Our Dysfunctional Financial Regulatory Structure

One of the disheartening aspects of the financial regulatory reform effort is that there is currently little discussion of how to fix a regulatory system that is structured haphazardly and is often dysfunctional.  The current structure, as most everyone who looks at it concedes, is not something one would construct from scratch; it is the result of historical reaction to crises and other pressures.

One example is the current division of responsibilities between the SEC and the CFTC.  Why is it logical that the SEC regulate options on securities and security indices, the CFTC regulate futures on broad-based security indices and options on these futures contracts, and that they share jurisdiction on futures on narrow-based (non-exempt) security indices and futures on single (non-exempt) securities?  The CFTC also has sole authority over futures on government securities, even if it is a single issue of T-bills.

The SEC and the CFTC have had many disputes, though many of the most contentious issues between them have been resolved.  With the enactment of any legislation that is vague on the dividing line between the two agencies on OTC derivatives and between them and the bank regulators, new disputes among regulatory agencies are likely.

All the financial regulators had problems with the CFTC during the 1980s and 1990s, because of the vagueness of the Commodity Exchange Act and its exclusive jurisdiction provision.  The much maligned Commodity Futures Modernization Act (“CFMA”) resolved many of these problems, but derivatives legislation could cause new problems if not well written.  For an example of a badly written legislative draft, one need look no further than Treasury’s original proposal.

(The common wisdom at the moment is that the CFMA was a major cause of the financial crisis.  This can be debated, but what is clear is that the regulators did not use the authority they had to rein in excesses.  The housing bubble was not caused by the CFMA; synthetic collateralized debt obligations are securities subject to SEC jurisdiction; and significant leverage of banks and bank holding companies and their exposures through credit default swaps to AIG could have been considered unsafe and unsound banking practices.)

The Gramm-Leach-Bliley Act caused a major dispute between the SEC and the bank regulators.   The dispute was over the permissible security activities of bank trust departments without triggering the registration requirements of the Securities Exchange Act.  This dispute, which I was not involved in but knew some of the participants on both sides, became vicious and, unfortunately, at times personal.  This is not conducive to good working relationships among agencies.

The OCC has a conflict of interest in regulating banks, since its budget, unlike that of the SEC, is determined by the amount of fees it collects.  If a bank opts out of a national charter and chooses a state charter, the OCC has less money to spend.   One might suspect that this serves as an incentive for the OCC to make the national charter as attractive as possible.

The bank regulators (OCC, FDIC, Fed, OTS) have squabbled over capital rules.  The agencies have different interests.  For example, the FDIC is concerned, as it should be, with preventing situations from arising that would generate large payments from its insurance funds; the OCC, as mentioned, wants to be helpful within reason to the banks; and the Fed arguably has general monetary policy and financial system concerns.

Some disagreement among agencies can be healthy; better policies can result out of debate and compromise.  Also, during times of crisis, the agencies normally do cooperate and work well with each other.  It is the period before the crisis happens that I am concerned about.  At times,  the discord between the agencies has been unhealthy, and competition among agencies may have led to regulation that was too permissive.

It is not easy to determine the optimum regulatory structure.  The U.K. some years ago decided to consolidate financial regulatory authority in a single regulator, the Financial Services Authority (“FSA”).  That did not work out that well either, and the Conservatives plan to give some regulatory authority back to the Bank of England should they win the election.

However, the split between the SEC and the CFTC is hard to justify as the economic purposes of some of the instruments they regulate have become very similar.  It is also hard to justify the number of bank regulators.  One could look also at a number of smaller regulators, such the National Credit Union Administration, the Federal Housing Finance Agency, and the Farm Credit Administration.  The regulatory role of the Fed is one aspect of reform that has been thought about, but I am not sure that it has been explored analytically as much as it should.

Regulatory dysfunction has been a problem, and the current legislative proposals, while rearranging and adding responsibilities, merging the OTS into the OCC, and creating a new consumer protection agency, are not seriously addressing it.