Scrambling for Solutions

Get ready for the mother of all lobbying battles in Washington later this year when the Obama administration starts pushing its reform agenda for financial regulation in the U.S. Congress. There’s no question that some form of regulatory overhaul is necessary as the United States-and indeed most the world-struggles to cope with a severe global recession brought about largely by unchecked excesses in some of our financial markets, and at some of our largest financial companies.

The greatest economic crisis in nearly 70 years should remove all doubt that our regulatory system is broken, but this isn’t the first time that someone in Washington has wanted to modernize a structure that can trace its lineage as far back as the Civil War. The problem with regulatory reform is that it ends up swatting a hornet’s nest of special interests that swarm against it. As you would expect, some of the opposition comes from the companies being regulated-banks, insurance companies, mutual fund companies, and so forth. But stiff opposition sometimes comes from federal regulators fighting to protect their turf on the theory that no change is better than change that costs their agency power and prestige. And this might shock you, but even powerful committee chairmen in Congress might look askance at any reform measure that transfers some of their power and prestige to someone else’s committee.

As outlined by Treasury Secretary Timothy Geithner in late March, the Obama administration would propose to accomplish the following:

• Appoint a single independent regulator with responsibility over “systemically important firms” and critical elements of the payment system.
• Set higher standards on capital and risk management for systemically important firms.
• Require all hedge funds above a certain size to register with the Securities and Exchange Commission.
• Create a robust regulatory system for the OTC derivatives market.
• Establish a stronger regulatory framework for money market mutual funds to make them less susceptible to large-scale, panic-induced runs by customers
• Strengthen the federal government’s resolution authority to protect against the failure of complex institutions.

Regardless of what you may think about Geithner’s proposal in its entirety, there are elements in it that should be taken seriously. Much has changed since the last time our banking system was under this much stress, which was a five- to seven-year period from the late 1980s to the early 1990s, when thousands of thrifts and banks failed and the U.S. economy finally tumbled into a sharp recession. For one thing, the rapid proliferation of complex financial products, like credit default swaps and collateralized debt obligations, created significantly higher levels of systemic risk in the financial system. The banking industry’s view of risk also became less conservative as subprime lending went from being a closely controlled specialty to a growth business, and originators emphasized riskier structures like option ARMs and high loan-to-value loans. And securitization-which was supposed to reduce risk by getting loans off the balance sheets of banks-ended up creating a financial pandemic by spreading the contagion globally.

There are so many items on Geithner’s reform agenda that would impact so many interested parties that I’m tempted to predict it will end up like Custer at the Little Bighorn, which is to say surrounded and defeated. But the best time to attempt this undertaking is now, when the crisis is still fresh and the outcome uncertain. It would be tragic, in my view, if this propitious moment were to slip away without any meaningful regulatory reform, and any measure that reduces systemic risk in the U.S. financial system will most likely create a better situation than what we have now.

The toughest battle in Congress may be over which agency should become the new systemic risk regulator. The Federal Reserve would be the logical choice, although Chairman Ben Bernanke has so greatly expanded the bank’s traditional activities during the current crisis that Congress may be wary of giving him even more power. My guess is that the Fed will get the job as the top risk cop because it has served that role on an ad-hoc basis throughout the present crisis, and there really aren’t any viable alternatives.

Another important component of the Geithner proposal is to regulate the OTC derivatives market, including all those credit default swaps that American International Group’s Financial Products Division sold like Popsicles on a 90-degree day. The secretary had this to say about AIG during written testimony to the House Financial Services Committee last March. “The days when a major insurance company could bet the house of credit default swaps with no one watching and no credible backing to protect the company or taxpayers from losses must end.”

Amen to that, brother.