Further Thougts on Financial Regulation

The ability of the federal and state governments to navigate the current economic and financial troubles is in some doubt. The U.S. Congress divided on partisan lines on the stimulus bill, and the political mess in Sacramento, which one can only hope does not lead to an avoidable economic disaster, does not make one sanguine about what may come next.

With emotions heightened by economic fears and distress, the issue of restructuring the financial regulatory system in the U.S. will be taken up, probably sometime this year. There will be demands to do something, but it will be difficult to agree on what that should be. The hope is that the necessity to compromise on legislation and incorporate ideas from people with different philosophies results in laws that are both widely accepted and effective. Sometimes, though, this results in poorly drafted and self-contradictory legislation, and the courts are left to sort out the resulting mess.

For example, the Commodity Exchange Act is a badly drafted statute, and has generated much litigation over its meaning, with the SEC and the CFTC often offering courts opposing briefs. The litigation reached the point of near absurdity, at least from this non-lawyer’s point of view, when a Supreme Court case hinged on the definition of the word “in.” The 1997 case, Dunn v. CFTC, concerned what would seem like a simple question – whether or not the CFTC had jurisdiction over OTC foreign currency options. But this question, and others revolving around the limits of CFTC jurisdiction over derivatives, consumed an inordinate amount of time and energy in disputes among government agencies and different industry groups for approximately 25 years. This is something to be avoided.

But will it be? The concern rises from both the charged political atmosphere and the Paulson Blueprint, which many think, or are hoping, will provide the framework for considering regulatory restructuring issues.

The difficulty of dealing with these issues in an atmosphere of economic fear and political calculations needs no explanation. It should be noted, though, that financial regulatory issues are often difficult to deal with, even in somewhat calmer times. The Gramm-Leach-Bliley Act, enacted in November 1999, for example, led to a long, bitter fight between the SEC and the bank regulators over what securities activities bank trust departments could engage in without triggering SEC broker-dealer registration and other requirements.

The Paulson Blueprint posits as the “long-term optimal regulatory structure” a regime governed by three “distinct” regulators. Each of these regulators would be focused on one of “three key” areas – market stability, prudential financial regulation for entities benefitting from government guarantees, and business conduct regulation. The market stability regulator would be the Federal Reserve; the two others would be newly created agencies. In addition, two other government agencies would be created – the “Federal Insurance Guarantee Corporation,” with very limited regulatory authority, and a “Corporate Finance Regulator.”

Part of the problem with this structure is the potential overlap in the three areas. For example, the catalyst for the current financial crisis was the problems with subprime mortgages. Extending mortgages to individuals for more than they could afford on the belief that a rising housing market would make everything all right, and in any case the mortgages would end up in someone else’s portfolio, would seem to be a business conduct issue. But it turned out to be also something that would involve prudential financial regulation and market stability. Who would be responsible for something like this under the new structure. What if the three regulators disagreed?

Another issue that raises some concern is the role of the Federal Reserve in this structure. It is clear why the Paulson Blueprint assigned the Fed this authority, since there is no clear alternative. The Treasury Department is not set up to do this, and it does not have the continuity in the most senior positions to perform this function with any degree of consistency over time.

The Fed, though, would be losing its current authority over Fed member state-chartered banks. It would be monitoring and gathering information on potential risks to the system, without being involved in the normal examination process. One could well imagine that the Fed would be looking for things to do, and that this would bring it in conflict with the other two regulators.

Moreover, many observers think the Federal Reserve has made some mistakes in recent years that have contributed to the current crisis. Arguably, interest rates were kept too low for too long, especially in the face of a housing bubble that the Fed was late to recognize, and it did not use its authority to curb abuses in subprime mortgage lending practices. While this will be debated, if the Fed’s monetary policy is mistaken at some future point and is leading to market instability, how can it adequately perform the role of market stability regulator? There is no good answer to this question, and, if one thinks that there should be a dedicated market stability regulator, the Fed is the logical choice, but there may need to be a change in the Fed’s structure to do this well. Or, one may want to rethink this issue.

The Paulson Blueprint appears to take a middle position between the very fractionated regulatory system in the U.S. and the single financial regulator in the U.K. Otherwise, the Blueprint likes the idea of “principles,” rather than rules-based regulation, said to be operative in the U.K. It is not totally clear what this distinction means, since the U.K.’s Financial Services Authority has issued plenty of rules, and, one hopes, financial rules are based on principles. At the time, “principles-based” regulation seemed to be easily deciphered code for lighter regulation, but that is clearly not going to happen any time soon.

In any case, both the U.S. and the U.K. regulatory structures did not perform well as the seeds of the current crisis were germinating. The current buzz phrase is “smart regulation,” as contrasted with tougher or weaker regulation. This sounds good, but what does it mean? No one is for stupid regulation.

The Administration and Congress should proceed carefully and thoughtfully as it considers regulatory structure and not pass something just so that they can say they did something. The U.S. regulatory structure was not planned and is the result of particular historical circumstances. It can be improved. But there are limits on what can be accomplished now to deal with future problems. We do not know what those will be, and ultimately we will depend on the people in power at the time to develop appropriate policy.