layers of risk can be measured.  They can’t.  The only option is to peel back those layers until they are manageable chunks.  This means chopping off arms that have a conflict of interest and separating them into their own companies.  Implied firewalls in these banks have been shown to be more comparable to sieves.

At the very least, the reform trudging through our legislative system is designed with good intentions.  No one expects this to be an easy or quick fix, but the fact that Congress is only quietly dragging their feet is a good one.  It will be interesting to see how the voters decide to reward this political courage.  That will certainly influence any more reform movements in the future.  As always… it is a matter of incentive.

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