Paulson Wants to Tighten Reins on Investment Banks

In contrast, mortgage lenders and brokers, whose practices contributed to the credit problems, get far less rigorous oversight. "The mortgage lenders and the mortgage brokers are regulated at the state level, if at all," said Alice M. Rivlin, a former Fed governor now at the Brookings Institution. "That's a definite hole."

A report this month by the President's Working Group on Financial Markets, a high-level advisory panel consisting of the federal government's top financial-market overseers, said lax oversight of mortgage brokers was in part to blame for allowing homeowners to get loans they could not afford.

Earlier this decade, the late Fed governor Edward M. Gramlich tried repeatedly to convince his colleagues to rein in these brokers and impose tighter restrictions on subprime lending. But Alan Greenspan, Fed chairman at the time, rebuffed Gramlich, and lobbyists for mortgage brokers also fought the move. In the wake of the current crisis, however, the Fed will soon unveil new rules to force brokers to follow tighter guidelines, according to financial lobbyists.

Hedge funds have also concerned some federal officials in recent years. The funds were able to avoid oversight because they were generally open to only wealthy investors, who were deemed sophisticated enough to watch out for themselves. But Goldschmid, a Democrat, and former SEC chairman William H. Donaldson, a Republican, concluded that the proliferation of these funds threatened the wider financial system, and they approved a measure to monitor them more closely.

A federal circuit court rejected the plan in 2006, and the current SEC chairman, Christopher Cox, declined to appeal. At the time, Cox said his legal advisers had concluded an appeal would be futile.

The government's regulatory regimen can often be hard to follow. The SEC is charged with protecting investors in securities and enforcing laws designed to stop fraud and market manipulation by people who buy and sell those securities. But it has limited ability to address the activities of investment banking firms that operate brokerage houses.

Since 2004, the SEC has been allowed to monitor the five largest securities firms' funding, risk management and soundness. But unlike the Fed, it cannot inject cash into a struggling institution to help when it faces a liquidity squeeze, as Bear Stearns did two weeks ago.

The Bush administration and some senior lawmakers have also tried to strengthen the regulation of mortgage finance giants Fannie Mae and Freddie Mac. The proposal to hand oversight of the companies to a new and more powerful agency gained prominence when Freddie Mac reported serious and previously undiscovered accounting problems in 2003.

The companies initially lobbied vigorously to block the change but have now said they would welcome a new regulatory system. They are still haggling over details, which has hung up the plan in the Senate.

Not everyone agrees, however, that more-strict regulation is the best way to solve financial problems. "People like me who want to reduce regulation do not want to make more and more companies wards of the government," said Peter J. Wallison a former Treasury official under President Ronald Reagan now at the American Enterprise Institute.

Even those who prefer more regulation have difficulty deciding which new powers to sanction. "The real problem if you have an overall regulator is, 'What do you really expect that regulator to do?' " Rivlin said. "It is extremely difficult to manage risk at the level of a Citibank or a Merrill Lynch; they are involved in so many things, and the markets move so rapidly. The best a regulator can do is assure itself that the institutions have good risk management procedures."

Regulators will inevitably have a hard time keeping up with financial advances. "The markets are always a generation ahead of the regulators," said Adam Lerrick, an economics professor at Carnegie Mellon University. "The best you can hope is for regulators to catch up to the current crisis, but they might not be able to do that."

Staff researcher Richard Drezen contributed to this report.