Paulson’s Mixed Bag

By DIANA FURCHTGOTT-ROTH

It’s been a tough year for New York bankers and financiers. Just when it looked like things couldn’t get much worse, Treasury Secretary Henry Paulson, himself a former captain of finance, made a dramatic entrance on Monday to say, “I’m from Washington, and I’m here to help.

Mr. Paulson proposed a smorgasbord of changes to America’s financial regulatory system, arguing that “our current regulatory structure was not built to address the modern financial system.” As a former chairman of the board and the chief executive officer of Goldman Sachs, he is no enemy of Wall Street, whence he came to Washington.

His proposal raises two questions: Is it possible to design a regulatory system that is capable of meeting the challenge he outlines? Second, can Congress, especially a Senate that needs 60 votes to pass anything controversial, ever adopt it?

Mr. Paulson proposed these major changes:

• Have Congress assert federal regulatory authority over insurance companies, until now regulated only by the states, so that insurance companies, like banks, would be free to choose either state or federal charters.

• Assign to the Federal Reserve Board new authority to act as a market stability regulator that sets standards for investment banking and hedge funds.

• Consolidate federal regulation of banks with the Comptroller of the Currency, abolishing the Office of Thrift Supervision and thrifts — formerly savings and loan associations.

• Merge the Securities and Exchange Commission and the Commodity Futures Trading Commission into one entity that regulates trading of securities and options.

• Create a mortgage origination commission to prevent the reckless lending and inadequate disclosure that contributed to the subprime mortgage crisis. Such an agency could benefit ordinary people whose only investment is their home.

Could Mr. Paulson’s paradigm work to make our financial system operate better? Yes, but regulation cannot take all the risk out of investing, and so markets would continue to have ups and downs. Risk may bring reward, but also loss. If you don’t want risk, you can buy certificates of deposit at a bank.

Moreover, Wall Street, rewarded by some of the largest salaries and bonuses in America, attracts some of its best minds in America. Past attempts at regulating financial instruments have failed because as certain instruments are regulated, others that have not occurred to the regulators, or that are unconstrained by their authority, bubble up in their place.

A political economy professor at Carnegie Mellon, Allan Meltzer, has proposed a simpler solution to stabilize financial markets: tax Wall Street bonuses at a high rate to encourage firms to pay higher salaries, rather than bonuses based on number of dubious trades, sales, or deals. “We need to stop paying people on Wall Street to do bad things,” he said in a phone conversation. “They do it because they have to do it.”

Where Mr. Paulson’s proposals are particularly helpful is in changing incentives for insurance markets. Mr. Paulson wants to create a federal insurance regulator, giving insurers a choice of federal or state government regulation.

Now each state regulates its own insurance markets. A Utah company that wants to sell policies in New York must register in New York and comply with its requirements.

Some companies outside New York don’t do that, and New Yorkers can’t buy their products. If such a company switched to a federal charter, New Yorkers would have more choices.

This creation of a federal charter for insurers, backed by federal legislation, would almost certainly be opposed by some state insurance commissioners. They may argue that it would violate the principles of federalism. Given the dual federal-state chartering of banks, this is not a persuasive complaint.

In contrast, other proposals could have negative effects. Mr. Paulson said that “the Federal Reserve is the natural choice for the important task of market stability regulator,” yet this conflicts with its mandate of keeping a sound currency with low levels of inflation. The Fed cannot both regulate market stability and control inflation because the former might require more monetary liquidity at the same time that the latter requires less.

Further, as Mr. Paulson proposed, the market stability regulator would have the power to “review certain private pools of capital, such as hedge funds and private equity, which have the potential to contribute to a systemic event.” These pools of capital are mobile and can go offshore if regulated.

In addition, even though the merging of banks and thrifts under one regulator might be helpful, thrifts have expanded access to mortgages, allowing worthy new homeowners credit. Merging thrift and banking regulations could make it harder for some to obtain mortgages.

The dynamics of power in Congress mean that, as Mr. Paulson has acknowledged, no legislation to move forward these proposals is likely this year. It’s not Republicans against Democrats, it’s Democrats divided among themselves.

Senator Schumer, a member of Senate Banking Committee, praised the proposals, saying, “I think it is a very good foundation.” Yet House Financial Services Committee Chairman Barney Frank, a Massachusetts Democrat, criticized the plan because he said that it “goes too far in diminishing the role of the states.”

Whatever the merits and demerits of Mr. Paulson’s plan, one thing is certain: New York’s bankers will have to manage without Washington’s legislative “help” for a while longer.