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Politics Are Polluting Financial Reform Debate

It’s too bad that politics of financial reform have so polluted what should be a serious debate about government bailouts and moral hazard.

Democrats have not helped the issue, failing to understand that real bipartisanship means you could lose 10 of your own senators, but get 20 of theirs in the bargain.

But blame for the real politicization of the process should be laid at the feet of Senate Minority Leader Mitch McConnell, who charged that Democrats wanted to create a system to bailout the banks.

I’ve spoken with several Republicans who say the Democrats never wanted to do anything of the kind. In fact, they point out that the section of the bill McConnell criticized was crafted with significant input from Republicans.

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Government Regulation

That doesn’t mean there is no merit to the Republican notion that the existence of a bailout fund could actually increase moral hazard, or unwarranted risk-taking, on the part of the banks because they know that the fund will be there to bail them out.

On the one hand, it’s hard to argue that the existence of a similar fund at the Federal Deposit Insurance Corp. to guarantee deposits increases moral hazard. Banks know if the FDIC comes in to bail them out, their institution will be closed and sold off and management will be removed.

The liquidation provision in the Dodd bill is similar in that respect. In fact, the idea of a pre-funded $50 billion fund has been pushed by Sheila Bair, the Republican appointed head of the FDIC. But the real argument the Republicans have is that bank creditors will be tougher on banks if they know there will be no government bailout, forcing banks to pay more for their debt.

It could also force them to run the business more carefully and take on less risk. The only way to eliminate this moral hazard is to take away from the government, including the Treasury and the Federal Reserve, the ability to come in and ever bailout a financial institution.

Sounds good, right? But how realistic is it? When the financial markets are in panic, when there is a threat that the banking system could seize up, is it realistic to believe that the government won’t step in?

At the heart of the liquidation portion of the Dodd bill is the recognition that the government will act during a panic. It creates a pool of funds that will pay for the resolution of big banks and proscribes what government can do. The process can only be initiated with the approval of three bankruptcy judges. It mandates that management is replaced, that equity is wiped out and unsecured creditors bear losses. Little if any of that happened in the most recent crisis.

Both choices have costs. Peter Wallison writes in today’s Wall Street Journal that depositors will be forced to pay for the $50 billion bailout fund through lower interest rates paid by the banks. Yet the lack of a bailout fund would also raise costs for banks if that results in creditors charging higher rates for banks and requiring greater security.

That, then, is the choice: between one idea that says if you create the fund and the mechanism, it will be used and relied on; and the other that says, it’s best to recognize reality, promise harsh penalties and limit what government can do.

Both sides want to end bailouts. The debate is over how.