graphic: Brooks Elliott via Flickr

You can tell that financial reform will be the next heavy lift in Washington because everyone’s chattering about it today, and proposing a variety of solutions. But they actually come down to something a lot simpler than what’s being proposed: regulators need a few clear rules, and they need to do their jobs. Mike Konczal elaborates:

People talk a lot about the “unregulated” shadow banking market, but it is important to remember that they were (poorly) regulated by the SEC. And the SEC gave an exemption to 5 firms – Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley – to leverage up further in the 20-40 to 1 range, while commercial banks were still leveraged in the 8-12 to 1 range. The more leverage means the bigger the returns, but the harder the falls. This increased the regulatory arbitrage of the shadow banks, because these five firms could act as if they were commercial banks but could be significantly more leveraged, offering better deals and crowding out the market.

There is nothing in the Dodd Bill that would have stopped this other than the hope that regulators at the Federal Reserve are smarter, more resistant to lobbying, and will let their actions be more transparently monitored, critiqued and subject to democratic review by the public and the general community of investors than the SEC. Maybe this is true today, and maybe this is even true on a medium term time frame. By why take the chance, when we can simply put in a hard line of 15-to-1 like in the Frank Bill?

Exactly. Dodd’s draft leaves the rulemaking process largely up to regulators who proved themselves incapable of making those decisions to the good of the consumer and the taxpayer rather than the Wall Street titan.

It’s possible that capital requirements like that mentioned above from the Frank bill are insufficient for the current problem, and that size and not leverage must be attacked. But this is particularly true if the setting of those requirements are discretionary and put in the hands of regulators and officials who are susceptible to lobbying from the big banks.

What should concern everyone who thinks that laws can be written to successfully constrain size and risk is what Robert Reich argued today, that regulators have the ability today to enforce the laws on the books in such a way that would make the financial sector far less dangerous.

Before you wallow in hopeless cynicism, though, it’s worth noting that we already have a law against this. It’s called the Sarbanes Oxley Act of 2002. It just needs to be enforced […]

It requires CEOs and other senior executives to take personal responsibility for the accuracy and completeness of their companies’ financial reports and to set up internal controls to assure the accuracy and completeness of the reports. If they don’t, they’re subject to fines and criminal penalties.

Sarbox is directly relevant to the off-the-balance-sheet derivative games Wall Street has been playing. No bank CEO can faithfully attest to the accuracy and completeness of its financial reports when derivatives guarantee that the reports are incomplete and deceptive.

I’m not entirely hopeful that regulators will use whatever new tools they may be given any more effectively than they are using the tools from the last crisis.

David Dayen

David Dayen