At the Room for Debate, we were asked "What's missing from the Dodd proposal for financial reform?" My answer reiterates things I've been saying here for quite awhile:
Controlling Bubble Damage, by Mark Thoma: While we should certainly do our best to prevent bubbles through legislative and regulatory changes, and to prevent other problems like fraud, legislative and regulatory remedies can never ensure that the financial sector will be free of bubbles in the future. Thus, it’s important for financial reform legislation to limit the damage that bubbles can do.
An important factor determining the amount of damage a bubble can do is the amount of leverage in the financial system. The more leverage there is, the bigger the crash. For this reason, limits on leverage are essential.
Senator Dodd’s proposal does allow regulators to set limits on leverage, but that is not enough. This crisis demonstrates that trusting the judgment of regulators who are subject to ideological and regulatory capture can lead to insufficient oversight. We need strict upper bounds on leverage — 15 to 1 for example — limits that are independent of the regulators put in charge under any particular administration.
The other place that the legislation could do better is in limiting the size of banks. There is no convincing evidence that banks need to be as large as allowed under the Dodd legislation for the financial system to function efficiently. However, limits on bank size may not protect the financial system from a meltdown. If small banks are exposed to common risks or sufficiently interconnected, then many small banks could fail simultaneously and mimic the failure of a large bank, something that has happened in the past.
Reducing size is no guarantee of safety. But limiting bank size does limit the political power of financial institutions. Imposing regulations such as strict limits on leverage is much more difficult when banks are politically powerful, and that alone is sufficient reason to enact strict limits on bank size.