Financial Sector Overhaul Plan

June 17 - Today the White House released its plan to overhaul the financial sector.  If adopted, will the proposals prevent another financial crisis, yet still allow sufficient financial innovation, both of which would benefit us all?  In other words, is the administration proposing "smart regulation", which will mean less cost to U.S. taxpayers - now potentially on the hook for billions of dollars as a result of the financial market meltdown?  At first glance, the administration's proposals are comprehensive and would appear to improve financial market regulation and oversight in most of the areas creating the worst problems. The nation's financial sector has changed dramatically in the past 20 years and the regulatory structure has not kept pace.  

One of the challenges from the financial crisis is that our financial system has become a market-based rather than a bank-based financial system (ie, more reliance on securitization and all the structured financial products most of us have learned about as a result of the financial crisis, versus bank deposits).  The regulators are still trying to catch up.  We must have a regulatory system for our 21st century financial markets.  

But would the changes be "smart enough"?  Even with some consolidation, the regulatory structure would remain complex.  Moreover, worrying gaps would remain between the federal and state levels (state-chartered banks remain an important part of the U.S. system) and at the state level, most particularly in the housing market, which has been at the heart of the crisis.  In addition, the status of Fannie Mae and Freddie Mac, the government sponsored enterprises so directly a part of the housing market crisis (whose rescue has cost the taxpayer) is not tackled now.   Official interagency discussions on Fannie and Freddie will take place and proposals brought forward with the 2011 budget.   

Would moral hazard be minimized so that financial firms - especially those traditionally considered "too big to fail" - would not take risks that the taxpayer checkbook would end up covering? The proposals would appear to reduce incentives for risk and establish a higher level of monitoring and tools for prompt corrective action, as needed. However, implementation and in the end judgment will be critical and those are very difficult to shape and predict. 

The highlights of the proposal:

(1) To bring non-bank players into the regulatory fold.  Many players, including those involved in the securitization and derivatives markets, have operated outside the regulatory system even though they account for a large share of U.S. financial activity.  A number of those firms have been key players in the financial crisis. Regulators have not been able to adequately monitor and take corrective action.  It is essential to improve the current situation, but there will be a debate over the extent regulatory requirements should be placed on these firms, which have been a strong source of innovation and growth - as well as high risk.

(2) To reduce incentives for extremely risky investments, particularly those leading to the financial crisis.  Capital and liquidity requirements would increase, on both a national and presumably international basis (since this is a global financial crisis).  Regulators' ability to monitor and limit extreme risk would be increased.   It is important to bring incentives for risk more in line with firm activity, so that firms can continue to gain from the upside of a market but also have the discipline of any downside.

(3) To reduce regulatory gaps so that comprehensive supervision and regulation of interconnected and systemically critical financial firms would take place routinely.  One of the great challenges in addressing the financial crisis has been regulatory holes and inconsistencies.  In this context, the President would strengthen comprehensive supervision and regulation under the Federal Reserve.  While politically controversial, if not the Fed, then who ?  (The Fed has invoked emergency clauses under the Federal Reserve Act to take its extraordinary financial crisis actions. See forthcoming CRFB Fiscal Roadmap Project paper.) He would also create a new interagency Financial Services Oversight Council, chaired by Treasury, to monitor and assess systemic risk (essentially an elevation of the present working party looking at financial market matters); eliminate the federal thrift charter and regulator;  set up a new National Bank Supervisor to supervise all federally chartered banks (a combination of the thrift supervisor and present Office of the Comptroller of the Currency);  create an Office of National Insurance within Treasury (this would be a major change that nearly every recent administration has tried to achieve, since insurance is regulated at the state level);  and to require SEC registration for advisers of hedge funds and other private capital funds, while transferring some SEC powers to the Fed (this would mark the first time anything hedge-fund related would be brought under a regulator, despite an earlier attempt by the SEC that was rejected by the courts). Despite the laudable objectives of the proposals, the regulatory system, while simplified, would remain complex.

(4) To give regulators more tools to resolve crises, along the lines of what the FDIC does to resolve insolvencies in an orderly fashion.  The objective would be to avoid a Lehman-type situation in which federal regulators saw the only choices as being between a government bailout or Lehman collapse.

(5) To establish a new Consumer Financial Protection Agency to protect consumers from "unfair, deceptive and abusive practices".  It is not entirely clear what this agency would do, although it may be a vehicle to target housing market fraud and abuse, alot of which was missed by the responsible authorities.  Credit card issues may also be part of the responsibilities of the agency.