Financial regulation

Paulson the plumber

An ambitious plan to mend America’s cracked system of financial regulation

MUCH of it will take the best part of a decade to see the light of day, if it ever does. Even the short-term recommendations face a rocky path to implementation. Yet a plan unveiled by America’s Treasury on Monday March 31st is an important first salvo in a fight over the future of financial regulation in the world’s biggest capital market.

The review began a year ago in response to fears about America’s waning financial competitiveness. Then came the mortgage-inspired credit crunch and a host of new problems. The result is a hybrid document—albeit a keenly argued one—that emphasises agency consolidation, while advocating deregulation in some areas and new rules and institutions in others.

The system could certainly be slicker. Its important features date from the 1930s and subsequent changes have lacked any over-arching vision. Supervision of banks, brokers and derivatives is divided up among half a dozen agencies (in contrast to Britain where a super-regulator, the Financial Services Authority, oversees the entire market). Dozens of state regulators sit beneath them. Turf wars are common, duplication rife. Even those who run the agencies use words such as “antiquated” and “dysfunctional”.

The answer, reckons the Treasury, is to redraw lines. It suggests creating three new regulators, one to keep an eye on overall market stability, a prudential regulator for banks, thrifts and credit unions, and a business-conduct agency to oversee disclosure, consumer protection and the like.

The last of these would weaken the Securities and Exchange Commission (SEC), America’s main markets watchdog. The SEC would be merged with the Commodity Futures Trading Commission, which regulates futures, and the combined body would adopt the latter’s principles-based approach (the lawyer-heavy SEC, by contrast, likes to write and enforce rules). It would then take on bits of other agencies to become the business-conduct super-regulator.

Responsibility for market stability would fall to the Federal Reserve, whose role would be greatly expanded. Until now, the central bank has had only a portion of the banking system under its supervisory wing. It would get the authority to inspect institutions of all stripes in order to build a picture of overall systemic risks, and the power to insist on corrective action. It would also win wide-ranging powers to look at the books of investment banks that borrow through its discount window—an arrangement it was forced to introduce last month as Bear Stearns tottered.

The Treasury believes that several other changes—some related to the crunch—can be pushed through more quickly. It wants a mortgage-origination commission created within a few months. This federal body would oversee state licensing of mortgage brokers and underwriters, awarding grades to be used when packaging loans into securitisation pools. The poor quality of such debt is at the root of the mortgage crisis. Another suggestion is to give insurers, currently regulated state by state, the option of a federal charter. State oversight is costly and has stymied the development of national products.

Some types of financial firm that have until now escaped regulation would be brought into the fold, including hedge funds and private-equity firms. But Hank Paulson, the Treasury Secretary (and, as a former boss of Goldman Sachs, sympathetic to industry concerns), stresses that while such firms would be expected to provide more information, there is no plan to wrap them in red tape. Regulation, he believes, can never be a substitute for market discipline. Still, some on Wall Street are worried. Investment banks’ capital requirements are likely to rise, making it harder to get the stellar profits they enjoyed before the latest crash.

These moves are already proving controversial—a sign of political and inter-agency battles to come. Why is the Fed being given such an important role when it failed to spot the dangers in the credit bubble that burst last summer or to act on predatory mortgage lending, ask some. The Fed itself could be forgiven for worrying about being handed the task of spotting crises in advance, a feat that this time eluded some of the most sophisticated banks. The head of the Office of Thift Supervision, which will disappear in the revamp, is stirring up opposition to the Treasury plan.

Tellingly, Barack Obama, the front-runner for the Democratic nomination, was quick to label the plan as inadequate. By the time Congress and the next president are done with it, it is likely to look a lot less punchy. Mr Paulson’s chief aim is to streamline the system. He says wants regulation to be better, not necessarily more pervasive. But many others want to roll back the deregulation of the past two decades. For better or not, they have plenty more debating to do.