During President Obama's speech yesterday on the economy at Georgetown University, it was hard to miss that the biggest applause lines were those that criticized Wall Street for reckless risk-taking and squandering so much wealth and talent. To make sure it never happens again, the president challenged Congress to come up with an entirely new regulatory regime by the end of the year.
Good luck with that.
To begin with, what's the rush? Most of the damage has already been done, and at this point the industry is still in the midst of a massive restructuring. Until that process has finished and it is clear what entities, what products and what markets emerge from this restructuring, trying to figure out how to regulate them would seem a bit premature.
I also can't think of another sector that has proven itself so adept over the years at blocking even minor reforms, let alone something as ambitious as what the president has in mind. With so many conflicting interests among well-heeled firms and so many agencies fighting to protect their bureaucratic turf, the most likely outcome is political stalemate. Watching the Senate Banking Committee deal with financial regulation is a bit like watching a cow chew its cud.
That said, it is probably useful to begin thinking about what the new architecture for financial regulation should look like.
Step one is to consolidate day-to-day "safety and soundness" regulation of all financial firms -- banks, investment banks, bank holding companies, insurance companies, hedge funds, housing finance agencies-- in a single entity. In the past, each type of institution was regulated by a different agency. But over time, firms became adept at getting around regulation by finding the cracks between the agencies and playing one regulator off another.
But which of the existing bank regulators should get the assignment as prudential regulator? My vote is to build it around the Federal Deposit Insurance Corp. As an independent agency, the FDIC is a bit more insulated from the political influence wielded by banks and Wall Street firms. The FDIC's insurance culture has fostered a more cautious and conservative regulatory stance and led to a more arm's-length relationship with the banks that favors public disclosure of shortcomings rather than covering them up. As the agency responsible for taking over banks once they fail, the FDIC also has a special insight into costs of regulatory failure.
In addition to the prudential regulator, there will be a need for a separate agency to protect investors and supervise the markets in which stocks, bonds and futures are traded. There is absolutely no credible rationale for dividing the investor-protection responsibility, as we do now, between the Securities and Exchange Commission and the Commodity Futures Trading Commission. Nor, as we've learned from the AIG debacle, is there any reason to continue to exempt credit-default swaps and other derivative instruments from all regulation. Only the stubborn determination of members of the House and Senate agriculture committees to protect political contributions from the futures and derivatives industry stands in the way of consolidating all of these functions at the more aggressive SEC.
The recent troubles also suggest the need for yet a third regulator, whose sole mission is to prevent breakdowns of the entire financial system. This uber-regulator would have broad powers to gather whatever information it needs -- from other regulators or directly from any financial institution. It would need the power to order those other regulators to take steps to reduce those risks. And if all else fails, it would need the ability to provide liquidity to financial markets and take over major financial institutions that are about to fail. This sounds like a natural role for the Federal Reserve.
As part of the Fed's role as systemic regulator, Treasury Secretary Tim Geithner has proposed that the central bank also serve as the day-to-day regulator of any financial institution over a certain size. That's a terrible idea.
For starters, the Fed has proven itself a soft touch when it comes to day-to-day bank supervision. For nearly two decades under Chairman Alan Greenspan, the Fed saw its role as encouraging financial innovation through deregulation, preferring to leave it to markets to discipline the banks. That philosophy is now hard-wired into the Fed's culture.
Even worse is Geithner's notion of designating certain banks as too big to fail and then subjecting them to more stringent capital requirements and a special tax that would be used to pay for the occasional government bailout. In practice, that approach is likely to create a competitive imbalance between the biggest banks and everyone else, while inviting the giants to find clever ways to take on extra risk, knowing that the government will always be there to bail them out. Creating two classes of institutions with different rules and different regulators would also invite the kind of regulatory arbitrage and games-playing at which Wall Street excels.
Getting all this right would be useful in preventing future financial crises, but don't confuse it with a panacea. Much of the current crisis could have been prevented if the existing patchwork of agencies, using their existing powers, had simply done their jobs. Congress can create a better regulatory structure and can expand regulatory powers, but in the end, the one thing it can't legislate is the good judgment of the regulators.