Paulson Wants to Tighten Reins on Investment Banks

Treasury Secretary Henry Paulson makes remarks at the second annual Capital Markets Summit, Wednesday, March 26, 2008, in Washington. (AP Photo/Lawrence Jackson)
Treasury Secretary Henry Paulson makes remarks at the second annual Capital Markets Summit, Wednesday, March 26, 2008, in Washington. (AP Photo/Lawrence Jackson) (Lawrence Jackson - AP)
By Jeffrey H. Birnbaum
Washington Post Staff Writer
Thursday, March 27, 2008

Treasury Secretary Henry M. Paulson Jr., tempering the Bush administration's long preference for limited regulation of financial markets, called yesterday for strengthened federal oversight of investment banks in the wake of the collapse this month of Wall Street giant Bear Stearns.

Paulson urged that investment banks provide more information about their operations, especially since the Federal Reserve has begun to allow these firms, for now, to borrow public money when they run short on cash. He said the heightened oversight should also be temporary. This would subject investment banks to some of the oversight applied to commercial banks, which have long had ready access to Fed loans.

His recommendation comes after the Fed helped prevent the bankruptcy of Bear Stearns by brokering its sale to J.P. Morgan Chase and guaranteeing about $30 billion in Bear Stearns's risky securities with public funds. Two Senate committees said yesterday that they would investigate the rescue.

"This latest episode has highlighted that the world has changed, as has the role of other non-bank financial institutions and the interconnectedness among all financial institutions," Paulson said. "These changes require us all to think more broadly about the regulatory and supervisory framework."

In calling for a greater federal role, Paulson joins a growing consensus that high finance has changed so quickly in the past few years that it has outstripped the government's ability to regulate it. Although economists and officials are debating how to revamp federal oversight, they increasingly agree that steps must be taken to prevent a repeat of the credit market crisis that has beset the global economy since last summer.

"People in Washington are finally beginning to recognize that the financial institutions and products have changed dramatically and the regulatory scheme has changed very little," said Harvey J. Goldschmid, a former commissioner of the Securities and Exchange Commission. "It's time to take a serious look at who does what."

The Treasury will soon unveil a plan to streamline the regulatory system and strengthen federal oversight of investment banks and the esoteric instruments they sell. Lawmakers are considering an even tougher regimen. House Financial Services Committee Chairman Barney Frank (D-Mass.) has proposed creating a mega-regulator to oversee a wide range of financial institutions or giving that power to the Fed. Many institutions are supervised, with varying rigor, by multiple separate agencies.

The credit crisis started with overly lenient lending -- particularly subprime mortgages -- to financially shaky home buyers and then spread across the global financial system as those mortgages were packaged together and sold as securities.

The regulation of the markets for mortgages, mortgage-backed bonds and other securities "has lots of holes, about as many as Swiss cheese," said Charles W. Calomiris, a finance professor at Columbia University. American Enterprise Institute scholar Vincent Reinhart said, "Where things have gone bad is where regulation is the weakest."

The last decade has also seen enormous growth in intricate types of financial trading that occurs largely below federal radar. Trillions of dollars of securitized commodities -- mortgages and other investments that are grouped together -- are bought and sold with little federal regulation. Hedge funds, once a rare kind of investment fund for millionaires, now are relatively common vehicles for quick churning of stocks and bonds.

Paulson said yesterday that federal regulation, which largely dates from the Depression era, has had trouble keeping pace with this rapid innovation. Commercial banks are closely scrutinized while investment banks like Bear Stearns are more lightly overseen though their transactions and products are often similar. Hedge funds, private-equity firms, and various players in the mortgage industry are also barely regulated.

This patchwork is mostly an accident of history rather than the result of considered policies. Commercial banks and thrifts, formerly known as savings and loans, shoulder the highest level of scrutiny by federal and state governments. This control extends to capital requirements and management operations. In return, deposits are federally insured to a certain limit.

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