The first thing to keep in mind when appraising the President's new regulatory scheme for the financial sector is that it is merely the administration's wish list, with the Congress yet to be heard from, and likely to resist adding the chore of systemic risk regulator to the Fed's burdens. The second and more important although less noted fact is that the blurb on the jacket of an Obama oeuvre, in this case his "Guide to Light-handed Regulation", is never an accurate description of its contents.
There is a reasonable chance that Obama will get much, although not all of what Treasury Secretary Tim Geithner and economic adviser Larry Summers have advised him to press for. For two reasons: the recent near-melt-down of the financial sector has revealed weaknesses in the regulatory structure, and the president has been careful to treat politics as the art of the possible. He knows that every regulator reports to some congressional committee or committees, and that congressional barons are more than a little reluctant to give up power, which they have to do if the agency they oversee is eliminated or pared down. So initial plans to consolidate agencies have been severely modified, with only a few to be merged -- and not the most important ones.
The president has gone to great lengths to calm fears that he is unleashing draconian restrictions on the freedom of action of financial institutions -- reform, yes, revolution, no. "No" to those who argue in favor of the status quo, and "no" to those who want him to go further, perhaps as far as separating commercial from investment banking and shrinking banks that are too big to fail. He cannily labels his program both as the most far-reaching since Franklin Roosevelt's New Deal, and as an example of light-handed regulation. "You set up some rules of the road, ensure transparency and openness, guard against huge systemic risk that will lead...government potentially having to step in to avoid a depression, and then let entrepreneurs and individual businesses compete and do what they do," he said on Wednesday.
Start with the securitization process, which many believe converted a problem in the mortgage markets into a threat to the entire financial system. Geithner is eager to get the securitization process restarted, so that credit will flow more readily to the business community and consumers. So, rather than outlawing the process, he persuaded the president to take the quite sensible step of requiring those selling these securities to have some skin in the game -- retain 5 percent of the value of such securities. This means the issuer/ peddler remains at risk, and is less likely to push dicey paper out into the market. I would have preferred a higher figure, but why quibble when the administration has followed the first principle of good regulation: get the incentives of the private-sector players aligned with the broader public interest. Which they certainly were not when an individual bank could rake in profits from selling risky paper, feel confident that it would bear no cost in the event of default, but because its peers were acting in the same way, impose risks on the entire financial system.
The administration is also right to call for reform of the rating system to eliminate the conflict of interest inherent in the fact that the agencies get paid by the issuers of securities only if the deal gets done. No surprise, then, that the holy water of AAA ratings was sprinkled liberally over a great deal of paper that proved to be toxic, in some cases fatally so. Perverse incentives in action. Calls to the leading rating agency, Standard & Poor's, were rewarded only with a press release professing the agency's "commitment to working with policymakers and market participants around the world to help get the capital markets back on track." Whether that includes developing a new system of payment is unclear.
Then there is the Securities and Exchange Commission (S.E.C.), an agency that did not cover itself with glory during the boom years -- think Bernie Madoff. Obama proposes to transfer the S.E.C.'s power to regulate financial products flogged to small customers, including credit cards, student loans, and home mortgages, to a new Consumer Financial Protection Agency, and to a beefed-up Federal Trade Commission. Inter-agency squabbles to follow.
