Correction to This Article
The article misspelled the name of University of Maryland law professor Michael Greenberger.

Administration's Plan to Expand Financial Oversight Could Add New Risks

By Zachary A. Goldfarb
Washington Post Staff Writer
Tuesday, April 7, 2009

The Obama administration's plan for a sweeping expansion of financial regulations could have unintended consequences that increase the very hazards that these changes are meant to prevent.

Financial experts say the perception that the government will backstop certain losses will actually encourage some firms to take on even greater risks and grow perilously large. While some financial instruments will come under tighter control, others will remain only loosely regulated, creating what some experts say are new loopholes. Still others say the regulation could drive money into questionable investments, shadowy new markets and lightly regulated corners of the globe.

And a shortage of manpower raises questions about the government's ability to keep up with the vast and complex financial markets.

In congressional testimony last month, Treasury Secretary Timothy F. Geithner laid out the principles of the administration's proposals. He called in part for designating a federal agency that would be responsible for identifying financial companies whose failure could endanger the wider economy and for giving the government greater authority to wind down troubled financial firms. He also proposed new regulations for hedge funds, venture capital funds and private-equity funds, as well as for complex financial instruments known as derivatives.

These plans seek to mitigate some of the dangers exposed by the financial crisis. But while weak regulation is partly responsible for the current turmoil, the unintended consequences of government action over past decades also played a role.

At the top of the Obama administration's agenda is the creation of a regulator that can peer into any corner of the economy to root out threats that could shatter financial markets.

But some experts warn that such a "systemic risk regulator" could unleash new hazards if it can identify certain companies as being too large to fail. This could create an incentive for firms to grow dangerously big so they can win a government guarantee against failure. If a company has the promise of government protection, its creditors might be willing to lend it money at below-market rates because of the reduced probability the company will collapse and they won't get paid back.

The danger of this incentive is twofold. For one, a firm may be willing to take on more unreasonable risks. Second, if a company gets access to unusually cheap financing, its rivals are at a competitive disadvantage.

"If these entities are now perceived to be too big to fail within the protective net, then they get an advantage vis-à-vis other institutions that are not so perceived," said Lawrence White, an economics professor at New York University. "The creditors to these guys become even less inclined to monitoring and more inclined to say, 'Hey, let the government do it.' "

In the view of many financial experts, that is exactly what happened to mortgage-finance companies Fannie Mae and Freddie Mac before the government seized them last year. Congress chartered both companies to provide financing to lenders to make home mortgages. Their debt didn't carry the official backing of the U.S. government, but many creditors assumed the government would step in if the companies faltered.

That meant the interest rates Fannie Mae and Freddie Mac had to pay to borrow were just slightly higher than what the U.S. government had to pay. With access to cheap financing, the firms borrowed hundreds of billions of dollars and bought or guaranteed trillions of dollars in mortgages. Some of these went bad in recent years. Last fall, the companies nearly collapsed as a result, prompting the government takeover.

Geithner's proposals for hedge funds and derivatives also drew concerns from some financial experts. Geithner proposed that hedge funds register with the Securities and Exchange Commission and disclose information about their operations.

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