Keeping U.S. Financial Markets Competitve

The plan to overhaul the regulation of U.S. financial markets that Treasury Secretary Henry Paulson will announce on Monday morning is as broad and sweeping as it is overdue.

It has been in the works for a year, and predates the present crisis in credit and mortgage markets that started last August. That, though, has given urgency and focus to the work as well as providing an unwanted dress rehearsal for the envisioned expanded role of the Federal Reserve as the primary regulator of market stability.

It will take far longer than a year for the Paulson blueprint to become reality, or at least to become a reality in full--and it does present both "short- " and "intermediate-term" recommendations, as well as an "optimal" regulatory regime.

America's financial system of financial regulation has developed piecemeal, usually in response to episodic financial instability. Some of it dates back to aftermath of the Great Crash of 1929; the Fed itself was set up in 1913; national bank charters date to 1863.

It is also divided between state and federal governments. The result has been a warren of vested interests, both in the financial services industry and Congress, that has proved resistant to change.

Regulatory gaps have opened that fleet-footed financial firms have been able to slip through. And the system as a whole has fallen behind the fast-evolving complexities of the financial market, particularly in the past thee decades when liberalization and globalization have transformed both the markets and their participants.

Some of Paulson's reforms will be pushing on an open door in Congress, where many have pointed to lax regulation, particularly of mortgage origination and sales, as being a root cause of the present crisis.

"In broad outlines, we agree with large parts of Secretary Paulson's plan," Sen. Charles Schumer, D-N.Y., chairman of the Joint Economic Committee, said in a statement. "He is on the money when he calls for a more unified regulatory structure, although we would prefer a single regulator to the three he proposes."

As well as making the Fed the centerpiece of market stabilization and giving it the information gathering powers across all financial institutions to let it set up an early warning system of pending problems, Paulson's plan would give the Fed regulatory authority over all financial institutions that operate with government guarantees such as deposit insurance for banks. A new regulatory agency would oversee consumer protection issues, while the Office of Thrift Supervision, which supervises thrift institutions, would be folded into the Office of the Comptroller of the Currency, which regulates commercial banks.

The model of separating the regulation of financial institutions form business conduct and consumer protection issues is one that has been successfully introduced in Australia and the Netherlands. The Paulson plan also borrows something from the overhaul of Britain's regulatory system a decade ago, which created the Financial Services Authority, a single national agency covering all financial services that works in parallel with the central bank and finance ministry.

Paulson's other proposals include merging the Securities and Exchange Commission with the Commodity Futures Trading Commission. As financial intermediaries and trading platforms converge and financial products blend insurance, banking, securities and futures into derivatives, this makes sense.

Closing the regulatory gaps will help in another regard. Interagency disputes in the U.S. delayed the development of the international Basel II capital adequacy rules for banks, which arguably would have mitigated the present credit crisis if adopted by not allowing banks to take so many of their mortgage-related securities off balance sheet or to have leveraged up the way they did.

The Paulson plan's provision of tightened regulation of mortgage origination is likely to have the most legislative wind in its sails. A proposed new commission would lay down licensing standards for state mortgage companies and oversee the way states regulate mortgage origination and sales. Separate proposals to deal with home foreclosures and the current housing market turndown are expected from the Bush administration.

Far more controversially, Paulson is also proposing that one of the largest sets of investing institutions, insurance companies, be brought under federal regulation by being allowed to opt for federal rather than state chartering, and be overseen by a new federal regulator.

Big insurance companies have lobbied for the idea for years without ever making much of a dent in the opposition to the idea in Congress. But the growing institutionalization of capital markets means it makes little sense for some of the biggest institutions to remain regulated parochially, especially as it is they that are providing so much liquidity, pricing efficiency, risk dispersion and product innovation (and complexity) globally.

Bringing non-bank financial institutions such as hedge funds under closer scrutiny will be an easier sell in Congress. The danger is that legislators will overreact in the populist cause, and that improving regulatory coordination and oversight to ensure market stability will cross the line into legislating risk-taking, just as the corporate governance failures of the late 1990s led to Sarbanes-Oxley being too heavy handed.

As the Paulson plan says in the introduction to its executive summary, "financial institutions serve a vitally important function in the U.S. economy by allowing capital to seek out its most productive uses in an efficient matter." In that, risk-taking should be rewarded and punished by the markets, and everyone involved know as fully as possible what risks are being taken, and thus how to price them.

Few would disagree with the Treasury's assertion that "the U.S. regulatory structure is not optimal for promoting a competitive financial services sector leading the world and supporting continued economic innovation at home and abroad." Much of what Paulson proposes addresses that as much as the immediate crisis.

That is how it needs to be. Foreign financial markets have grown in size and sophistication and with it their ability to provide alternative sources of capital and financial innovation within a more efficient and modern regulatory system. America's financial markets are no more immune from those winds of globalization than its manufacturers or buggy whip makers.