Even Merton Miller, a Nobel prize-winning economist with a passion for financial arcana, found it “deadly dull.” But if ever there was a week when financial regulation set pulses racing, this was surely it-at least for those too young to remember the great reforms of the Depression.
Having spent much of the past year trying to prevent all-out financial collapse, America’s leaders are now turning their attention to reinforcing the structures that would prevent a repeat. The proposals that Barack Obama unveiled on June 17th would refashion the federal rules governing almost every corner of finance, pushing government much more deeply into private markets and partially rolling back 30 years of liberalization. It is, the president declared, nothing short of a “new foundation,” designed to curb “risks built on piles of sand.”
Eye-catching though the 88-page “white paper” is, it is not as bold as it might have been. In any case, it merely sounds the opening salvo in a battle that could stretch into next year, since much of the plan requires approval in Congress, where jurisdictional and ideological clashes beckon.
The emphasis is on closing gaps where risk had been allowed to build up. Supervision of all firms big enough to threaten overall stability will be consolidated under the Federal Reserve. These entities will be made to hold more capital and liquidity than smaller firms, though all will face higher requirements (which will be determined after a report at the end of this year). The Fed will be advised by a council of regulators that will also scan the horizon for emerging risks. Another priority is the construction of a mechanism to wind down any failed financial giant, not just banks, so that officials no longer face an unenviable choice between bail-outs (AIG) and system-shaking collapse (Lehman Brothers).
The net is also being cast over markets in which freewheeling growth contributed to the crisis. Those who package loans together for securitization will have to beef up disclosure and retain 5% of any deal they structure to encourage sounder underwriting-though the ban on hedging that exposure could be tricky to enforce. Sensibly, the plan calls for payment of arrangers’ fees to be spread over time and reduced if the loans blow up. It also builds on earlier proposals to rein in over-the-counter derivatives, such as credit-default swaps. Those not cleared centrally or traded on exchanges face higher charges.
Perhaps the most eye-catching-and certainly the most populist-measure is the creation of a Consumer Financial Protection Agency (CFPA). Taking some powers from the Fed and other bank regulators, this would have broad rule-writing and enforcement powers over mortgages, credit cards and the like. In light of the “liar loans” and option ARMs (a radioactive type of mortgage) that proliferated in recent years, it is hard to argue against an overhaul of such regulation. Still, concern is already mounting that the new agency will take an overly restrictive view of permissible products, limiting access to credit and curbing good as well as bad innovation. Others worry that it will have less leverage than traditional supervisors over banks peddling dodgy products.
A bigger concern is Mr. Obama’s failure to rationalize America’s tangle of regulators. The Office of Thrift Supervision (OTS) will be subsumed into another agency, but that still leaves four federal bank regulators (plus state agencies), and these will have to work alongside the CFPA. “The alphabet soup has lost three letters and gained four,” moans one consultant.
Dropping the idea of a single bank regulator and a merger of the agencies that oversee securities and derivatives, both of which were early Obama goals, was, say officials, a cold-blooded calculation based on the strength of political opposition: from congressional leaders, such as Barney Frank, who have cooled to the idea of a unified regulator in the wake of Britain’s unhappy experience; and from the committees that police, and take contributions from, banks and exchanges.
Leaving the framework largely intact is risky. The current set-up is not all bad: one regulator may spot a problem that another misses. But even with the OTS gone, banks will be able to shop for friendly charters. Disagreements between agencies over the dangers lurking in commercial property led to a delay in urging banks to tighten standards. And inter-agency feuding has been growing: witness the spats between the Federal Deposit Insurance Corporation and other regulators over deposit insurance and their treatment of Citigroup.
Other punches have been pulled, too. For big insurers, frustrated at having to be regulated state by state, the wait for an optional federal charter goes on. Nor were concrete proposals offered on money-market funds, runs on which intensified the trauma following Lehman’s demise. Officials argue, with some justification, that these omissions are sound tactics: Congress can swallow only so much esoteric reform in one go.
Even without these measures, the white paper may get pulled apart. There is unease on Capitol Hill over an expanded role for the Fed and continued Balkanization. Bank lobby groups will try to water down the consumer agency’s powers and to persuade lawmakers that higher capital requirements will curb lending to hard-working Americans (and put the industry at a disadvantage to international rivals). The reforms must jostle with other initiatives, such as health care, for legislative time. Some doubt their chances of passing in any form until next year. The new foundation’s plans may have been drawn up; its final shape and timing are uncertain.