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Congress should direct regulators to require financial firms to put more consistent levels of capital non-borrowed money behind any investment, whether its a government security or a junk bond. Banks will still make mistakes, sure, but such rules reduce the chances that theyll make the same mistake all at once, bankrupting the industry.
Third, regulations should discourage financial firms from borrowing so much in overnight markets. When lenders pull their money instantaneously from such markets, they cause asset sell-offs and exacerbate panic. Financial firms should be free to borrow in short-term markets, but they should put more capital down behind such borrowing, making it more expensive.
Only when these rules are in place, coupled with some modest tweaks to the bankruptcy code, can financial firms go bankrupt without taking the economy with them. As investors realize that Washington wont step in with mass-scale bailouts next time because it wont have to, theyll be more careful lending money.
The GOP leadership should point out that the 1,336-page Dodd bill is the anti-thesis of these clear, consistent rules.
Dodds bill, for example, creates new regulatory authorities, such as a Financial Stability Oversight Council, to determine in advance which types of financial firms and instruments are risky and which arent. But the solution is not to try to do a better job at an impossible task. The FSOC likely would have declared AAA-rated mortgage securities safe as houses at the peak of the real estate bubble, just like almost everyone else.
Republican Sens. Richard Shelby (Ala.), Bob Corker (Tenn.), Mitch McConnell (Ky.) and others can say: Just as Washington regulators cant predict which industrial firms are going to succeed or fail, regulators cannot predict which financial firms and instruments are going to succeed or fail. We need rules that allow markets to reward success and punish failure, not government micromanagement futilely to foreordain success or failure.
Trying to predict the future of financial markets, as Dodd wants regulators to do, sets Washington up for its own failures and sets taxpayers up for more too big to fail bailouts.
The alternative bill that Republicans presented last week doesnt provide a crisp contrast to the Dodd bill. It quibbles with details rather than offering an entirely different story altogether.
Theres still time to fix a bad bill, though, and strengthen financial markets through the marketplace of political debate.
Nicole Gelinas, author of After the Fall, is a contributing editor to the Manhattan Institutes City Journal.