By Clive Crook, National Journal
© National Journal Group Inc.
Friday, April 4, 2008

Paul Krugman of The New York Times and the editorial writers of The Wall Street Journal hate to agree, but Treasury Secretary Henry Paulson Jr.'s blueprint for financial regulation brought them to it. Krugman called the proposal "the Dilbert strategy" -- mere displacement activity, redrawing the org chart to no real effect. So did The Journal, more or less: "No bureaucratic deck chair goes unmoved," the paper observed wearily. (Does that make the financial system the Titanic? Let that pass.)

	The new regulatory structure proposed by Treasury makes much better sense than the current one.

Krugman wants tougher regulation than Paulson proposes, whereas The Journal thinks that any kind of regulation is a waste of time: The market will provide. So one must not exaggerate this sudden convergence. Still, with Krugman and The WSJ and just about everybody else ganging up on the Treasury proposal, it would be fair to say that Paulson was attacked from all sides. Given that his plan has little chance of ever being implemented and, as Paulson himself said, no chance of even being acted on this year, a small measure of praise from anybody, really, would be something. Let me see what I can do.

So far as reviewing the current system goes, much of what Treasury says is correct. The present structure is a mess. It is easy to find financial activities covered by multiple regulators -- or by none. Five separate federal regulators oversee deposit-taking banks; the states have their own overseers, in addition. For the insurance business, it is the other way around: mostly state regulation, little federal oversight. Investment banks are less closely regulated than deposit-taking banks -- though, following the Bear Stearns collapse, they now enjoy some of the same protections. Other institutions deeply implicated in the current turmoil -- hedge funds, for instance, and all manner of mortgage lenders and servicers -- are virtually unregulated.

The problem is that the lines between different kinds of financial institutions have blurred over the years. The pattern of regulation was formed in layers over decades, when a bank was still just a bank and a nonbank wasn't. The present untidy patchwork -- triple-stitched in some places and full of gaping holes in others -- no longer makes sense.

There are two main alternatives to this outdated approach of "regulate by type of institution." One is to create a single regulator that spans all types of financial services. The United Kingdom did that in 2000, with mixed results. Its Financial Services Authority has just published a brutally self-critical analysis of what it did wrong in the recent Northern Rock saga, when a big British bank failed because of the subprime crisis and eventually had to be nationalized. Just now, not many people are holding up the FSA as a model.

The other way is to "regulate by objective" -- creating regulators that cover a wide span of institutions but have a clearly focused mandate. The core aims of financial regulation are to stabilize the financial system as a whole; to provide for the safety and soundness of its component firms; and to protect consumers and investors from unfair dealing. So you can do what Australia and the Netherlands, for instance, have done, and create one regulator for each of those duties.

This is what the Treasury blueprint proposes as its "long-term optimal regulatory structure." It envisages the Federal Reserve Board as the market-stability regulator, with "responsibility and authority to gather appropriate information, disclose information, collaborate with other regulators on rule-writing, and take corrective actions when necessary." Treasury also proposes a prudential regulator, merging the Office of Thrift Supervision and the Office of the Comptroller of the Currency. And, finally, the blueprint includes a new business-conduct regulator, focusing on consumer protection, in effect absorbing the Securities and Exchange Commission and the Commodity Futures Trading Commission.

Credit where it is due (forgive the expression): This structure makes much better sense than the current one. And structural design, contrary to what Krugman and The Journal say, does matter. Missing, unclear, or overlapping regulatory responsibilities make it too easy to pass the buck, so that issues go unaddressed. The organizational chart makes a difference. Whatever view you take about the exact causes of the current financial crisis, it is hard to deny that the failure to effectively regulate the subprime mortgage business is deeply involved. It is also hard to deny that this failure had a lot to do with fuzzy lines of regulatory responsibility and some outright holes in the system.

Under the arrangements that Treasury is proposing, all three regulators would have the duty and the authority to oversee the subprime mortgage business, but in each case with a separate and clearly defined mandate. The Fed would monitor system-wide risks (and would be granted wider access to the information it needs to do that); the prudential regulator, "with appropriate authority to deal with affiliate relationship issues," would be responsible for curbing the banks' off-balance-sheet adventures; and the business-conduct regulator would attack the excesses, ranging from recklessness all the way up to plain fraud, of currently unregulated or semi-regulated nonbank mortgage originators.

The next time a financial meltdown occurred, at least we would know whom to blame and for what. As in most things, accountability helps.

On the other hand, architecture is not all that matters. Paulson said this week, "The blueprint is about structure and responsibilities, not the regulations each entity would write." What those regulations actually say, and how competent the regulators are in enforcing them, are obviously critical.

New curbs are needed on mortgage lending; on off-balance-sheet risk; on the opacity of new financial instruments. The blueprint has nothing to offer on any of this. And even if you accept the plan for what it is, it has another big gap. The authority of its prudential regulator is confined to institutions that benefit from "explicit government guarantees" -- meaning deposit-taking banks. But the government's safety net is not confined to firms with explicit guarantees. In emergencies, it deems other institutions (such as Bear Stearns) too important to fail.

Even before the attacks from all sides had begun, the Bush administration was not proposing action on the blueprint. Most of the reforms are for the medium term and beyond, Treasury says. The measures that the Fed took under its existing elastic powers are where the action is at the moment. These steps include the Bear Stearns intervention (the de facto acquisition, at taxpayer risk, of impaired financial assets, thus crossing a supposedly inviolate line); the Fed's new "temporary" discount-window access for investment banks; and its other technical innovations for supplying liquidity.

Congress is also moving to wring out new legislation addressing the distressed housing market. Months of gridlock in the Senate gave way midweek. Some of the boldest ideas on what should be in this long-delayed measure -- including an expanded, and potentially expensive, role for the Federal Housing Administration in guaranteeing new loans, plus new rules to let courts rewrite existing mortgages for borrowers in bankruptcy -- seemed likely to fall away for now. That would leave an expansion of state mortgage-refinancing bonds, tax reliefs for homebuilders and buyers of houses in foreclosure, more money for counseling, and other bits and pieces.

In the short term, more important than any of this -- as The Journal's editorial writers correctly say -- are the adjustments that the financial markets are making of their own accord. Investors are fleeing from risk, debt ratios are being reined in, dubious off-balance-sheet exposures are being brought back on the books, and stressed-out banks are seeking new capital to shore up their financial defenses. All well and good. It is true, also, that a rush to tighten financial regulation could do more harm than good (shades of Sarbanes-Oxley) if it overburdens the financial industry or creates new incentives to take risks with taxpayers' money.

But none of this means that intelligent regulatory reform is to no purpose. The point is that this market backlash against the earlier credit mania might yet go too far. Despite what the Fed has done and what Congress may do, it is still too soon to say where all of this ends.

Perhaps housing prices are about to find their floor, restoring some value to mortgage-backed securities and easing the financial panic. Maybe then the economy will scrape by with only a mild downturn. But maybe not. Most analysts think that home prices have a lot further to fall. Millions more mortgage defaults are in the pipeline. This financial emergency is not over. The gloom could still infect the real economy much more seriously than it has so far.

Ingenious as markets may be, an exaggerated cycle of credit-driven boom followed by panic-induced bust is neither desirable nor necessary. Better financial regulation can help to attenuate the ups and downs. It is a matter not of more regulation or less, but of making the rules smarter. How to do that is a discussion that has barely even begun.

-- Clive Crook is a senior writer for National Journal magazine, where "Wealth Of Nations" appears. His e-mail address is ccrook@nationaljournal.com.

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