Key senators weighed in Tuesday on how to make the US banking system safe for Main Street.

A plan unveiled by Sen. Christopher Dodd (D) of Connecticut would simplify what is now a patchwork of bank regulators. It would strengthen oversight of risky activities such as the market for so-called derivative securities. And if a large bank gets into trouble, the plan calls for a controlled shut-down – not a taxpayer-funded bailout.

Financial experts widely agree that a regulatory overhaul is urgently needed. Senator Dodd introduced his plan in the Senate Banking Committee, which he chairs. The White House has made its own proposals, and the House Financial Services Committee has its own plan.

The question is whether any of the proposals will tame problems that helped create the deepest recession since the 1930s. These problems spanned from risky mortgage products to a failed regulatory climate created by both Republicans and Democrats in Washington.

Bankers have political clout

It’s very tricky to design fixes that strike a balance between encouraging marketplace innovation and guarding against credit bubbles and busts that have surfaced with periodic regulatory. The job is made still more difficult by the strong lobbying clout of the the banking industry.

The risk is that, in the wake of extraordinary taxpayer-backed efforts to rescue banks and the economy, not enough will be done to keep America from getting into similar trouble down the road.

“We have not changed the financial regulatory framework in a substantive way so as to limit excessive risk taking,” Simon Johnson, a finance expert at the Massachusetts Institute of Technology, told a congressional hearing last month. “The proposals currently proceeding through Congress are unlikely to make a significant difference.”

He said the US economy retains significant strengths in entrepreneurship and innovation. But Mr. Johnson said that skewed incentives have allowed bankers to reap big profits for activities that may do little for the private sector overall. And when those activities become downright unprofitable – as at some big firms in the recent crisis – the losses are often carried primarily by taxpayers.

Sen. Dodd's key proposals

Here are key elements of Dodd's plan:

• Confront a “too big to fail” mentality among banks. The crisis showed that some institutions are so important to the system that regulators wouldn’t allow their collapse – due to worries about the ripple effects. The Senate plan, like the House plan, tries to create a middle ground in which giant firms could face a bankruptcy-style shutdown, but in a controlled way that doesn’t cause panic. And it establishes some incentives for banks not to get too large. It remains to be seen if this will work.

• Set up a single federal bank regulator. Today’s system of multiple regulators allows banks to “shop” for regulators who may be most friendly. The House and Obama plans don’t seek such a change. Either way, finance experts say the problem of “regulatory capture” – in which regulators often see things from the perspective of the companies they oversee – may persist.

• Create a new Consumer Financial Protection Agency to regulate products such as mortgages. This goal is shared by President Obama and House Financial Services chairman Barney Frank.

• Set up an independent agency to guard against systemwide risks, in addition to the regulators tasked with narrower oversight of specific types of institutions. The House plan, by contrast, would have the Federal Reserve take the lead in watching for systemic risk.

The 1,100-page draft bill contains many more elements as well.

“I’m impressed by the [Dodd] plan to have Federal Reserve Bank presidents appointed by Congress,” says Dean Baker, an economist at the Center for Economic and Policy Research in Washington. “This idea that the banks pick their regulators is crazy.”

Bankers help pick their own regulators

Currently, local business leaders including bankers play a key role in choosing who heads the 12 regional Fed banks. In turn, the Fed is a key regulator of large banks, and played a pivotal role in bailouts last year.

Mr. Baker says the Dodd plan moves in a positive direction on many fronts, but he questions whether it goes far enough.

One big example: complex trading in derivatives.

He says none of the plans Congress is considering will strongly regulate that arena, which could leave the financial system exposed to crisis in the future. Last fall, insurer AIG’s derivatives exposure sent fear rippling through financial markets, as investors wondered who would be caught short if AIG couldn’t pay off on the contracts it had entered. Taxpayers ended up footing the bill to cover the derivative deals, and rein in a potential panic.

More broadly, Baker says Congress hasn’t addressed the question of how to give regulators the right incentives. When times are good, bank supervisors face a political backlash if they try to crack down on credit-market excess. Baker adds that the regulators – including the Fed chairman – don’t tend to lose their jobs if they fail in their risk-management duties.

“What’s the structure of incentives ... when the next bubble builds?” Baker asks. “No one is even talking about that.”

See also:

Bankers face activists’ anger in the streets of Chicago

Foreclosures rise. Big banks show profits. How can that be?

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