Reading the Tea Leaves on Regulatory Reform

It has been widely reported that within the next few weeks the administration will unveil a new, comprehensive financial markets regulatory scheme. Speculation about the scope of the proposal has been intense. In last week's New York Times, Stephen Labaton reported that the administration probably wouldn’t recommend rolling all four bank regulators up into one agency, but that a new agency for credit card and mortgage regulation was still a possibility. In the background, administration officials have been meeting with a constellation of experts to hammer out details. In one recent meeting, a group of academics, policy analysts and researchers was asked questions that provide some insight into the administration’s general approach. The questions, combined with recent news reports also suggest that the regulatory agenda has been finalized, but they’re still fighting about money and political turf.

The Treasury Department has previously aired two pieces of the puzzle: resolution authority and regulation of the over-the-counter derivatives market. The resolution authority proposal was outlined in a March 26th press release (TG-72). The press release asked Congress for an FDIC-like power to seize and dismember institutions deemed a risk to the entire financial system. Left unresolved was which agency would be the resolver. Resolution authority appears still to be on the table: the experts were asked where the administration could obtain the money to carry out resolutions of institutions that aren’t banks. The FDIC’s resolution process is paid for out of a fund derived from payments made by FDIC-insured institutions.

Secretary Geithner has carefully avoided answering questions about who would swing the sword of resolution, but he has stressed, on several occasions, the need for a new regulatory entity that could police institutions that pose a risk to the financial system generally. He has not, however, been specific about this new agency’s power or role. A number of players have leaped into that void. In late March, a bipartisan bill was introduced in the House and Senate (HR 1754, S 664) that would create a council composed of the heads of all the financial regulatory agencies. This group (called the Financial Stability Council) would be in charge of assessing systemic risk. This bill framed the terms of the debate – should systemic risk be overseen by a loose collection of regulators, or should there be a new agency? Sheila Baer at the FDIC and Mary Schapiro at the SEC (who would be members of a financial risk council, but would lose turf if a new agency were created) have, unsurprisingly, expressed approval of the council idea. The experts were also asked to weigh in on this question. Is a systemic risk council an acceptable compromise, they were asked, or do we need a new regulatory agency?

Over-the-counter derivatives regulation, on the other hand, seems squared away. On May 13th, Secretary Geithner sent a letter to Senator Harry Reid outlining the administration’s proposal for OTC derivatives regulation. According to a source with knowledge of the meeting, the experts were not asked about OTC derivatives regulation.

The US financial regulatory system was constructed piecemeal in response to a variety of historical events. The result of this ad hoc approach is a patchwork of jurisdictions that overlap in some areas but don’t cover other areas at all in others – a problem is known as “regulatory fragmentation.” On the evidence of the last few questions, regulatory fragmentation is still on the agenda. The experts were asked how much they thought regulatory fragmentation contributed to the current crisis. They were also asked to describe how well the existing system protects consumers and investors. Last week, a report from the Associated Press (“Fed Would Serve as Risk Regulator under Obama Plan,” AP Datastream, 5/28/09) described a draft regulatory scheme that would create two major regulatory agencies – one protecting consumers and one protecting investors. The investor protection agency would be created by merging the SEC and the CFTC. Merging or eliminating regulatory agencies has proved to be a reasonably hot political potato. Every agency, it seems, has a champion in Congress. These champions stand to lose power if their pet agency is curtailed. The New York Times article spent several paragraphs addressing the “political cost” of correcting regulatory fragmentation.