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Wharton Professors Assess the Financial Reform Bill

In a recent blog post, Wharton professors Susan M. WachterMarshall E. BlumeJeremy J. SiegelKent Smetters, and Richard Marston were asked about whether the financial reform legislation currently being considered by Congress will be effective at averting future financial crises.  They all agree that the legislation is far from perfect, and 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.)

However, the professors also worry that this new regulation of derivatives does not resolve the problems inherent in credit-default swaps and other insurance-like derivatives. 

The professors also note that the bill's central clearinghouse provision for derivatives does not deal with mispricing risks, or low price relative to higher risk.  According to the professors, this causes risk to build up in the financial system.  They also note other weaknesses in the legislation:

  1. The "Volker Rule" barring or limiting many Wall Street firms from trading on their own accounts may be difficult to enforce
  2. The  consumer financial protection agency may not be strong enough, and may not have any more effect than efforts of other regulators.  

In sum, the Wharton professors seem to agree that certain parts of the financial reform bill will improve existing regulation.  But they also seem to agree that the ability to avert the recent financial meltdown already existed amongst the regulators; however, the regulators did not seem to have the will or the foresight to do so.  

The full text of the Knowledge@Wharton blog post is available at:  http://knowledge.wharton.upenn.edu/article.cfm?articleid=2516