About two days a week throughout the fall last year there would be a black suburban parked on the street I walk from the red line to work. On these days I’d walk a little slower to see Treasury Secretary Paulson walk from a giant office building into the waiting car. I saw him the day after Lehman failed, the only thing fresh looking about him was his suit- and the day after the inauguration, with 8 foot high metal cage-like fences spilled down Penn Avenue as far as the eye could see, tons of trash blowing surreally in the freezing wind- this time looking more relaxed in his basketball shorts and unbuttoned shirt. It was pretty surreal to wake up and read the Journal or Times chronicling the latest historical market failure and then cross paths with its leading financial firefighter. A year later I’m afraid the sense of urgency of those fall months is fast diminishing. A tragedy of the last year is a terrible thing to waste. From the ashes of a failed regulatory system, that cost 3 million people their jobs and nearly as many their homes, and $7 trillion in wealth, is the promise to build a sleeker, more common-sense, more responsive regulatory system. And here many people will stop me simply with the semantics, “regulation” is a terrible word- so call it what you will. The basic concept though holds true in essentially every aspect of life. We don’t get on a jet plane and just hope the proper safety checks have been done and the pilot isn’t drunk, we “regulate” it, we don’t trust a stranger to deliver our new baby at a whim, we “regulate” it. So those who would notionally dismiss regulation as a bad thing should maybe stop flying or stop having kids.
The legal zeitgeist of these times is the President’s Financial Regulatory Reform proposal (http://www.financialstability.gov/docs/regs/FinalReport_web.pdf). In a little over two short months this entire white paper has been translated to authorizing language and sent to the Hill, where as usual it was met with a startling sense of complacency and criticism without much constructive feedback. If this can pass in some form by 2010 my hypothesis of complacency is proved wrong. If not, a similar asset bubble and burst cycle and all of the capital contraction, income decline and job loss and capital loss (repeat) is not just possible but probable. The impetus to correct a clearly insufficient financial regulatory regime – one that forced the government to choose between catastrophic failure and chaos or injecting huge of amounts of taxpayer dollars- is otherwise lost. Critics can say what they like about the choices made last year, but with Bear, Lehman, AIG, WaMu- those were the options. Here are some core tenets of the President’s regulatory agenda.
1) Capital ratios. A working group is currently drafting the details due out in a couple months. When the banks’ experienced severe asset valuation shocks they were forced to liquidate and perpetuate the cycle. With better loan loss provisioning this cycle could have been prevented. In practical terms, probably means going from tangible common equity ratios of 4% to 8%.
2) Resolution authority. The FDIC can repossess and either break up or auction off bankrupt depository institutions. There is no similar authority for non-depositories or holding companies that own depositories. The Fed can loan money to anyone or anything so long as it is last resort and there is sufficient collateral. If there isn’t, then there is no way to protect innocent bystanders from the consequences of large bank failure. The President’s proposal would permit the Fed with Treasury consent, to seize and efficiently break up large failing firms.
3) Preventing regulatory arbitrage. Under current law, thrift holding companies (banks with a higher share of mortgages created to facilitate liquidity in the housing market), industrial loan companies (like GMAC or GE Capital), credit card banks, trust companies and grandfathered non-bank banks are exempt from most supervisory requirements, simply because they were left out of the BHC Act. Firms (like Bear, Lehman, AIG, WaMu) simply owned one of these entities and could simultaneously avoid regulation while having access to the Fed’s lending if they got into trouble. This gave the public no risk management function but sole responsibility should they encounter significant risk. Heads I win, tails you lose. Financial companies should not be able to escape consolidated supervision by technicality.
4) Systemic risk regulation. The proposal creates a new category of Tier 1 financial companies which will be overseen by the Federal Reserve. These would be firms whose failure threatened the entire market, and would be subject to coordinated and robust prudential regulation. Bank holding companies consist of so many separate entities that they can have a dozen separate regulators each and allows firms to arbitrage the differences to their advantage.
5) Consumer financial protection. A central catalyst of the ’08 recession was the set of uninformed and stupid decisions consumers made- like buying houses they couldn’t ever afford or signing up for credit cards with early payback penalties. The proposal observes correctly that finance and economics have a distinct world view, one that does not manage the cultural, psychological and communications challenges inherent in good consumer advocacy. There are bright lines that could be established, but it takes clear authority and communication otherwise it will likely die in the interagency process as it has for decades. Without clear responsibility for common-sense consumer protection there can be no accountability. There are consumer protections for seatbelts, kids toys and lawnmowers, it's time for some for households' budgets too.
6) Office of National Insurance Regulator. The U.S. regulates the insurance industry essentially entirely at the State level and is the only G-20 country without a national framework for insurance oversight. There is clear executive will to do so, now we need legislative consensus.
7) Office of National Bank Supervisor. This would consolidate the Office of the Comptroller of the Currency (which regulates interstate banks) and the Office of Thrift Supervision to oversee all national banks. One office in Treasury would have sole authority for national banks and be able to provide consolidated prudential oversight rather than the current fragmented system.
8) Financial Services Oversight Council. This would force regulators to actually talk to each other and coordinate policy while closing gaps in regulation. In ’08 we saw a fundamentally ad hoc response among the Fed, FDIC, OCC, Treasury and others with predictable turf wars and inefficiencies. Before any major action, like designating a firm a Tier 1 Financial Holding Company or intervening in an institution’s distress, this council would meet to have an integrated approach. It would be a consensus building forum while avoiding the tenuous nature of decision by committee by giving the Treasury Secretary executive authority as the Chairman.
9) Central clearinghouse of derivatives. This would establish a central resolution, clearing and payment exchange for derivates. Most derivatives today are cleared by JP Morgan and Mellon Bank of New York, so creating a consolidated exchange would be eminently doable. By providing transparency in this market, it would not prevent dealmaking, hedging or economically valuable speculation, it would just provide basic information to inform the price discovery mechanism. It was a surprise to most of the world that AIG had a hedge fund grafted on top of it that had drunkenly bet the house on the U.S. housing binge. If people could have seen this, the asset valuation collapse could have been incorporate in prices in near real time and prevented a huge dis-equilibrium and subsequent quick collapse. Contrary to popular misconception, this proposal would not prohibit custom derivatives.
People on the Hill who have better ideas should put them forward, but a system that allowed the consequences of the last year is definitionaly in need of repair. Just ask a harried former Republican Treasury Secretary.
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