June 18, 2009
Is Financial Regulatory Reform Even Necessary?
Posted by David Zaring

There's plenty of punditry out there on the Obama blueprint.  It is not a dramatic reorg of financial regulation - as Joe Nocera observes, "the Obama plan is little more than an attempt to stick some new regulatory fingers into a very leaky financial dam rather than rebuild the dam itself."

He makes that sound like a bad thing, but our traditions should be abandoned at their peril, and so on.  More, I also agree with Elliott Spitzer, who writes:

Each of the major regulatory steps that the Treasury secretary and the director of the National Economic Council have set forth makes eminent sense. Yet each was already squarely within the purview of an existing federal agency.

Veteran readers of this blog will know that I think that the Depression era statutes guiding the Fed, FDIC, and Treasury have largely permitted the massive interventions into the regulatory system that we have seen so far (the exception, I think, were those bailouts to non-banks, but there the question is whether the language of the Fed's authority, which permitted them, had somehow been qualified by decades of practice, which would not have).  Those statutes are short, old, and have catch-alls that can be interpreted very broadly indeed.  Moreover, federal courts are supposed to defer to agency interpretations of statutory terms, even if those interpretations are novel.  So federal agencies could take phrases like "safety and soundness" and put very new spins on them.

Spitzer made his career exactly this way; he dusted off an old statute in the state of New York, realized it provided for extremely broad basic powers, and used it to go after Wall Street and run for governor.  So it isn't surprising to hear, as he has been saying for a while, that he doesn't see the need for new powers.

Understood this way, what financial regulatory reform really is is an effort to take stock, in a democratic way, of what the regulators should be doing.  By specifying new powers, Congress will be limiting agencies as much as it will be expanding their authority, by indicating what it wants from the system, and what isn't a priority.

So to answer the question at the top of this post, no, in my view, financial regulatory reform isn't really necessary, at least not from a "can we regulate hedge funds? or derivatives? demand they be traded on exchanges?" kind of way (except where Congress explicitly blocked that sort of thing, and to be sure, there are some things for which legislation would be needed, like insurance, abolishing OTS, etc).  Whether you think it has value depends on what you think about a taking stock exercise - and whether you think that Congress or the regulators themselves are best suited to the job of sketching out the next regulatory regime.

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Comments (6)

1. Posted by fedgovernor on June 18, 2009 @ 11:24 | Permalink

Oh come on. This post is claptrap.

Bernie Madoff didn't exist in a vacuum. He was a creation of the Securities and Exchange Commission, the reputed watchdog agency tasked with regulating our financial markets.

Very smart people reported to the SEC that Madoff was running a Ponzi Scheme. They provided ample proof. Over multiple years.

Madoff was being protected by the SEC.

It's stupid to talk about what regulatory this or that should be done when the cops are up to the arses in the pickle barrel.

2. Posted by Elizabeth Brown on June 18, 2009 @ 11:42 | Permalink

The reforms that are necessary and that would address why regulators didn't use some of the powers that they had are the structural ones that Obama has refused to put on the table because to get them through probably would require too much political capital that he would rather spend to get his healthcare package passed. The white paper does not eliminate many of the ways that financial firms can engage in regulatory arbitrage because of the multiplicity of state and federal regulators.

For example, part of the reason that the OCC was not as willing to crackdown on some of the questionable bank lending practices was that the banks could shift to a state charter and state regulation if they thought the OCC was getting too strict. The OCC is considered more powerful and has a larger budget if it regulates more banks and more of the larger banks. So it has an incentive to keep those it regulates happy so that they will continue to choose it as their regulator.

Most state regulators similiarly didn't crackdown on predatory lending, although some of them tried, because the banks could shift to a federal charter and the OCC had a reputation as being less consumer friendly than state regulators. That was underscored by the Watters v. Wachovia decision by the Supreme Court. See http://www.supremecourtus.gov/opinions/06pdf/05-1342.pdf

Structure does matter. The structure led to a race to the bottom in regulation, both in terms of enforcement and in terms of substance.

I know you keep claiming that regulatory "competition" is beneficial. I think that you have failed to provide sufficient evidence that on balance that the benefits out weigh the costs. Certainly this "competition" fostered the regulatory arbitrage which contributed significantly to the most recent financial crisis. For more on the costs of regulatory "competition", see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=757010

3. Posted by Mike Guttentag on June 18, 2009 @ 14:54 | Permalink

Excellent post. Aren’t there a few places where some legislative intervention is now necessary, such as the reregulation of credit default swaps and the take-over of non-bank institutions?

4. Posted by Jake on June 18, 2009 @ 20:23 | Permalink

It is astounding that any sentient being would pay heed to anything that Spitzer has to say.

5. Posted by David Zaring on June 19, 2009 @ 6:53 | Permalink

Yes, you need legislative intervention to do things that Congress has expressly forbidden, and to abolish agencies. But making the Fed a systemic regulator? Establishing an insurance monitoring outfit? Those could probably be done without such approval.

6. Posted by Jeff Lipshaw on June 20, 2009 @ 5:25 | Permalink

My sense, generally, is that there's a lot of hindsight bias going on in these discussions. Politicians and regulators, like generals, are usually fighting the last war. Sarbanes-Oxley, as well as the "money-loosening" that followed the bursting of the Internet bubble are examples. By way of shameless promotion, I've posted an attempt at a deep dive on why it is so hard (despite the couple of lucky or prescient souls who saw it coming, but then again, I've hit long shots at the race track too) to regulate systemic risk looking forward rather than backward in The Epistemology of the Financial Crisis: Complexity, Causation, Law, and Judgment. The gist of the metaphor is that it's awfully hard to prescribe the medicine when you are still trying to figure out what the disease is!

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