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Commentary By Nicole Gelinas

What Brown Can Do To Fix Banks

SENATE REPUBLICANS have said what they don’t like about the Democrats’ plans to fix Wall Street. Now, Republicans should say what they do want. Senator Scott Brown won his seat partly because voters are angry about bank bailouts. Now he can show fellow Republicans that there’s a way to work with Democrats to protect the economy from Wall Street — not by expanding government, but by improving its rules.

Last week, Brown said that he can’t support Senator Chris Dodd’s financial reform bill. “It’s going to hurt community banks and small banks,” Brown said of the Connecticut Democrat’s legislation. “It’s going to hurt small business.” Brown also came under scorching criticism for asking a reporter, “What areas do you think should be fixed? . . . I’ll get a team and go fix it.”

In fact, Brown is right to perceive that fixing this problem is easier than everyone thinks — and dead-on to be concerned about small banks and businesses.

The Dodd bill would harm small firms by creating a “financial stability oversight council.” This regulator would decide which securities create excessive risk in the marketplace and which financial companies are so big or complex that their failure would cause an economic disaster. The government would then treat those banks and securities differently than others.

While this sounds good in theory, it presents two problems.

First, this regulator will not be able to predict the future. In the past, the government has deemed highly rated mortgage securities — the kind that led to the 2008 financial crisis — to be safer than other types of investing. Five years ago, regulators probably would have said that insurance firms like AIG were safe, as that was conventional wisdom at the time.

Second, with regulators giving special attention to “systemically risky” financial firms, investors in those firms will feel too safe. Bondholders will feel free to lend money to the top five banks, under the presumption that the government will end up protecting them no matter what.

The Dodd bill won’t close off this expectation, even though it harms the small banks that Brown is worried about. Bondholders would rather lend to big banks, so smaller banks would have to pay more to borrow. The special focus on big banks also harms small businesses, which rely on credit from small banks, which then becomes more expensive.

Favoring big or complex banks hurts Boston industry, too. Innovative start-ups in other industries must compete for top talent against New York banks. These banks, thanks to implied government support, can pay higher salaries and bonuses.

Brown should try to convince fellow Republicans that these problems are fixable — but also that doing nothing is not the fix. Wall Street’s entitlement to bailouts has ruled the financial system for 26 years, ever since the Reagan administration bailed out a big bank’s bondholders in 1984.

There’s an alternative: fair markets. Republicans should call for stricter and more consistent borrowing limits across all financial firms and financial securities, regardless of size or presumed risk. If banks have to make the equivalent of 10 percent down payments in cash on their investments, they would choose more carefully and would be less vulnerable to making the same mistake all at once.

Brown should get behind another important fix — derivatives reform — that is also rooted in free-market principles. Just as Washington does with old-fashioned securities like stocks, it should require banks to trade complex instruments, like credit-default swaps, on public exchanges. On these exchanges, regulators can limit borrowing, and anyone can see how many such instruments trade, and at which price.

When Washington regulates derivatives to promote transparency, the market can discipline itself, and global confidence in the US financial sector improves. As is now obvious to the overseas investors who lost money on a now-infamous Goldman Sachs derivative called Abacus, banks aren’t creating a free market when they customize financial instruments in secret so that no one can compare any one instrument against another. The perception of opacity and insider-dealing hurts America’s financial industry — including Boston’s mutual fund sector, which depends on confidence in its ability to treat investors fairly.

Sadly, only one Republican — Senator Charles Grassley of Iowa — voted for public derivatives trading in committee on Wednesday.

People want leadership from someone who hasn’t spent decades maintaining Wall Street’s status quo. Leading senators on both side of the aisle, including Dodd, don’t qualify. But Brown could be the voice that voters need. To protect the economy from Wall Street, Congress needs to make Wall Street live by the same consistent sink-or-swim principles by which other businesses live.