WSJ: Reshaping Financial Oversight

The worst financial crisis since the Great Depression is about to prompt the most far-reaching renovation of the rules and institutions that regulate finance since the 1930s. And the change won't wait for the economy to recover. The Obama administration is rushing to finish a proposal for reshaping financial regulation and wants Congress to act on it by the fall.

Source: Source: WSJ | Published on May 29, 2009

The current crisis exposed two huge vulnerabilities. One is that a handful of financial institutions grew so large and so intertwined that the failure of just one put the entire world financial system at risk. There are two basic never-again solutions: either break them into smaller pieces or better regulate them to make them less prone to collapse. The political winds in Washington are blowing toward the latter.

The other vulnerability, as Federal Reserve Chairman Ben Bernanke put it recently, is "that an approach to supervision that focuses narrowly on individual institutions can miss broader problems that are building up in the system." Both in and out of government, there's a strong consensus to name an overarching overseer of financial stability -- both to keep an eye on institutions so big that their collapse would hurt everyone and to prevent and treat financial infections spreading throughout the system, such as complicated instruments that imprudently rely on house prices rising forever.

But who should be this financial stability regulator? The growing consensus, though not the universal one, is the Fed, despite congressional concerns that the Fed already has too much power.

An alternative pushed by Sheila Bair, head of the Federal Deposit Insurance Corp., would create a council of regulators and give it power to overrule any individual regulator. The White House and the Treasury dismiss this idea. The Fed itself displays a delicious ambivalence. On one hand, Fed officials express concern that if they get the designation they will be an easy target when the next crisis hits. On the other, they recoil at the notion that any other agency get the job.

But how much power to give the Fed? Here's where it gets interesting. In the past week, two private-sector groups emphatically said the Fed should be the sole financial stability regulator. The groups are the Committee on Capital Markets Regulation, a collection of Wall Street executives and academics led by Harvard law professor Hal Scott, and the Squam Lake Group, 15 academics convened by Dartmouth finance professor Kenneth French. Neither could agree on what the Fed should do beyond, as the Squam Lake Group put it, "gathering, analyzing and reporting information about significant interactions between and risks among financial institutions."

The Fed now oversees big bank-holding companies. The Capital Markets panel said the central bank could supervise a designated set of systemically important financial institutions of all kinds. Or it could supervise all financial institutions of any size. Or it could surrender direct supervision for any individual institutions to a new British-style Financial Services Authority. Committee members couldn't decide. Three Squam Lake Group members, speaking in Washington, said the group hadn't reached consensus on whether the Fed should have more or less authority over individual institutions.

Within the White House, Treasury and Fed, there's a growing sense that someone other than the Fed -- perhaps the FDIC -- should get the chore of closing or selling off big financial institutions outside of bankruptcy, a role the FDIC now plays for banks. The appetite for demolishing existing agencies or, for instance, merging the Securities and Exchange Commission and the Commodities Futures Trading Commission has waned; the politics are simply too tough.

So the big question is how the administration, and eventually Congress, will define the Fed's financial-stability job. The Fed could be instructed to prick asset bubbles before they explode, a prospect that frightens the Fed because it may be impossible. More likely, it will be given the only slightly more limited job of maintaining the financial plumbing system, regulating big institutions and markets that could threaten financial stability, and setting the size of the capital cushion big institutions must maintain.

But the details are crucial: Will the Fed be told to make a list of "systemically important" institutions to oversee? Or is such drawing of a circle somewhere between impossible and stupid? Will big firms have an unfair advantage because markets know the Fed will protect them? Or will they be forced to hold more capital or pay fees to the government? Will the Fed become chief supervisor of big insurers, who now have no federal regulator? What about very big hedge funds? Will the Fed be able to overrule other bank regulators or ban certain practices across all companies? Will big diversified financial firms still report to different regulators for each line of business? Will the Fed surrender oversight of smaller banks or consumer protection?

The reaction to the Great Depression gave us the Securities and Exchange Commission, created deposit insurance, divided commercial banking from investment banking, and shifted power inside the Fed to Washington. The response to the Great Panic of 2008 surely will bring similarly long-lasting changes. We just don't know yet what they will be.