The first thing to keep in mind when appraising the President’s new regulatory scheme for the financial sector is that it is merely the administration’s wish list, with the Congress yet to be heard from, and likely to resist adding the chore of systemic risk regulator to the Fed’s burdens. The second and more important although less noted fact is that the blurb on the jacket of an Obama oeuvre, in this case his “Guide to Light-handed Regulation”, is never an accurate description of its contents.
There is a reasonable chance that Obama will get much, although not all of what Treasury Secretary Tim Geithner and economic adviser Larry Summers have advised him to press for. For two reasons: the recent near-melt-down of the financial sector has revealed weaknesses in the regulatory structure, and the president has been careful to treat politics as the art of the possible. He knows that every regulator reports to some congressional committee or committees, and that congressional barons are more than a little reluctant to give up power, which they have to do if the agency they oversee is eliminated or pared down. So initial plans to consolidate agencies have been severely modified, with only a few to be merged — and not the most important ones.
The president has gone to great lengths to calm fears that he is unleashing draconian restrictions on the freedom of action of financial institutions — reform, yes, revolution, no. “No” to those who argue in favor of the status quo, and “no” to those who want him to go further, perhaps as far as separating commercial from investment banking and shrinking banks that are too big to fail. He cannily labels his program both as the most far-reaching since Franklin Roosevelt’s New Deal, and as an example of light-handed regulation. “You set up some rules of the road, ensure transparency and openness, guard against huge systemic risk that will lead…government potentially having to step in to avoid a depression, and then let entrepreneurs and individual businesses compete and do what they do,” he said on Wednesday.
Start with the securitization process, which many believe converted a problem in the mortgage markets into a threat to the entire financial system. Geithner is eager to get the securitization process restarted, so that credit will flow more readily to the business community and consumers. So, rather than outlawing the process, he persuaded the president to take the quite sensible step of requiring those selling these securities to have some skin in the game — retain 5 percent of the value of such securities. This means the issuer/ peddler remains at risk, and is less likely to push dicey paper out into the market. I would have preferred a higher figure, but why quibble when the administration has followed the first principle of good regulation: get the incentives of the private-sector players aligned with the broader public interest. Which they certainly were not when an individual bank could rake in profits from selling risky paper, feel confident that it would bear no cost in the event of default, but because its peers were acting in the same way, impose risks on the entire financial system.
The administration is also right to call for reform of the rating system to eliminate the conflict of interest inherent in the fact that the agencies get paid by the issuers of securities only if the deal gets done. No surprise, then, that the holy water of AAA ratings was sprinkled liberally over a great deal of paper that proved to be toxic, in some cases fatally so. Perverse incentives in action. Calls to the leading rating agency, Standard & Poor’s, were rewarded only with a press release professing the agency’s “commitment to working with policymakers and market participants around the world to help get the capital markets back on track.” Whether that includes developing a new system of payment is unclear.
Then there is the Securities and Exchange Commission (S.E.C.), an agency that did not cover itself with glory during the boom years — think Bernie Madoff. Obama proposes to transfer the S.E.C.’s power to regulate financial products flogged to small customers, including credit cards, student loans, and home mortgages, to a new Consumer Financial Protection Agency, and to a beefed-up Federal Trade Commission. Inter-agency squabbles to follow.
Most important, the previously independent Federal Reserve Board will have new powers, but will now have to cope with a political overseer. Obama wants the Fed to have broad powers to prevent systemic failure, one reason he wants the Fed to be given the power to oversee not only banks, but any financial institutions the failure of which would create systemic risk. Caught in the net would be GE Capital, the finance arm of GE, which is larger than many banks, and any hedge funds and private equity groups that might become large enough to fall into the “too big or interconnected to fail” category.
But like other agencies, the Fed would report to a new Financial Services Oversight Council (FSOC), housed at the Treasury, with “a permanent full-time staff” to provide the Fed and other regulators with the information they need to do their jobs, never mind that these agencies have their own staffs to provide such data. There is a lot more, including a proposal that regulators be allowed to seize failing institutions. And there is some possibility that Congress will confer more than a watch-advise-and-coordinate role on the FSOC.
The net effect will be an increase in capital requirements to enable financial institutions to withstand future stresses — which means lower profit margins for banks; new regulation of non-bank financial institutions; greater power for the Treasury and, therefore the politicians who have the power to appoint and approve its key personnel; and a flood of new regulations as the plethora of regulators churns out specific rules designed to give flesh to the President’s skeletal outline — a fact of which Obama is well aware, and why his attempt to present his proposals as minimally intrusive and “light handed” should be taken with the output of a large salt mine.
Obama claims that all of this will allow America “to lead the global economy” down a new path to better regulation. Other nations, however, have different sorts of reforms in mind, as the EU summit meeting of finance ministers, ending today, makes clear. The EU favors much tighter regulation of hedge funds and private equity than the Obama administration contemplates, partly because France and Germany want to reduce the competitive advantage Britain now enjoys in the provision of financial services. And British legislators are under pressure from the Bank of England to separate commercial from investment banking, a move proposed here by former Fed chairman Paul Volcker, but rejected by the president. One thing is certain: international differences in the scope and nature of regulation will remain, presenting opportunities for regulatory arbitrage by shrewd financial players. Not a bad thing: that will prevent regulators in individual countries from over-reaching, lest they lose business to other, more welcoming jurisdictions.
Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).
