Senate Republicans have struggled to find a theme in their opposition to Sen. Chris Dodd's (D-Conn.) financial reform bill — even as they greenlight debate. The GOP should do more than try for incremental change. Instead, Republicans should present to the public a clear goal — allowing free markets to govern Wall Street and a set of simple rules to get there.
[IMGCAP(1)]Republicans can say: Senators on both sides of the aisle want to end "too big to fail." But the fatal flaw in Dodd's bill is that it would try to decree an end to taxpayer bailouts, rather than create the conditions necessary to achieve that end.
Americans can understand that in a free-market economy, success in business doesn't happen by decree. Instead, it is the result of a consistent, predictable set of rules that apply to everyone. Similarly, failure in finance can't happen by government decree. It must be the result of consistent, predictable rules.
The right rules are the rules that allow financial firms to fail without causing so much harm to the economy that bailouts are inevitable.
First, we need clear borrowing limits and trading rules for all financial instruments. That way, burst bubbles do not leave so much debt behind that they bankrupt the financial system.
History shows that these rules work. Since the Great Depression, Washington has limited borrowing in the stock market. Speculators cannot borrow more than half the value of a stock, no matter how "safe" investors and regulators perceive that stock to be. That's why, when the tech bubble burst in 2000, losses did not bankrupt the financial industry. Congress needs to apply such borrowing limits to new markets — including unregulated derivatives like credit-default swaps.
If these rules had been in place in 2008, and the insurer American International Group had put, say, 10 percent down behind its credit-derivatives promises, it could have gone under without bankrupting the financial system. The cash cushion would have absorbed big losses. As recently as 1995, a major investment bank, the United Kingdom's Barings Bank, went bankrupt without taking down the financial system, because it made its derivative bets on regulated exchanges that required cash down.
Wall Street firms will claim that they can't trade "customized" derivatives on independent exchanges because the instruments are too complex. That's the point. We need simplicity.
Second, we need consistent borrowing limits across financial firms — no matter how "safe" their investments seem. This rule, too, would help end too big to fail. Another reason that the financial industry has required multitrillion-dollar infusions of taxpayer capital since 2008 is that Washington allowed financial institutions to invest in supposedly airtight mortgage-backed securities with negligible cash down to absorb any losses — because losses on "safe" securities seemed inconceivable.
Congress should direct regulators to require financial firms to put more consistent levels of capital — non-borrowed money — behind any investment, whether it's a government security or a junk bond. Banks will still make mistakes, sure, but such rules reduce the chances that they'll 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 won't step in with mass-scale bailouts next time because it won't have to, they'll 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.
Dodd's 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 aren't. 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 can't 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 doesn't provide a crisp contrast to the Dodd bill. It quibbles with details rather than offering an entirely different story altogether.
There's 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 Institute's City Journal.