Wednesday, February 4, 2009

Organizational Boxes and the Limits of Financial Regulation

Now that it has happened, the current financial and economic crisis can be said to be overdetermined. Choose whom or what you want to blame – the Fed for keeping interest rates too low for too long and not using its existing authority to limit subprime mortgage abuses, financial market participants for employing excessive leverage and/or lax credit standards, Fannie Mae and Freddie Mac for undertaking too much risk with too little capital and contributing to the weakening of mortgage underwriting standards, novel financial products such as certain OTC derivatives and CDOs for creating hard to understand linkages among market participants and contributing to excessive risk-taking, regulators for failing to do their jobs, etc. It now all seems so clear that this was inevitable, but, before it happened, the consensus not so long ago was that the worst that could happen was perhaps a leveling off of housing prices and some containable problems with subprime mortgage defaults and foreclosures. Those predicting disaster were dismissed, at best, as having an interesting point of view.

In reaction to the current economic travails, there are calls for restructuring our financial regulatory system to make sure this does not happen again. Our financial regulatory system has some obvious flaws, and the performance of regulators has been less than optimum. The system could benefit from change. But we should not delude ourselves that there is some ideal regulatory structure that will prevent all further crises. After all, most people, in and out of government, missed that the financial system was waiting for a match, which turned out to be the problems in subprime mortgages, to start the forest fire with which we now have to contend. Moreover, neither the single regulator model in the U.K. nor the fragmented regulatory structure in the U.S. performed admirably as this crisis was developing.

In any case, regulatory restructuring will be difficult to accomplish. For evidence, just look at the Special Report on Regulatory Reform by the Congressional Oversight Panel (created by the TARP legislation). The three members of that panel appointed by Democrats approved the report, and the two members appointed by Republicans essentially produced another report. To compound ideological differences, there will also be turf considerations among Congressional committees and government agencies and the business interests of those subject to regulation as legislative proposals are considered.

An obvious problem that should be corrected at some point is the fragmented nature of bank regulation and the budgetary incentives for the Office of the Comptroller of the Currency and the Office of Thrift Supervision to retain the institutions they charter. But making wholesale regulatory reform as was done in the 30s should not be done in haste. Some consensus needs to be formed about what it is we expect from financial regulators.

An example of regulation that was done badly was the creation of the Office of Federal Housing Enterprise Oversight (“OFHEO”) in the early 1990s as the financial safety and soundness regulator of Fannie Mae and Freddie Mac. There was justifiable concern in the George H.W. Bush Administration about the risks these institutions posed to the financial system and to the federal government, which everyone knew would be called upon to help out if the firms got into financial trouble. But OFHEO failed. Fannie Mae and Freddie Mac became riskier, not safer, during the period they were regulated by OFHEO. The mistake of establishing a small regulator charged with overseeing two enormous and politically powerful entities is not likely to be repeated. But that does not mean other mistakes will not be.

Among other issues, careful thought is needed concerning how much power should be concentrated in one or several agencies, how to resolve issues of regulatory overlap if there is more than one agency, and the proper regulatory role of the central bank. Also the management of potential conflicts among agencies need to be considered, such as one agency charged with encouraging prudential lending practices and another agency concerned that a credit crunch is stifling economic growth.

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