05/24/2010 05:12 am ET Updated May 25, 2011

The Brown Amendment: Do the Volcker Rules Live?

The administration may be distancing itself from the Volcker Rules, but the same is not true of all Senators. (Why did President Obama go to the trouble of endorsing Mr. Volcker's approach to limiting risk and size in the banking system, if his key implementers - led by Treasury Secretary Tim Geithner - were going to back down so quickly?)

Among a number of sensible amendments under development in the Senate, Senator Sherrod Brown (D., OH) proposes the following language: (text attached)

"LIMIT ON LIABILITIES FOR BANK HOLDING COMPANIES AND FINANCIAL COMPANIES.--No bank holding company may possess non-deposit liabilities exceeding 3 percent of the annual gross domestic product of the United States."

And a few paragraphs later, an essential point is made clear: this includes derivatives,

"OFF-BALANCE-SHEET LIABILITIES.--The computation of the limit established under subsection (a) shall take into account off-balance-sheet liabilities."

And there is a strong provision for requiring prompt corrective action if any bank exceeds this hard size cap.

Naturally, the Federal Reserve is pushing back.

The Fed's argument is that any kind of size limitation would be too blunt an instrument - successful regulation requires nuance and subtlety.

Perhaps, but there's a big problem with relying on subtle regulators. Over the past thirty years, almost all our regulators and supervisors have become either sleepy or captured - in a cognitive sense - by the very people they are supposed to be watching over. (Chapters 3 and 4 in 13 Bankers document this in detail; more on that when the book comes out next Tuesday.)

The question of the day can be framed as the classic, "Who will guard the guardians?" Or you can just ask, loudly, "Where the heck were the people charged with the safety and soundness of the system over the past decade?"

It would be sheer folly to rely on "smart regulation" going forward - yet Larry Summers and Tim Geithner seem to be taking that approach. Just answer this, preferably in public: What happens when another president with the philosophy of a Reagan or a Bush starts to make appointments?

Or just think about this. The New York Fed is run by a senior executive of Goldman Sachs. At the same time, the former head of the New York Fed holds a top position at Goldman - where he is responsible for interacting with regulators around the world. And the practices, if not the explicit rules, of the New York Fed apparently permit its board members to buy stock in companies that the Fed oversees. Please explain exactly how this web of arrangements will help keep regulation strong and effective moving forward.

The Brown amendment is not perfect - in 13 Bankers we recommend a blanket size cap, rather than treating deposit and non-deposit liabilities separately. But this amendment would definitely be a step in the right direction.

Our regulators have failed us, repeatedly. What we need now is some smart legislation.

Cross-posted from The Baseline Scenario.