Five Problems Financial Reform Doesn't Fix

"We would have loved to have something like this for Lehman Brothers," said Hank Paulson with a sigh, in a recent New York Times story. "There's no doubt about it."

Paulson was talking about the financial-regulation bill that the Senate passed today. And he's right: the next time there's a financial crisis, regulators will say a quick prayer of thanks to Rep. Barney Frank for giving them the power and information to quickly figure out what's happened and how to respond. The legislation ushers derivatives out of the darkness and onto exchanges and clearinghouses, gives regulators the power to oversee shadow banks and take failing firms apart, convenes a council of superregulators to watch the megafirms that pose a risk to the full financial system, and much else.

But the bill does more to help regulators detect and defuse the next financial crisis than to actually stop it from happening. In that way, it's like the difference between improving public health and improving medicine: The bill focuses on helping the doctors who figure out when you're sick and how to get you better rather than on the conditions (sewer systems and air quality and hygiene standards and so on) that contribute to whether you get sick in the first place.

That is to say, many of the weaknesses and imbalances that led to the financial crisis will survive our regulatory response, and it's important to keep that in mind. So here are five we still have to watch out for:

1. The Global Glut of Savings: "One of the leading indicators of a financial crisis is when you have a sustained surge in money flowing into the country which makes borrowing cheaper and easier," says Harvard economist Kenneth Rogoff. Our crisis was no different: Between 1987 and 1999, our current account deficit—the measure of how much money is coming in versus going out—fluctuated between 1 and 2 percent of gross domestic product. By 2006, it had hit 6 percent.

The sharp rise was driven by emerging economies with lots of growth and few investment opportunities—think China—funneling their money to developed economies with less growth and lots of investment opportunities. Think, well, us. Ben Bernanke—not a man known for his vivid turns of phrase—called the hundreds of billions of dollars that emerging economies were plowing into our financial system every year "the global glut of savings," and said "it is impossible to understand this crisis" without talking about it.

But we've gotten out of the crisis without fixing it. China is still growing fast, exporting faster, and sending the money over to us. And we're still happily taking it, because it allows us to spend without growing. After falling to 3 percent after the crisis, the current account deficit is back up to 4 percent and rising. Rogoff thinks that's a problem. "One or 2 percent would be more sustainable," he says.

2. Household Debt—And Why We Need It: The fact that money is available to borrow doesn't explain why Americans borrowed so damn much of it. Household debt as a percentage of GDP went from a bit less than 60 percent at the beginning of the '90s to a bit less than 100 percent in 2006. "This is where I come to income inequality," says Raghuram Rajan, an economist at the University of Chicago. "A large part of the population saw relatively stagnant incomes over the '80s and '90s. Credit was so welcome because it kept people who were falling behind reasonably happy. You were keeping up, even if your income wasn't."

Incomes, of course, are even more stagnant now that unemployment is at 9 percent. And that pain isn't being shared equally: inequality has actually risen since before the recession, as joblessness is proving sticky among the poor, but recovery has been swift for the rich. Household borrowing is still more than 90 percent of GDP, and the conditions that drove it up there are, if anything, worse.

3. The "Shadow Banking" Market: The Great Depression was visually arresting: Long line of frantic families lining up outside their bank to pull every cent out before the bank collapsed. The financial crisis started out similarly severe, but aside from some despondent-looking traders, there was nothing to look at. That's because it wasn't, at first, a crisis of consumers. It was a crisis of banks.

It never became a crisis of consumers because consumer deposits are insured. But large investors—pension funds, banks, corporations, and others—aren't insured. They use the "repo market," a short-term lending market in which they park their money with other big institutions in exchange for collateral—collateral like mortgage-backed securities. But when they hear that their collateral is dropping in value, they demand their money bank. And when everyone does that at once, it's like an old-fashioned bank run: The banks can't pay everyone off at once, so they unload all their assets to get capital, the assets become worthless because everyone is trying to unload them, and the banks collapse.

"This is an inherent problem of privately created money," says Gary Gorton, an economist at Princeton University. "It is vulnerable to these kinds of runs. It took us from 1857, which was the first panic really about deposits, to 1934, to come up with deposit insurance." This year, we're bringing this shadow banking system under the control of regulators and giving them all sorts of information on it and power over it, but we're not doing anything like deposit insurance, where we simply make the deposits safe so runs become an anachronism.

4. Rich Banks: In the 1980s, the financial sector's share of total corporate profits ranged from about 10 to 20 percent. By 2004, it was about 35 percent. Simon Johnson, an economist at MIT, recalls a conversation he had with a hedge-fund manager. "The guy said to me, 'Simon, it's so little money! you can sway senators for $10 million!?' " Johnson laughs ruefully. "These guys [big investors] don't even think in millions. They think in billions."

What you get for that money is favors. The last financial crisis fades from memory and the public begins to focus on other things. Then the finance guys begin nudging. They hold some fundraisers for politicians, make some friends, explain how the regulations they're under are onerous and unfair. And slowly, surely, those regulations come undone. This financial crisis will stick in our minds for awhile, but not forever. And after briefly dropping to less than 15 percent of corporate profits, the financial sector has rebounded to more than 30 percent. They'll have plenty of money with which to help their friends forget this whole nasty affair.

5. Lax Regulators: The most troubling prospect is the chance that this bill, if we'd passed it in 2000, wouldn't even have prevented this financial crisis. That's not to undersell it: It would've given regulators more information with which to predict the crisis. But they had enough information, and they ignored it. They get caught up in boom times just like everyone else. A bubble, almost by definition, affects the regulators with the power to pop it.

In 2005, with housing prices running far, far ahead of the historical trend, Bernanke said a housing bubble was "a pretty unlikely possibility." In 2007, he said Fed officials "do not expect significant spillovers from the subprime market to the rest of the economy." Alan Greenspan, looking back at the financial crisis, admitted in April that regulators "have had a woeful record of chronic failure. History tells us they cannot identify the timing of a crisis, or anticipate exactly where it will be located or how large the losses and spillovers will be."

But this bill leans heavily on regulators: they watch the firms, set capital requirements, have to reach consensus before taking down a failing institution, and, well, everything else. Greenspan, in that same speech, expressed a preference for rules that "kick in automatically, without relying on the ability of a fallible human regulator to predict a coming crisis." The bill contains precious few of them.

"In history," says Gorton, "it always takes us a long time to get financial regulation right, and I expect it will this time, too. Maybe we're done for this year, or the next couple. But we can't possibly be done."