Three legs of financial reform

Today, two columnists tout two pillars of bank reform, each worrying that fearsome bank lobbying will bend the Obama administration's resolve.

In this corner, Clive Crook urges the G20 to follow Geithner's proposals and act in concert -- so that banks cannot forum shop -- in raising capital ratio requirements and a cap on total leverage for systemically important banks:

The global finance industry is in no position, yet, to mount a vigorous campaign against changes which, if they are adequate, will implicitly tax its growth. That is what higher capital requirements would do, and is precisely why they are needed. Checking the industry’s expansion must be seen as an aim of policy, not an unintended consequence.

And over at the New York Times, Paul Krugman insists that the sine qua non of true bank reform is compensation reform (as proposed back in January 2008 by Raghuram Rajan) -- retooling the current massive incentives for bankers and traders to take excessive risks :

According to recent reports, the Fed’s board is considering imposing new rules on financial-firm compensation, requiring that banks “claw back” bonuses in the face of losses and link pay to long-term rather than short-term performance. The Fed argues that it has the authority to do this as part of its general mandate to oversee banks’ soundness.

I wonder whether a third leg of the stool -- Obama's proposed banking consumer protection agency -- may not be the most important of all. No one seems to be paying much attention to this -- except the banks, which are vociferously opposed. Krugman nods toward this proposal, but also dismisses it as only "the beginning of reform."

Hmm. Notwithstanding the complexities of securitzation, credit default swaps, and capital ratios, it was a simple failure of consumer protection -- tolerance of massive underwriting fraud, abusive loan products like negative principal loans, incentives for loan officers to put people into higher-interest loans than they qualified for -- that blew up the credit bubble and provided the toxic material for all those toxic securities that brought the banks low and triggered the credit default swap obligations that threatened to bring the whole financial system to its knees.

That's not to say that banks could not find other stupid risks if they were prevented from deceiving retail customers and offering them excessive credit. Pay incentives and capital ratios are crucial, too. But if consumer protection is merely a "first step," it's also a first priority.