‘Reform’ bill heavy on restriction, light on reform

Administration officials and members of Congress fret that banks aren’t lending enough, and that companies aren’t hiring enough, to reduce unemployment significantly and get the economy moving again.

But while Washington wrings its hands, it continues to bash banks, hedge fund and private-equity fund managers, and health insurance and pharmaceutical companies. This fuels populist resentment, which Washington then uses to justify what appear to be punitive new regulations on banks and other financial institutions — which probably will make lending and hiring even more unlikely.

Case in point: the financial-reform bill in the House of Representatives.

At press time, the bill contained several proposals aimed at big banks.

One would require banks to hold larger reserves, and another would require that they pay into a $150 billion government fund that would be used to pay for future failures of financial companies. Neither proposal would bring about the intended result.

The increased reserves would reduce banks’ ability to lend to businesses, and also reduce their profitability. The $150 billion tied up in the “failure” fund would represent capital that couldn’t be used to back loans.

Contributions to it would raise banking costs, which likely would be passed on to borrowers, dampening business growth.

Further, as Treasury Department officials pointed out, the very existence of the fund could induce banks to take more risk because they could expect to be bailed out if they get into trouble. A far better approach would be to raise capital requirements and/or assess a “failure fee” on banks that regulators perceived to be moving too far out on the risk spectrum.

Banks and other financial institutions also likely would be assessed fees to help offset the estimated $1.1 billion cost of a consumer financial protection agency. They would also have to deal with the added regulations the agency imposed on them.

Banks no doubt are being cautious in their lending, waiting to see whether these provisions actually become law. That caution, in turn, is slowing the recovery, because businesses can’t get the working capital that they need.

The House bill would also give the government unprecedented power to limit the growth of — or even shrink — large, healthy financial institutions. Washington would be able to order banks to split off certain operations or subsidiaries, or refrain from mergers or certain businesses if their size or contractual relationships were deemed to pose systemic risk to the economy.

This is a dangerous power. It could easily be misused by politicians to reward or punish certain institutions.

No one can begrudge the government’s power to shrink an institution that seems to be heading toward financial difficulty — something regulators are paid to monitor. But power to split up healthy institutions lawfully pursuing business is a step too far.

The uncertainty over what standards regulators will use in making such a determination, and the implications for the growth of the large financial institutions, appears to be weighing down bank stocks. The share prices of JPMorgan Chase & Co., Citigroup Inc., Morgan Stanley and The Goldman Sachs Group Inc., for example, have been trending down since the debate on the House bill heated up and it became clear that amendments were making the bill tougher on banks and other financial institutions than previously anticipated.

The bill, as originally outlined by Financial Services Committee Chairman Barney Frank, D-Mass., had many excellent provisions, including the creation of a financial stability council to oversee and regulate large institutions, and monitor them for systemic risk. It also provided for the greater regulation of over-the-counter derivatives, strengthening the investor protection powers of the Securities and Exchange Commission and establishing an orderly process for dismantling large, failing financial firms.

The initial proposal walked a fine line between being sensibly tough and being punitive. The amendments of the past few weeks have pushed it strongly toward the latter.

However guilty the banks are of recklessness, a financial-reform bill that reeks of revenge will only cut off American noses (and jobs and credit and economic recovery) to spite our faces.

Perhaps cooler heads will prevail in the Senate than in the House, leading to more-moderate provisions. If not, our economic recovery may continue at its leisurely pace for quite some time.