Today's object lesson is the so-called financial services regulatory reform plan announced by Treasury Secretary Hank Paulson. Both the Journal and Times treat his proposals as significant. Their headlines, respectively: "Sweeping Changes in Paulson Plan," and "Treasury’s Plan Would Give Fed Wide New Power."
There is less here than meets the eye, and what is here is guaranteed not to be implemented during the remaining months of the Bush presidency. And that of course is precisely the point of this exercise. Appear to be doing something and dump the mess in the lap of your successor.
To the details. Remember where we are: we've had years of misguided confidence that investment banks could be left to their own devices, that the wonders of the originate-and-distribute model meant Things Were Different This Time. Specifically, the powers that be believed that risks were so widely spread and diversified that the financial system was now much more resistant to systemic shocks. We've seen what a crock that idea was.
So although no one has come up with a detailed reform plan, it's clear that the old model is badly tarnished. Since we have demonstrated that losses from investment banking risk-taking will be socialized, curbs need to be put on them. Otherwise, the very presence of a put to the government will guarantee untoward speculation and poor allocation of capital. In addition, continued taxpayer funded rescues of institutions with egregiously well-paid staff would eventually result in bankers' heads on pikes.
A number of ideas have been proposed: tougher capital requirements; restrictions on the use of off-balance sheet entities; driving more trading on to exchanges; limiting the risk-taking of institutions that are big enough to be systemically important (say allowing them to risk only a certain portion of capital in hard-to-value, volatile, or illiquid products); pro-cyclical capital charges; addressing poor incentives; improving transparency and disclosure.
But would any of the measures proposed by Paulson have prevented our crisis-in-motion? No.
What Paulson offered up instead what a plan for some consolidation of financial services industry regulatory oversight. This isn't useless; it would help prevent regulatory/supervisory arbitrage and allow for more consistent implementation of any new regulation. But to pretend that bureaucratic consolidation is tantamount to reform is dishonest. But the New York Times parrots the Administration's story line:
The proposal is part of a sweeping blueprint to overhaul the nation’s hodgepodge of financial regulatory agencies, which many experts say failed to recognize rampant excesses in mortgage lending until after they set off what is now the worst financial calamity in decades.
In reality, the biggest single culprit was a lack of willingness of major regulators, in particular the Fed, to intervene in a securitization process that, as long as it beefed up housing prices, was seen to be virtuous. A secondary factor was that the Federal government, largely through favorable court rulings, has for the most part stripped states of the power to regulate financial services firms. Yet many states have been far more aggressively pro-consumer than the Feds; usury laws, now gutted, existed only at the state level, as did the tougher versions of predatory lending laws. Ironically, had the states been more in the driver's seat (which is a less rather than more consolidated regulatory approach), the mortgage crisis might have been severely blunted (it might not have been attractive to design and market the more aggressive subprime products if they would have been permissible only in certain states). But the Federal government has long had a regulatory bias that favors industry profits over consumer protection.
Yes, as we'll detail, Paulson did add a couple of bells and whistles that were a slight nod to the need to reform. But some had already been served up (and we had deemed them wanting); one is severely misguided.
To the guts of the Paulson program. From the Journal:
Mr. Paulson's plan will include merging some agencies, such as the Securities and Exchange Commission with the Commodity Futures Trading Commission, while broadening the authority of others, such as the Federal Reserve, which appears to be a winner under the proposal. Mr. Paulson is expected to recommend that the central bank play a greater role as a "market stability regulator," with broader authority over all financial market participants.
Mr. Paulson is also expected to call for the Office of Thrift Supervision, which regulates federal thrifts, to be phased out within two years and merged with the Office of the Comptroller of the Currency, which regulates national banks. One reason is that there is very little difference these days between federal thrifts and national banks.....
In addition to some of the short- and medium-term changes, Treasury officials have also designed what they believe to be an "optimal structure" of financial oversight. It would create a single class for federally insured banks and thrifts, rather than the multiple versions that now exist. It would also create a single class of federally regulated insurance companies and a federal financial-services provider for other types of financial institutions.
A market stability regulator, which would likely be the Fed, would have broad powers over all three types of companies. A new regulator, called the Prudential Financial Regulatory Agency, would oversee the financial regulation of the insurance and federally insured banks. Another regulator, the Business Regulatory Agency, would oversee business conduct at all the companies.
Note also that the SEC would be merged with the Commodity Futures Trading Commission.
"Market stability regulator" is a dangerous bit of Newspeak. This is code for the fact that the Fed's role as chief bailout agency will be formalized. And when Japanese regulators there spoke about promoting market stability, that meant protecting industry incumbents, usually by somehow limiting competition and therefore improving profits.
And this program sounds as if it is replacing a hodgepodge now fractured by type of institution (thrifts vs. national banks vs. securities firms) with a smaller number of regulators that will be fragmented functionally. The idea of the Business Regulatory Agency is utter hogwash. How do you oversee business conduct separate and apart from supervisor audits? This agency is bound to be toothless, which is probably the point. And if I read this correctly, we will have the new Prudential Financial Regulatory Agency and the Fed (n the cases of banks with significant trading operations)regulating the same institution, which can lead to either overlapping mandates (which generates conflicts) or supervisory gaps.
Now to the elements that involve some bona fide regulation. Again from the Journal:
A key part of the blueprint is aimed at fixing lapses in mortgage oversight. Mr. Paulson plans to call for the creation of a new entity, called the Mortgage Origination Commission, according to an outline of the Treasury Department's plan, which was first reported by the New York Times. This new entity would create licensing standards for state mortgage companies. This commission, which would include representatives from the Fed and other agencies, would scrutinize the way states oversee mortgage origination.
Also related to mortgages, Mr. Paulson is expected to call for federal laws to be "clarified and enhanced," resolving any jurisdictional issues that exist between state or federal supervisors. Many of the problems in the housing market stemmed from loans offered by state-licensed companies. Federal regulators, too, were slow to create safeguards that could have banned some of these practices.
We had noted before that the merit of mortgage licensing idea depended not on the licensing standards itself (do you really think making brokers take courses and sit an exam is going to lead to better behavior?) but on the standards for conduct, monitoring procedures, and enforcement. Paulson hasn't mentioned any of those. Similarly, it isn't clear how deeply the federal authoriites can get into interfering with, um, overseeing the states on mortgage origination. Since deeds are recorded locally, and contracts are a state law matter, Washington's influence may be limited.
In keeping with notion that the Fed is underwriting the financial system, the Paulson plan gives lip service to the idea the the central bank should have enhanced regulatory powers. However, the proposals are remarkably vague. From the executive summary:
First, the current temporary liquidity provisioning process during those rare circumstances when market stability is threatened should be enhanced to ensure that: the process is calibrated and transparent; appropriate conditions are attached to lending; and information flows to the Federal Reserve through on-site examination or other means as determined by the Federal Reserve are adequate. Key to this information flow is a focus on liquidity and funding issues. Second, the PWG should consider broader regulatory issues associated with providing discount window access to non-depository institutions.
This says the Fed should be able to send inspectors into an institution once it has started propping it up. That is tantamount to shutting the barn gate after the horse is in the next county. The Fed should be supervising any institution that it might have to bail out, period. And the idea that the Fed can effectively examine an organization that it hasn't previously overseen is utter bullshit. Do you think the Fed has any ability to monitor Bear?
Despite its overly generous warm-up, the New York Times does point out the many shortcomings of this plan:
While the plan could expose Wall Street investment banks and hedge funds to greater scrutiny, it carefully avoids a call for tighter regulation.
The plan would not rein in practices that have been linked to the housing and mortgage crisis, like packaging risky subprime mortgages into securities carrying the highest ratings.
The plan would give the Fed some authority over Wall Street firms, but only when an investment bank’s practices threatened the entire financial system.
And the plan does not recommend tighter rules over the vast and largely unregulated markets for risk sharing and hedging, like credit default swaps, which are supposed to insure lenders against loss but became a speculative instrument themselves and gave many institutions a false sense of security.
Congress would have to approve almost every element of the proposal....Mr. Paulson’s proposal is likely to provoke bruising turf battles in Congress among agencies and rival industry groups that benefit from the current regulations.
And the real kicker:
The bulk of the proposal, however, was developed before soaring mortgage defaults set off a much broader credit crisis, and most of the proposals are geared to streamlining regulation.
In other words, this isn't even rearranging the deck chairs on the Titanic; it's keeping the ship on full throttle with a only slight change in course.