Financial Regulatory Reform: IV

In my book I suggested a moratorium on financial regulatory reform: wait until the economic recovery is well under way and the causes of the financial crash have been well studied. There is no urgency about financial regulatory reform because there is no imminent risk of another crash. For a time at least, the world's central bankers, and the financial industry itself, will be hyper-alert for another housing or credit bubble. The wisdom of delay is confirmed, in my eyes at least, by the proposals in Financial Regulatory Reform, the lengthy "white paper" issued last week by the government.

But given the pressure to "do something," I shall make a few proposals, guided by the principles that structural reform--creating new agencies, shifting regulatory power from one agency to another, and the like--is unresponsive to the problems of regulation that the financial crisis has brought to light, and that, in light of our as yet imperfect understanding of the causes of the crisis, modesty should be the watchword.

The first proposal is to commission an in-depth study of the causes of the financial crisis, along the lines of the study by the 9/11 Commission of the intelligence failures that enabled the 9/11 plotters to elude detection. The essential point is that the in-depth study be conducted by neutrals rather than by persons who had an official role during the run-up to the financial crisis. The analysis and recommendations in Financial Regulatory Reform are contaminated, as it seems to me, by the complicity of some of the authors (or officials who shaped the analysis and recommendations, whether or not they contributed to the drafting of the Report itself), in the regulatory failures that largely caused the crisis. Instead of acknowledging the causal significance ot these failures, the Report tries to shift the blame to the private sector and to structural deficiencies in regulation that--the Report argues unconvincingly--prevented the regulators from anticipating and preventing the crisis.

My remaining proposals are of measures to improve regulatory performance, as distinct from the organization of financial regulation. First, we need a program that will rotate financial regulatory staff among the different financial regulatory agencies, to broaden the perspectives of regulators, reduce the "stovepiping" of information that may relate to a wide range of companies and financial markets, expose regulators to new ideas, reduce turf warfare based on misunderstandings, and make a career in financial regulation more interesting and challenging. The model is the military reforms, instituted by the Goldwater-Nichols Act of 1986, that made service in joint commands a prerequisite to promotion to a senior level.

Second, it would probably be a good idea to finance the financial regulatory agencies out of congressional appropriations rather than fees paid by the regulated firms. The fee system puts the agency and the regulated firms in the approximate relation of seller to customers, and let's not forget the slogan that the customer always knows best. The particular danger is that a firm will, by configuring its structure in a particular way, bring itself under the jurisdiction of an agency that, desiring to increase its fee income, offers (implicitly of course) a softer regulatory touch. There is the further danger, when an agency is supported out of fee income, of a mismatch between the penalty function of fees and the revenue function. Fees set at the right level to deter risky practices may generate too little or too much income to finance the agency at optimal size.

My most important suggestion is also borrowed from national security. (In recent years I have written extensively on the reform of national security intelligence as well as on responses to catastrophic risks generally, and this writing has influenced my views about the reform of financial regulation--the financial crash of last September was sudden, catastrophic, and unanticipated.) The suggestion is to create, within the Federal Reserve, the National Security Council, or the President's Council of Economic Advisers, a capability for financial intelligence and emergency financial planning. The regulatory failures that underlie the current depression did not result from a lack of legal authority, as the regulators argue in an effort to excuse their failure, or from the structure--overelaborate though it is--of regulation of the financial sector. They arose from lack of foresight and knowledge, and they can be rectified, at least to some degree, by a sharper focus on information collection and analysis and on contingency planning.

These are separate tasks. The first is the pure intelligence task. The Treasury Department already has an intelligence office, the duties of which include detection of financial transactions for the support of terrorists. Keeping track of lawful, but possibly risky, transactions and balance sheets should be easier than unraveling terrorist funding networks. And contingency planning is not wholly alien to financial regulation--think of the stress tests (which were not invented by Secretary Geithner, by the way, but are a standard tool of bank regulation). Stress tests are designed to identify financial weaknesses before they cause actual bank failures; the object, as the name implies, is to determine whether, if the bank is stressed by adverse economic developments, it can survive. If it flunks the test, there is time to take precautionary measures to avert failure should the stressful conditions materialize.

A rather grim parallel to the idea of contingent financial regulatory planning is the "COG" (continuity of government) plan, which is the plan for ensuring the survival of the U.S. government in the event of a nuclear attack, or comparable catastrophe, that destroyed Washington. It is almost incomprehensible that some counterpart plan was never devised to deal with the possibility of a catastrophic failure of our financial institutions. It is not as if such a failure were unprecedented; it happened in the United States and other countries during the Great Depression, and in Japan as recently as the 1990s. Warnings of a housing bubble and a possible ensuing banking collapse were issued as early as 2002, and gained in frequency and urgency as the bubble expanded and burst. By 2007 a deterioration of the financial system was evident. Even the Federal Reserve expressed concern, but when disaster struck last September, the government was taken unawares and had no remedial plan to put into effect. The Federal Reserve and the Treasury Department reacted vigorously, but in an obviously improvised way that impaired business and consumer confidence. The government's failure to save Lehman Brothers was an especially serious, and wholly avoidable, blunder.

So financial regulation can be improved without an elaborate reorganization of the regulatory structure; whether it can be improved with such a reorganization may be doubted.