One Regulator to Rule Them All
In the midst of a market meltdown fueled by a nervous housing sector, Treasury Secretary Henry Paulson unveiled a 200-plus page blueprint for overhauling the regulatory structure of the nation’s financial institutions. In many ways, this is a welcome and important first step toward modernizing the current patchwork of rules applied to various financial products. At the same time, caution is required to avoid creating a regulatory monolith with sweeping new powers that can do more harm than good.
That the nation’s financial regulations desperately need refurbishing there is little doubt, and the Treasury’s report echoes the findings of earlier studies. Many of the current rules date back to the Depression and even before, with few substantive changes in the ensuing years. The regulatory underbrush has grown thick and regulatory agencies have become entrenched in their own particular piece of the puzzle. Like many federal agencies, financial regulators have developed a “stovepipe” mentality, with each regulator looking down its own set of pipes while ignoring fundamental changes beyond their purview. Mission creep and self-preservation have created unwieldy and sometimes conflicting rules that make compliance costly. In fact, a study released by the Committee on Capital Markets Regulation in 2006 suggests that the regulatory burden has contributed to the rise of other financial centers around the world where companies find regulatory compliance is not as onerous.
The market, on the other hand, has been anything but static. Innovation and technology have blurred the lines between financial products, a trend acknowledged and facilitated by the passage of the Gramm-Leach-Bliley Act in 1999. The new law promoted competition between banks, insurers, and other financial institutions, providing consumer a wider range of choices and a more liquid market.
In response to these realities, the Treasury report includes sweeping changes in the hopes of streamlining the system. Regulatory roadblocks are targeted, as with the recommendation to implement an optional federal charter for insurers who have been stymied by the failure of reforms at the state level. Elsewhere, the report calls for merging the SEC and the CFTC, noting that the agencies are a distinction without a difference in today’s market. More broadly, the report suggests an “objectives based” approach to regulation, and those objectives are listed as market stability, prudential financial regulation, and business conduct regulation. For each, there would be a designated regulatory authority. The report divides the market into three major segments—those operating under federal deposit insurance, those operating with some type of federal guarantee, and those chartered federally to provide financial services products.
A healthy revision of current regulatory burdens is a good idea. What is not is the suggestion that the Federal Reserve become the market stability czar. The Treasury report recommends a broad expansion of regulatory powers for the Fed to oversee all three market segments. By nature, markets are dynamic, making stability a difficult policy goal subject to political pressure and manipulation. Already without any reforms, the Fed has moved into dangerously uncharted waters, with more than $400 billion of its balance sheet now exposed to credit risk through its new lending facility. Further expanding the Fed’s mandate for an idea as nebulous as “market stability” exposes taxpayers to new risks while leaving the Fed to juggle the trade-off between sound money and market stability in a political environment.
Prices are dynamic signals, and efforts to subjectively stabilize them will cause distortions and inefficiencies that reduce economic growth and further politicize the finance industry. Indeed, at the root of the current crisis is a dramatic underpricing of risk in mortgage-backed securities. The ratings agencies—themselves protected creatures of the federal regulatory code—assigned and in some key cases continue to hold AAA ratings on mortgage-backed securities that are clearly impaired. More transparent and competitive pricing, not stability, should be the goal of reform.
No matter how Treasury and Congress move forward, no regulatory changes should occur without a careful cost-benefit analysis. Buried on page 146 of the report is a call for the new regulatory bodies to follow the principles of prudent regulation. This would entail public comments as well as a requirement for cost-benefit analysis. However, many of the regulatory institutions discussed in the report are independent agencies beyond the reach of federal guidelines for cost-benefit analysis, and the Federal Reserve is established as an independent body beyond even congressional reach. Concentrating rulemaking authority in such agencies may actually diminish transparency while increasing the regulatory burden. Any reforms must include a specific requirement for regulatory review.
The financial services sector is clearly vital to the U.S. economy, responsible for 8.1 percent of the nation’s GDP. Yet it operates under an aging regulatory framework that sorely needs updating. The Treasury report offers a reasonable starting point for this discussion. However, the zeal for regulatory engineering must be tempered with by an understanding of markets. By definition markets are risky. Markets can be volatile, they can be self-correcting, they can be used to manage risk, but they cannot be controlled by even the best regulatory plans. Rather, the goal should be to establish a sound institutional framework that treats all market participants equally while removing any unnecessary impediments to competition.
