Regulations Need Regulators

By Steven Pearlstein
Wednesday, April 2, 2008

It was Hank Paulson's bad luck that he launched the Treasury's work on a new "blueprint" for financial market regulation just as the worst credit bubble in history was about to reveal how badly the regulators had blown it.

Paulson and his confederates, Robert Steel and David Nason, originally set out to update and streamline a regulatory apparatus that had failed to keep up with changes in global financial markets and bring a lighter touch to regulation they blamed for New York's loss of market share to financial centers in London and Hong Kong.

But having spent the past several months scrambling to prevent a financial meltdown that has its roots in regulatory nonfeasance, the Treasury team has had to acknowledge that better regulation might not always mean less regulation. And while their blueprint is flawed in several respects, they have laid out a credible framework for an important debate that will extend well into the terms of the next president and Congress.

Don't pay too much heed to the grousing from state or federal regulators who would lose stature or authority under the Treasury proposal, or the industries they oversee. Although they will always couch their arguments in terms of protecting consumers and investors, their motivation has almost everything to do with self-justification and self-preservation.

All you really need to understand is that in an era when financial service companies operate globally and offer a wide range of products to a wide range of customers, it is ridiculous to have four different federal bank regulators working along with more than 50 independent state banking and insurance regulators. Nor is it any less ridiculous to have the Securities and Exchange Commission overseeing stock and bond markets and the Commodity Futures Trading Commission overseeing markets in stock and bond futures -- but nobody overseeing the $45 trillion market for derivatives contracts tied to those stocks and bonds.

With so many regulators already on the case, you would have thought one or two might have raised a ruckus about the shoddy industry practices that brought us to the verge of financial meltdown. Which brings us to the biggest problem with the Paulson regulatory blueprint: No matter how many regulators you have, or how you rearrange the regulatory organizational chart, none of it will work if regulators don't understand that their job, at crucial moments, is to substitute their own judgment for that of market participants.

For most of the past 20 years, such a sentiment was viewed as apostasy by the true believers in free markets who dominated the debate over financial regulation. Their belief, most frequently articulated by former Federal Reserve chairman Alan Greenspan, was that it was beyond the ability of a mere mortal to distinguish between a bubble and a genuine bull market, or determine when prudent lending had given way to excessive leverage. Whatever regulatory discretion was allowed was ceded to the banks' own computerized risk-management systems that were supposed to avoid calamity but somehow failed to consider what would happen if everyone ran for the exits at the same time.

Missing in the Paulson blueprint is any acknowledgement of the limits of these internal risk-management systems and the importance of experienced regulators who are given the proper incentives and insulated from political influence.

In the same way, the Treasury blueprint puts too much stock in industry self-regulation, which is fine for ferreting out isolated misdeeds but has a near-perfect record in failing to halt widespread abusive practices or the slow deterioration of standards. Paulson & Co. also put excessive faith in the power of "transparency" -- the favorite new buzzword of the anti-regulators -- and the ability of markets to discipline those who take excessive risk with other people's money.

Based on these and other misconceptions, the Treasury proposal limits the jurisdiction of its new "prudential" regulator to federally insured banks, rather than extending its reach to investment banks, pension funds, insurance companies, mutual funds and private-equity funds. The logic for a broader mandate is simple. Many of these different lines of business coexist within the same company, and we've had plenty of experience with companies trying to evade regulations by cleverly moving money and risk to other divisions. Moreover, while you'd expect the prudential regulator to keep close tabs on those parts of the company that have government guarantees, we also know that in a crunch the viability of the entire enterprise can be threatened by the failure of any of its less-regulated parts.

The Treasury blueprint also fails to explain why the government should leave derivatives markets unregulated. To a large degree, credit default swaps and other derivative instruments have become standardized products traded widely on secondary markets, with prices that can be checked by the call to any trading desk or a click of the mouse on a Bloomberg machine. As markets, they are now just as large and just as important to the functioning of the global financial system as the old-fashioned stocks and bonds markets. Leaving them outside the framework of a modernized regulatory system seems patently absurd.

Such suggestions, of course, are sure to bring angry protests from industry groups warning that any increased regulation of their activity will "stifle innovation" and "reduce the efficiency" of capital markets. We can dismiss their protests with two observations.

One, while innovation and efficiency are worthy goals, the past several months show that we also value the stability and predictability that only good regulation can provide.

Two, while some might consider no-doc loans, overrated CDOs and hedge funds with leverage ratios of 33 to 1 as examples of innovation, most of the rest of us would consider them unproductive speculation or outright fraud.

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