Financial Regulation for the Future

As the Obama Adminstration begins the process of reforming the financial regulatory system, the usual crew of columnists, commentators, pundits and bloggers are putting forth laundry lists of suggestions. Regulate credit default swaps, we are told. Formalize the derivatives markets, with centralized pricing processes like exchanges and centralized settlement and clearance functions. Tighten up capital requirements for financial institutions, and step back from the do-it-yourself risk-based capital requirements permitted under current international bank regulatory standards (which, in effect, allow financial institutions to largely decide for themselves how much capital to set aside; not surprisingly, they gave themselves higher grades for risk management than outsiders might have, with sad results that are all too familiar today). Establish prudent standards for mortgage loans, especially subprime loans, adjustable rate loans and any loan that may involve increases in monthly payments. Substantially increase the extent of governmental oversight of financial institutions, and make sure that hedge funds are covered. Make unequivocally clear what the heck Fannie Mae and Freddie Mac are and how much responsibility the federal government will have for their liabilities. Also make unequivocally clear what the major banks and their shareholders can expect from the government when a financial crisis hits. When Bear Stearns was too big to fail, but the much larger Lehman Brothers wasn't, it's no wonder that interbank lending evaporated last fall. Do something to definitively clean up bank balance sheets, like create a bad bank to buy toxic assets or nationalize troubled banks.

There is one point that may have been missed. It's important to regulate for the future. Like many generals, the regulators may be tempted to fight past wars. Almost all the suggestions for reform focus around past problems. These problems will be examined in depth as investigations are conducted. How things went wrong and how they could have been prevented will be analyzed in detail. Stringent regulations and controls will be instituted to prevent a repetition of the past. Enforcement actions, if warranted by the evidence, will be taken to emphasize the point.

But the past probably won't repeat itself. The securitization market for mortgages and consumer loans has largely evaporated, and you couldn't find a new CDO today if you wanted to. Credit default swaps aren't enticing with few creditworthy counterparties available and no centralized system of settlement and clearance. Liar loans and the like have left the scene as banks impose actual credit standards on borrowers because they can't sell loans to investors any more and therefore need to make responsible lending decisions. Almost all of the senior bank executives who wallowed in leverage are now pursuing other opportunities.

The most important task for financial regulators is to look for the battles that will be fought in the future. The financial services industry is second only to high tech in its capability for innovation. For perhaps the next five to ten years, banks and other financial institutions will be reasonably prudent, either because they will have learned their lessons or the government regulators peering over their shoulders will ensure that they learn their lessons. But, just as summer turns to fall and fall turns to winter, the financial services industry will seek to develop new products and services that will ease investor savings out of the scope of regulatory oversight and into another brave new unregulated world where profit margins are higher, executive bonuses are larger, and bureaucrats are scarcely to be seen. This is when the lunacy could begin anew. To guard against such a replay, regulators must not only change rules but also perspectives.

First, regulators should stay current with financial innovation. Congress put the regulatory agencies on the map to guard against the failings of markets. We know from the past 300 or more years that the financial markets cycle through booms and busts, and then more booms and busts. Another boom and bust is inevitable. How it will occur is presently unknown. But one can fairly predict that some time in the next few years, a 25-year old MBA or two will design a new financial thingamajiggy that will not be subject to government regulation and will catch on in the market. As soon as the higher ups in the big banks notice this development, their eyes will widen at the thought of grander bonuses and they will push this product to the edge of every imaginable envelope. Investor savings will be siphoned off into the great unregulated beyond and perhaps placed at far greater risk than investors realize. Bad things will happen, hair will be pulled, teeth will be gnashed, blame will be assigned and lives will be ruined. Regulators must be proactive in monitoring the development of financial products, and the ways in which they are used. Since the financial services industry is so highly innovative, regulators must make every effort to keep up with innovation; not after the fact but as it occurs. This can be done. It's simply a matter of gathering the information. The federal bank regulators and the SEC have examiners who can get up-to-the-minute information about bank activities. They and other regulatory staff should make it a priority to keep up with financial innovation and how new products are being used. Banks will grumble about giving potentially proprietary information to the government. But that's life. After the current debacle, that's a small price to pay for restoring investor confidence, and for the massive amounts of taxpayer dollars they have received and will receive.

Second, regulators should believe in themselves. In the past, attempts by a few regulators to assert authority over derivatives were met by, among other things, assertions that government bureaucrats couldn't understand such sophisticated products and would surely regulate them in a way that would hamper the markets. Some of these assertions even came from senior regulatory officials. Bureaucratic dumbness, if it exists, isn't an excuse to abandon governmental protection of investors, depositors and the financial system as a whole. Hire smarter government employees, if necessary. But the truth is that (a) the government has plenty of intelligent people who can understand complex financial products if they obtain enough information; and (b) very few people in the private sector truly understood these products, as is abundantly evidenced by the catastrophe that has resulted from their misuse. Government employees have sometimes achieved great things when they believed in themselves, worked hard, gave up evenings and weekends for the job, and refused to be held back by naysayers. Morale and zeal at the SEC have been lagging. While the stereotypical ultra-cautious, office-politicking, perks-obsessed, responsibility-avoiding, pension-awaiting bureaucrat is much too common way too often, there remains a cadre of committed public servants at the SEC who can, if given the opportunity, do the world a world of good. They have been crippled by a hostile White House, an unsupportive Congress, and the worst agency leadership in a generation or more. If they are given a chance to vindicate the public interest, they can and will. The financial regulators, including their leadership, must believe in themselves and in their capacity to do good. If they do, they will.

Third, to the Congress and the White House, start by healing thyself. The regulatory structure in the United States is meant to be independent of politics. Way too much for way too long, it has been anything but that. In the world of federal regulation, there is, separate from political considerations, such a thing as right and wrong, good and bad. Regulators must be allowed to call strikes when the pitch is inside the strike zone, regardless of who the batter may be. They must be allowed to quarantine those that could spread infectious disease, even if they are highly placed on Wall Street. One of the greatest impediments to regulatory proactiveness has been political pressure. Congress has a legitimate oversight function. But neither it nor the White House should protect the culpable, reckless or those that pose a risk to the financial system, and unfortunately one cannot say that the slate is clean in this respect. When the state police can write anyone, including the governor and the President, a speeding ticket, you'll have public safety on the highways. Things aren't different in the world of financial regulation.