Regulating the Unknown: Can Financial Reform Prevent Another Crisis?

Congressional negotiators are ironing out differences in two mammoth financial reform bills — one passed in the House in December, the other by the Senate in May. Backers, mainly Democrats, say the result will prevent the kinds of excesses that brought on the financial crisis and recession. But could the measures really do that?

Some of the features may help, but plenty of risk would still be left in the system, according to several Wharton faculty members. “[The proposed reform] is not, ultimately, a game-changer in terms of preventing a crisis,” says Wharton real estate professor Susan M. Wachter, noting that “a lot is left to the discretion of regulators,” and it is not certain regulators would spot a brewing crisis in time or have the political will to deal with it.

Had the reforms most likely to be implemented, such as centralized trading of derivatives, been in place years ago, the recent financial crisis “would have been minimized,” states Wharton finance professor Marshall E. Blume. But, he adds, “The real issue is: How do you regulate what we don’t yet know is going to happen?”

Wachter, Blume and other Wharton faculty say the House and Senate measures could have been both much worse and much better. Under the provisions most likely to emerge from the House and Senate conferences are new systems for spotting risk before it mushrooms, and for shutting down troubled financial institutions before the need for taxpayer bailouts. Most derivatives will be moved out of the opaque over-the-counter market to be traded instead on transparent exchanges. And credit-rating agencies will have to operate under stricter standards. There also will be some form of national consumer protection agency.

“What finally came out is not as bad as it could have been,” says Wharton finance professor Jeremy J. Siegel. “Obviously, the [Federal Reserve] should have been exercising oversight [prior to the recent crisis], looking at the riskiness of firms. This [Senate bill] gives the Fed the explicit responsibility and right to do that.”

Among the Wharton faculty members interviewed, the most popular reform is the move to centralize trading of derivatives, including hard-to-value mortgage-backed securities. Both bills would create a centralized exchange and clearinghouse that would make prices public, and assure that each party to a trade gets what it is due — payment or delivery of securities — even if the other party defaults. A major factor in the financial crisis was uncertainty about the value of complex securities, or whether counterparties would meet their obligations. (A counterparty is defined as a person or legal entity that is party to a contract.)

Blume believes an exchange and clearinghouse will lead to greater use of standardized derivatives, making it easier for market participants and regulators to see trading patterns and prices, as they do with the stock exchanges. These safer, standardized products, Blume notes, would grow to dominate the derivatives market because they would be cheaper and easier to use, reducing potential problems from customized derivatives that would continue to be traded on a less transparent over-the-counter market. “Requiring a central clearinghouse for many of the derivative securities is a great idea,” Blume adds. “It will help provide financial stability to the markets.”

A clearinghouse, says Kent Smetters, professor of insurance and risk management at Wharton, would require derivatives users to put up collateral, just as ordinary investors face margin requirements when they invest money borrowed from their brokers. “For the most part, I agree with that,” Smetters states. “It is certainly a lot better than the alternative, which is the government trying to impose all sorts of capital reserve requirements.”

But Wachter and Wharton finance professor Richard Marston worry that the reform bills fail to resolve the problems inherent in credit-default swaps, an insurance-like derivative that upended American International Group, the giant insurer, forcing a $182.5 billion taxpayer bailout. Credit-default swaps pay off if an underlying debt, such as a corporate bond or mortgage security, falls in value or goes into default. Regular insurance is issued only to people or businesses with “insurable risk” — like the owner of a home. But there is no such requirement with credit-default swaps, allowing speculators to use them to bet on the ups and downs of securities they do not own. AIG ran into trouble by writing credit-default swaps and then not having the money to pay off after the market tanked.

“This is an insurance product,” Marston notes. “The main reason that AIG called them ‘swaps’ is that this nomenclature allowed them to escape insurance regulation…. Note that the Congressional bills leave this problem unsolved.”

Mispricing Risks Remain

Wachter calls the exchange-clearinghouse requirement “a good thing” but notes it is not a perfect guarantee against the mispricing — a low price relative to risk — that brought on the crisis. Some market participants, she says, are set up to profit on large, short-term risks and don’t necessarily worry about risk building up in the system. In fact, the issuance of high-risk mortgages and mortgage-backed securities actually increased as participants began to see a climax approaching, as participants rushed to make profits before the expected collapse, Wachter adds.

These “short-run-oriented” players “will inject risk into the system,” Wachter says, noting that just how these incentives and behaviors work is not yet well understood. Market transparency from an exchange and clearinghouse is therefore useful only to the extent there is a regulator able to gather information and willing to use it to avert problems.

Still, Wachter says a centralized derivatives exchange is a good step. “The more I learn about it, the more I see some virtue in this proposal,” Siegel adds. Had it been in place a few years ago, growing risks would have been more obvious, counterparties would have been required to put up more collateral, and “the problem would have been evident much earlier than it was.”

Watching those risks build would be the role of the Financial Services Oversight Council that both bills would create, but Wachter says the House and Senate bills do not provide enough guidance on what constitutes systemic risk: “The language is not really there.” She also notes that Wall Street firms, hedge funds, regulators and other market participants have long had high-priced analysts assessing risk, but they failed to sound an alarm in the recent crises. “So is it a convincing argument that the federal government is going to be able to hire them, at the federal pay rate, and be able to stop things that the private markets couldn’t?”

Blume, too, warns that simply creating a new bureaucratic entity does not necessarily resolve problems. “There will be a group of people meeting, but I’m not sure the council will have any real power,” he says. “I suspect that it was more cosmetic than anything else.” Politics often interferes with good regulation, Siegel notes, arguing that the government’s policy of increasing home ownership encouraged the subprime lending that triggered the recent crisis.

Congress has also wrestled with another key issue: what to do to avoid another taxpayer bailout of financial institutions deemed “too big to fail.” Both bills provide for regulators to step in to dismantle troubled institutions in an orderly way. The House bill would establish a $150 billion fund financed by the largest financial services firms, while the Senate bill would recoup expenses from the industry after the fact.

Siegel hopes the $150 billion fund is scrapped. “I think that could just be a fund that could be used by Congress to support all sorts of losing firms,” he says. Although bailouts initially cost taxpayers hundreds of billions of dollars, much of that money has been repaid.

Siegel says the Senate bill would likely push troubled firms to go through a quick bankruptcy process that not only would wipe out shareholders, but would leave many bondholders with deep losses as well. That would be a good process, he says, because it would make lenders more cautious and impose more discipline on financial services firms. Too many bondholders were left unscathed in the recent crisis, he says. When this happens, it creates a moral hazard in which market participants might still choose very risky options with higher returns because they think the government will bail them out of future crises.

Snags in the ‘Volcker Rule’?

Also to be worked out as the House and Senate confer is the “Volcker Rule,” proposed by former Federal Reserve chairman Paul Volcker, an advisor to President Obama. It would bar many Wall Street firms from trading in their own accounts. Generally, the Senate bill takes a tougher stance on barring speculative trading, while the House bill would give the oversight council power to prohibit such trades if it finds they threaten the system.

Smetters says it could be very hard to enforce the Volcker Rule. “How do you know if, when a bank buys derivatives, that they are really buying [them] for their own book?” he asks, noting that in many cases the bank may be hedging risk related to a customer’s bet.

“I think banning it is too stringent a rule,” adds Siegel, arguing that proprietary trading “really had nothing to do with the crisis.” The Federal Reserve has plenty of power to discourage risky behavior if it is willing to use it — by simply labeling a firm “systemically risky,” for instance. “They would take a hit in the markets. They don’t want to be on a watch list for systemic risk.”

The bills also differ on treatment of credit-rating agencies such as Standard & Poor’s, Moody’s and Fitch. The firms came under heavy criticism for giving investment-grade ratings to mortgage-related securities that later collapsed. A key problem, many critics say, is that the agencies are paid by the firms that issue the securities. The Senate bill would establish an independent board to assign ratings agencies to securities, so issuers could not shop around for the best ratings. The House bill would require the agencies to register with the Securities and Exchange Commission and would impose stiffer liability standards.

Siegel opposes a system of government ratings assignments, preferring instead to require that issuers reveal all the ratings a security receives if it is presented to more than one rating firm. “I like full disclosure,” he says. Blume feels the ratings agencies are already sufficiently chastened to avert serious abuses. He notes that the agencies now know more about assessing risks of complex securities “and have made the ratings standards much more stringent.”

Another controversy involves a proposed consumer protection agency to write and enforce rules on things like bank accounts, mortgages and other loans. “I’m not impressed,” says Siegel. It’s no longer necessary to protect consumers from products like subprime mortgages, since they are no longer being offered, he notes. And there’s a risk that some products will become more expensive as a result of overzealous regulation. Prepayment penalties on mortgages, though much criticized, can help reduce loan rates, he adds.

Blume, too, doubts a new consumer protection agency will do much better than previous efforts. “We already have substantial government regulation of financial products. It obviously didn’t work, particularly in the mortgage area. So what we’re going to do is we’re going to add some more infrastructure to make it work? Why the new infrastructure should work better than the old infrastructure, I don’t know.”

He and Smetters also fault the bills for failing to give the consumer agency broad powers to regulate insurance products, which they say are often overpriced and subject to misleading marketing. Blume says the market itself is likely to correct some problems, such as excessive risks in products like credit-default swaps. “I don’t think you are going to have any trouble in that market for the next five years. People get burned once and they don’t get burned the same way again until they forget.”

But Marston worries the markets are still at risk. “I believe that nothing in the bills will prevent another crisis. The basic problem is that securitization has changed banking in a fundamental way,” he says, referring to the creation and trading of instruments such as bonds based on pools of mortgages. “It ties all financial institutions and investors together, so you can’t wall off the banks.”

Regulators, he argues, could have stepped in to prevent or minimize hazards that led to the crisis. Instead, they allowed financial institutions to issue credit-default swaps with AAA ratings they didn’t deserve, they allowed lenders to sell risky mortgages, and they let financial institutions use off-balance sheet entities to hide risks. “How do you get good regulation?” Marston asks. “The bill doesn’t make much progress in that. But maybe memories of this crisis will help keep regulators vigilant.”

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