By Marc Seltzer; originally posted on April 20, 2010, at care2.com

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As the Senate moves towards consideration of financial industry reform, politics again threatens to overwhelm substance in the debate.  Conservatives have attacked Democratic legislation with the moniker “bailouts forever.”  Political writer Mark Halperin charged Republicans with “intentionally misreading the law,” echoing claims of angry Senate Dems.  Unlike with health care reform, where budget complexity defied evaluation without experts and CBO forecasts, the core principles of financial reform are fairly straight forward.

The following is what you need to know to make your own decision:

A.  Protections against risky behavior by financial institutions

1. Capital Requirements
Companies will be forced to keep more money available — “capitalization” or “capital reserves” — to protect themselves against losses so that typical companies will not be at risk of collapse in a downturn.  Sufficient capital could have eliminated the need for bailouts of financial institutions in 2008-2009.

2.  Leverage Restrictions
Financial companies will be limited in how much money they borrow and put at risk. Many institutions make money by investing and taking risk with borrowed funds.  This extends their gains in boom times, but threatens overwhelming losses in a bust.  Private companies are still allowed to place their bets, even risky bets, but they cannot do so using such high percentages of borrowed funds, creating a risk of nonpayment when their investments go bad.

Capital and Leverage rules are the key to protecting the economy from a 2008-style crisis. No longer would the great extent of irresponsible risk be tolerated.  With each individual company taking less risk, a severe downturn in the economy could drive some financial entities out of business, but would not threaten the entire financial industry and thus require government assistance.

Watch out for “too big to fail” arguments from the Left (“break up the banks”) or Right (“endless bailouts”). Canada has five of the largest banks in the world and none faltered.  Canada’s financial institutions are regulated with the same type of serious oversight included in current US proposals.  Capital requirements for Canadian banks were held at 7 percent going into this crisis, while the global average was closer to 4 percent. Canada’s chief financial regulator, OSFI Superintendent Julie Dickson, remarked in November 2008, “We have seen how strong capital cushions in Canada have paid off to the benefit of our institutions and overall financial system.” (My comparison of the U.S. administration’s proposals with the Canadian regulatory system)

The point is, capital, leverage and risk management are more important than size.  In fact, no one financial institution in the US was too big to fail as far as the effect on jobs, small business loans or the stock market.  The problem was that many separate but co-dependent entities were unable to handle a downturn and would have failed within a period of months, if not for government intervention.  Early in the Great Depression 5000 banks failed.  Making each bank smaller is irrelevant, if they all fail.

B.  Specifically dealing with failing companies.

1.  Closing companies down — “FDIC Resolution Authority”
The administration’s proposal is to use the FDIC (Federal Depository Insurance Corporation), which currently closes banks that are failing, to close all financial institutions, when they fall below financial operating requirements.  The FDIC is highly regarded for efficient and effective “weekend” bank closures.  FDIC agents take over Friday at 5:00 p.m., and Monday the bank is open for customers, but under FDIC supervision.  The FDIC locates a new buyer quickly and gets out of the way once new management takes over.  Previously, there was no law permitting FDIC action on failing financial institutions that were not technically chartered banks.  Thus, Bear Sterns, Lehman Brothers, Citi, etc., could not have been closed by the FDIC.

The alternative approach, proposed by critics of the FDIC model, is to allow failing financial institutions that are not banks to file for bankruptcy.  Advocates say that bankruptcy courts have more expertise than the FDIC at large complicated business structures.  However, bankruptcy does allow the management to continue through the failure and to propose corrective plans, using the bankruptcy court to deal with creditors.

In the 2008-2009 crisis, insurer AIG would have had to file bankruptcy, if the federal government did not bail it out.  In bankruptcy, AIG and its management would still have aimed to protect their own interests, despite the anticipated international catastrophe of its own making. (Many financial institutions had used AIG to insure themselves against losses; AIG’s collapse would have led to additional major collapses worldwide)

According to the proposed “FDIC resolution authority” model, the financial institution will be taken over and immediately managed by experts with the public’s interest in mind.  Presumably, the bankruptcy model would also protect the larger financial system, since higher capital and leverage standards, discussed above, would serve to lower the amount of damage that any one institution could cause in failure. However, the FDIC, as a banking regulator, has expertise in the financial system, while bankruptcy courts handle competing public and private interests in all types of businesses, and may not always have a view to protecting financial stability.  Remember, the purpose of the new law is to stop poor decision-making of a few entities from impacting the entire industry and the wider economy.

2.  Industry-Financed Disaster Fund
The Senate legislation plans for the financial institutions to contribute to a fund to be used if needed in closing companies.  The 50 billion dollar fund would shield taxpayers from having to pay for any costs incurred by failing financial institutions.  While the new law intends to avoid bailouts altogether, by making financial institutions less risky, more self-sufficient, and by closing them before they create systemic damage, it provides that any bailouts that do occur will be paid from a fund created with private financial company fees.

Should industry-financed bailouts be allowed? Imagine, for example, that a financial institution failure would cause a functioning private hospital to be shut down for a week while it sought new financing from another bank.  In that case, not because of a threat to the wider economy, but because of other public purposes, short-term bailout financing, using the institution-financed fund, might be deemed appropriate, at no cost to the tax payer.

The reason that Congress is rejecting the idea of outlawing any possibility of bailouts, is that it is possible that public purposes will be served by having a bailout option.  What is different here is that the government will not be forced into bailout because the new capital and leverage requirements will protect the wider economy.  Thus, Republican claims that bailouts using public funds will continue, do not take into account the fact that new capital and leverage requirements are the primary defense against systemic risk.  It is not by pledging, even through legislation, to avoid bailouts that we will be protected.  It is by stopping companies from taking so much risk that the entire system is put in danger of collapse.

C.  Consumer Protection

Fundamental consumer protections already exist to keep financial institutions from stealing or mismanaging their customers assets.  However, as the Madoff scandal illustrates, the government is not always effective in policing.  In addition, in the real estate market, many homebuyers obtained mortgages without fully comprehending the terms and consequences.  The new law aims to provide additional protection for consumers.  Krugman: Looters in Loafers

The financial industry is strongly against the consumer protection provisions, partly because they do not know how aggressive the new body will be in regulating business practices.  (Auto-finance example)  The current proposal puts a new consumer-protection agency under the authority of the Federal Reserve.  As the Federal Reserve traditionally regulates banks and manages monetary policy, including the interest rates that banks are charged to borrow funds for their business operations, the issue for the new consumer protection regulator will be how independent it remains from Fed regulators with different goals, and determining what level of protection balances business objectives with consumer rights.

These are the core ideas behind the administration’s plan, as spearheaded by Treasury Secretary Timothy Geithner and now incorporated into Democratic legislation.  As Congressional leaders posture about whether to support or oppose the plan and why, decide for yourself what’s politics and what’s substance.

More by Marc Seltzer:  Hate that Obama’s Near the Middle, Think Again!
Questioning Conventional Wisdom

Will Republicans return to power in November?  Listen to Marc Seltzer and Jessica Pieklo discuss political prospects at Redefining America:  Constitution and Leadership 2010

April 22, 2010 UPDATE: NY Times updates Dems efforts to push forward in the Senate and Republican opposition.