Did the Financial Regulation Bill Provide Too Much Discretion to Regulators?

The summer's giant financial regulation bill provided regulators a great deal of discretion on how to best implement new policy. Perhaps it provided a little too much discretion. Regulators are quickly discovering that some of the new rules are causing pretty big problems for the market, because Congress legislated ideas that seemed like good theory, but didn't provide regulators with a practical way to implement them. Some of the new rules aren't fully formed. Now they're asking Congress to rethink some of its regulating.

Some of the biggest problems regulators are running into are crowded around credit ratings. The private agencies who rated bonds were commonly blamed for some of the market's biggest problems, since so many of their grades on securities turned out to be incorrect. But the market had gotten so use to using those ratings as a crutch that it's not sure how to function without them.

The Wall Street Journal reports that regulators want more direction from Congress:

FDIC Chairman Sheila Bair said poor credit ratings were a "key contributing factor" to the financial crisis but defended ratings as an effective way to evaluate the quality of investments such as corporate debt. "I think we will also find that some of the more likely replacements ... are far from perfect," she said at the meeting.

Added Comptroller of the Currency John Dugan, an FDIC board member: "I do worry about there is a little bit of throwing out the baby with the bath water. It might be worth Congress taking a second look at."

Already two pretty significant problems have arisen regarding ratings. One provision removes from all laws and regulations. Unfortunately, regulators can't figure out a great way to otherwise assess asset risk (as explained here). The second makes the rating agencies liable if some of their ratings turn out to be incorrect (as explained here). Naturally, agencies don't want to be held accountable for their predictions about the future, so the market this provision affected initially shut down until the SEC temporarily lifted a separate requirement that ratings are included in official deal documents, which effectively shields the agencies from Congress' new rule.

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In both of these situations, lawmakers acted too hastily. While it's true that the rating agencies created problems due to their poor performance during the housing boom, and they should be reformed, you can't just get rid of their influence with the stroke of a pen. This is the kind of problem that results when legislation is rushed. Certainly, solutions do exist for each for these problems, but Congress didn't take the time to figure out which the best ones were so to enable regulators to act accordingly. Now, they feel they don't have the authority, or frankly know-how, to arrive at those conclusions themselves.

Anyone who follows Congress knows that, with a midterm coming up, there isn't a whole lot of time in its schedule to revise its large and complex financial regulation bill. For now, the market will have to figure out a way to contend with these changes. Instead of having Congress dictate the rules' implementation, regulators will have to rely on the input of academics, industry participants, and other experts. That's not necessarily a bad thing, but it will mean that the supposed certainty that passing the financial regulation bill was said to bring is still quite far off.