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Originally published Tuesday, August 25, 2009 at 4:25 PM

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Devil's in the details on reform of financial regulations

The Seattle Times supports the aim of President Obama's proposals for regulatory reform of the financial system, but urges caution on such details as special treatment for "Tier 1" financial companies.

PRESIDENT Obama's proposal of regulatory reform aims to reduce risks to the financial system as a whole. The aim is good. The actual bill has to be carefully vetted, because even the smallest detail can create unforeseen consequences.

For example, there is an international rule of banking that for every $100 in loans, a bank has to keep $8 in ready capital. The aim is to protect the bank and the banking system. But if a bank puts $100 into mortgage-backed bonds, the rule says it has to set aside only $1.60. This difference encouraged banks to load up on billions of mortgage-backed bonds, which in some cases sank them.

Part of the president's proposal is to redo these rules, called the Basel rules, and that is good.

The president also proposes to recognize a class of financial companies that are so big their failure would shake the system. They would have to have more capital and face tougher rules than other financial companies. Call it a tax on bigness.

In case of failure, these "Tier 1" financial companies would have an alternative to bankruptcy. The aim is to avoid last-minute bailouts, but the plan does include the possibility of federal money or credit. Critics say this implies that bondholders of Tier 1 companies would be protected, which would allow those companies an advantage in borrowing money. And that would be a reward for bigness.

We like the tax on bigness. We are not eager to create any more rewards for it, especially if the rewards are bigger than the tax.

The president's proposal has many other things that speak directly to the recent problems. It would have regulators reduce the use of credit ratings, which have been used as a substitute for independent thought. It would require that the people who write and package mortgage loans have their pay tied to the performance of the loans. It would regulate credit default swaps, the insurance policies that sunk AIG.

The proposal would also require all public companies to have an annual nonbinding shareholder vote on the pay of top executives. It's not clear how this would reduce systemic risk, but it would certainly add some zest to corporate governance.

Tomorrow: a new consumer-protection financial agency

Copyright © The Seattle Times Company

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