Why Fed reform won't work.

Commentary about business and finance.
March 31 2008 5:27 PM

Why Fed Reform Won't Work

Yes, the financial regulation system needs overhaul, but the proposed plan is a Band-Aid for Wall Street's mortal wounds.

Read more about Wall Street's ongoing crisis.

Henry Paulson. Click image to expand.
Treasury Secretary Henry M. Paulson

Here's how to think about the proposed reform of financial oversight unveiled by Treasury Secretary Henry Paulson on Monday: The Federal Reserve Bank, whose job already includes regulating a large component of the financial system, has failed pretty badly at its tasks. The proposed solution—to give it more responsibility—seems ridiculous and hazardous.

Yet that's the plan. Having ignored or been unduly confused by the complexity of the banks already under its jurisdiction, the new, improved Fed would get more books to examine for undue risk, adding in brokers and insurance companies.

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No one questions that the current network of financial regulators—which dates to the '30s—is confusing and unwieldy. There are seven existing bodies in Washington created specifically to avoid the type of looming crisis that might be created by a couple of trillion dollars' worth of opaque financial securities careening out of control. (And that's not including the Financial Accounting Standards Board, established as an independent entity to evaluate the veracity of how financial institutions value certain securities.)

But Paulson's plan wants to add a couple more: the Prudential Financial Regulatory Agency to watch government-guaranteed banks and the Business Regulatory Agency to focus on consumer protection.

None of that, however, will control the excesses of investment banks which, among other things, led to the mid-March meltdown of Bear Stearns. That task would putatively fall to the Fed.

To some extent, that is already what the Fed is charged with doing. The Fed is supposed to maintain liquidity to grease the system (through discount windows to the "worthy" banks); exercise monetary policy to keep it going; control risk; and provide oversight to protect consumers. It is already regulator to much of the industry, including bank holding companies and diversified financial holding companies formed under the Gramm-Leach-Bliley Act of 1999.

Had the Fed shown any appetite or competence for these roles, we might not be in the situation we are in now. It could, for example, have questioned how certain Wall Street institutions already in its jurisdiction—notably Citigroup and others that have been forced to write off billions in subprime mortgage losses—were overleveraging the loans on their books.

But it didn't. Today's banking system has too many intertwined players that all do one another's jobs. Its complexity is the creation of all the legislators who gleefully embraced deregulation during the last two decades.

We will not solve the problem of an unstable, risk-laden banking system by putting false hope into an ill-equipped body, no matter how much added "transparency" has been proposed.

The fundamental question remains: What is the overseeing body going to do with a more powerful window onto the financial industry? What would the Fed do if it noticed that every financial firm was creating and stockpiling risky securities and borrowing money to stockpile more? Is it realistic to believe it would intervene and cut the amount?

Or let's say that the Fed knew that flawed risk parameters were being used to evaluate these flimsy securities. Wouldn't enforcing penalties be construed as an infringement on free-market capitalism?

The Paulson plan does nothing to give the oversight agencies any more legal standing to intervene or enforce than they already possess. That's hardly surprising, given the vociferous opposition that greater regulation faces from Wall Street firms (to say nothing of barely regulated hedge-fund and private-equity firms).

This isn't to say that requiring greater transparency from the banking industry is a bad thing. But the illusion of greater transparency at the expense of true insight is a new disaster waiting to happen. It's like jumping out of a plane with a faulty parachute; the idea of the parachute gives you confidence, but that complicated drawstring that won't engage will get you every time.

Given this, it might be construed as a blessing that Paulson's proposed reforms seem unlikely to be enacted anytime soon. On Monday, Paulson said: "These long-term ideas require thoughtful discussion and will not be resolved this month or even this year."

Well, he's right about that. All of the plan's suggestions are cosmetic. Instead, let's please have a serious discussion about the nature of the banking system structure itself: its complexity, its responsibility, and the proper role of the federal government in regulating it. The United States has had such a debate before, leading up to the landmark 1933 Glass Steagall Act. We can and should have such a sweeping debate again.

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