Financial Regulatory Reform – Addressing Real Problems

A point I have been trying to make is that the financial crisis was partly due to a failure of the federal financial regulators to use their existing authority, not that they did not have sufficient authority.  Unfortunately, the current legislative proposals do not address the causes of this regulatory failure and may, in fact, compound it.

The legislative proposals contain some worthwhile provisions.  Even resolution authority, though it may not prevent all future “bailouts,” nothing can be done to prevent that, is a useful tool for the regulators to have, given that the Bankruptcy Code has some problems in dealing with financial institution insolvency. A consumer protection agency is also needed, given how many people were offered mortgages inappropriate to their financial situation.

However, while it may be good public policy to force interest rate swaps to trade on exchanges and into clearinghouses (this can be debated), this has nothing to do with addressing the issues raised by the financial crisis.  A provision that states that there will be no federal bailout ever of a derivatives clearinghouse is not useful.  It is political window dressing.  No futures clearinghouse in the U.S. has failed, but if a large one, say the CME, was about to, the consequences of not doing anything would be devastating.  (A CME failure may be unlikely, but it is not impossible.)   The federal government would do something, and, if need be, laws would be changed.

Concerning the regulators, the usual argument for not making any changes is that, while no one would design our current system from scratch, the numerous regulators have learned to work with each other and to make it work.  But the current system did not work during the period leading up to the crisis.

In times of crisis, the regulators work well together because they face a common problem and all feel a responsibility to do all they can to resolve the crisis.  It is in other periods that regulatory cooperation is less than it should be.  The agencies often bicker bitterly over policy and turf issues.  In the meantime, significant developments are missed, such as the growing CDO market resulting in banks laying off risk and concentrating at AIG.  Moreover, the current proposals may serve to increase discord, especially as new products are developed and it is far from clear which regulatory agency has the lead role.

In addition, there are the issues of regulatory capture and other agency goals, such as monetary policy.  The Fed could have used it authority to rein in the extremely loose underwriting standards for home mortgages and the complexity of the mortgages being offered to borrowers whose only hope of not defaulting was a continuing increase in real estate prices.  The bank regulators and the SEC could have reined in the use of off-balance sheet SIVs and the issuance of synthetic CDOs, and they could have aggressively questioned the appropriateness of the ratings of some of the new instruments and their use in various capital rules.

More serious consideration should be given to regulatory restructuring.  Also, in some cases, regulatory discretion may need to minimized.  Proposals such as the “Volcker” rule and capping the size of banks do that.

Unfortunately, there seems to be a dearth of serious analysis of the causes of the financial crisis and how best to restructure both the regulators and the financial system.  And while the crisis started in the housing market, the current focus is on the OTC derivatives market, which played a role but is far from the whole story.  The political necessity is to show that the government is getting tough on Wall Street and to enact something before the next election.  However, once we have entered into a period with no apparent, major problems (the European situation could cause some serious problems in the near future), the Wall Street interests will attempt to start whittling away at the most inconvenient aspects of the new law or laws. In some cases, they may be right and in others it will be pure self-interest.   I have no doubt, though, that whatever the rules are, major Wall Street players will find ways to adapt and be highly profitable.