No Big Fix for Global Finance

World leaders are talking bravely about fixing the global financial system. As the Group of Twenty heads toward an important summit in Pittsburgh on Sept. 24-25, they are vowing to bang out a regulatory structure that will keep rich, careless bankers from once again driving their firms to ruin and then getting bailed out by taxpayers. Finance ministers and central bankers who met in London earlier this month reported "substantial progress in delivering our ambitious plan."

But their plan is far less ambitious than what some voices were advocating as recently as last spring. Bank lobbyists have fought back hard, and recent improvements in the global economy and financial markets have robbed momentum from the reformers. What's more, truly ensuring change on a global scale would probably require a single international regulator with power to intervene in local affairs. Yet there is little appetite for that among the G-20, which includes the major industrialized countries as well as China, Brazil, and other developing powers.

The likely result? A package of worthy but lukewarm reforms that leave the global financial system—and taxpayers—exposed to another costly bust some years down the road. "We're not going to have a revolution," says Edwin M. Truman, a senior fellow at the Peterson Institute for International Economics who advised Treasury Secretary Timothy Geithner before G-20 meetings last spring. "The question is to what extent you're going to have, over the next year, a substantial evolution."

International and U.S. proposals on the table target the hot topics: increasing capital requirements, corralling the "shadow banking system" of nonbank lenders, and otherwise trying to ensure that risk doesn't balloon out of control. But in most cases they rely on the kinds of tools that failed the last time around, when supervisors proved less than vigilant, turf squabbles impeded regulation, and fears of foreign competition led governments to yield to industry demands for a lighter touch.

Cushions of Capital

In the chaotic months following the bankruptcy filing of Lehman Brothers on Sept. 15, 2008, few ideas seemed too extreme for consideration. Break up the giant banks. Regulate the survivors like utilities. Ban casino-like bets on the possibility of default by corporate borrowers. Prohibit credit-rating agencies from being paid by the agencies they rate. Above all, build a mechanism so that even huge multinational banks could fail without jeopardizing other firms and national economies.

The G-20 plan doesn't do any of that. It focuses on bolstering the cushions of capital that financial firms must hold, making sure they have the liquidity to survive a cash squeeze, and strengthening the supervision over them. By the end of this year global regulators are supposed to come up with a plan for banks to build up capital buffers in good times that they can draw down in bad ones. That would discourage banks from overlending in booms and choking off credit in busts, as they tend to do. Unfortunately, experience shows that banks are good at getting around tougher capital standards or persuading regulators to ease them.

The G-20 nations aren't even seeking fundamental restructuring. Banking firms could continue collecting government-insured deposits with one hand and, in other subsidiaries, make risky bets on the market—though the cost of doing so could rise.

To succeed, rules also must be applied consistently around the world, but gaps are appearing in European and U.S. officials' united front. European regulators want to establish explicit boundaries for bankers' pay and tie capital requirements to the risk of an institution's underlying assets. U.S. officials, on the other hand, are resistant to strict pay limits and are focused on the capital requirements of the biggest and most important institutions.

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.