The Bush administration is proposing the broadest overhaul of Wall Street regulation since the Great Depression. But the plan, to be unveiled on Monday, has its genesis in a yearlong effort to limit Washington’s role in the market.
And that DNA is unmistakably evident in the fine print.
Although the proposal would impose the first regulation of hedge funds and private equity funds, that oversight would have a light touch, enabling the government to do little beyond collecting information — except in times of crisis.
The regulatory umbrella created in the 1930s would grow wider, with power concentrated in fewer agencies. But that authority would be limited, doing virtually nothing to regulate the many new financial products whose unwise use has been a culprit in the current financial crisis.
The plan hands vast new authority to the Federal Reserve, essentially formalizing what has been an improvised process over the last three weeks. But some fear that the central bank’s role in creating the current mess will undercut its ability to clean it up.
All the checks and balances in the plan reflect the mindset of its architect, Treasury Secretary Henry M. Paulson Jr., who came to Washington after a long career on Wall Street. He has worried that any effort to substantially tighten regulation could hamper the ability of American markets to compete with foreign rivals, though he has intervened in the mortgage crisis to try to persuade banks to offer concessions to some troubled borrowers
As the full effect of the credit crisis becomes clearer, the political stakes are growing.
Mr. Paulson is clearly taking a stand against critics who support even stricter regulations, while rejecting any notion that the crisis in financial markets or the collapse of Bear Stearns can be laid at the administration’s doorstep. In a draft of a speech to be delivered Monday, he declares: “I do not believe it is fair or accurate to blame our regulatory structure for the current turmoil.”
And while he argues that the current regulatory structure is outdated, Mr. Paulson’s vision for the future echoes the traditional Republican view that new rules and agencies are no substitute for market discipline.
The proposals would, for the first time, create a set of federal regulators with authority over all players in the financial system, be they banks, insurance companies or other entities like hedge funds and private equity funds, which now operate virtually without regulation.
But that authority would be limited. The Fed, which Mr. Paulson proposes to make the “market stability regulator,” would be given explicit authority to limit the risks financial institutions take regarding “certain asset classes” and to “address liquidity and funding issues.”
Broadly speaking, those are the problems that have cost the nation’s largest banks and brokerage firms tens of billions of dollars. They took risks trading an alphabet soup of unregulated products cooked up by financial engineers, like C.D.O.’s (collateralized debt obligations) and C.D.S.’s (credit default swaps).
But the Fed would not be able to act simply because one bank or brokerage house was taking excessive risk. Instead, the Fed’s “authority to require correction actions should be limited to instances where overall financial market stability was threatened,” the proposal states.
The Fed has long had great prestige in Washington, but in the current crisis it has seen its decisions challenged from both the left and the right.
“The Fed oversaw this meltdown,” said Michael Greenberger, a law professor at the University of Maryland who was a senior official of the Commodity Futures Trading Commission during the Clinton administration. “This is the equivalent of the builders of the Maginot line giving lessons on defense.”
The Fed’s former chairman, Alan Greenspan, for years praised the growth in the derivatives market as a boon for market stability, and resisted calls to use the Fed’s power to increase regulation of the mortgage market.
On the right, some were appalled by the decision by federal regulators to intervene to keep Bear Stearns from collapsing. “I want market discipline, too, but you don’t do it by empowering the Fed,” said Representative Scott Garrett of New Jersey, a Republican on the House Financial Services Committee. “We’re trying to get transparency for the market from an institution that’s not transparent in its own workings.”
Under the Treasury proposal, while the Fed would have some authority to stop financial institutions from taking on too much risk through the use of exotic financial instruments, it appears that little would be done to limit the flow of such new products.
The Treasury says that it and other federal regulators still believe a principle it enunciated a year ago, “that market discipline is the most effective tool to limit systemic risk.”
New Thoughts on Regulating Derivatives
That discipline was largely lacking when the problems were being created, but now has returned with a vengeance, leaving banks with securities of dubious value that cannot be sold at any price that even approaches what they were thought to be worth only months ago.
“Turning over all this responsibility to the Fed doesn’t address the derivatives problem,” Mr. Greenberger said.
Other former regulators saw at least some promise in the proposal, which would create two other super-regulators in addition to the Fed.
One of the new agencies, which the Treasury calls a “prudential financial regulator,” would focus on the safety of financial institutions that have explicit government guarantees. The other watchdog would oversee business conduct to protect public investors and customers of financial firms.
Democrats reacted with some praise. “It’s a recognition, maybe a reluctant one, that you have to enhance regulation,” said Rep. Barney Frank, a Massachusetts Democrat who is chairman of the House Financial Services committee.
Arthur Levitt, a former chairman of the S.E.C., said he was “intrigued by the idea of an agency for investor protection that would extend across all products, principally because I am frustrated by the inability of other agencies to provide that protection.” He pointed to the failure of regulators to halt abuses by mortgage brokers and by a reduced willingness of the S.E.C. to bring enforcement cases in some areas.
But Mr. Levitt said he was concerned by proposals to expand the authority of self-regulatory organizations, like stock exchanges. As an interim step, Mr. Paulson proposed allowing those organizations to change their rules without seeking explicit approval from regulators.
“They have acted in their own self interest too often to allow them to get out from under the oversight process,” Mr. Levitt said.
Mr. Frank also praised Mr. Paulson for including protection of consumers in the plan. “That’s a big step forward and something Greenspan wouldn’t do,” he said.
Mr. Paulson, in the speech to be delivered Monday, says the long-term proposals he is making should not be acted upon while the current market stresses remain severe. Instead, he says, no final decisions should be made “this month or even this year.” Next year, of course, a new president will take office.
“This is the beginning of the process,” Mr. Levitt said. “This will become an issue in the presidential campaign, and I think that is probably good.”
Some industry representatives embraced the plan, reflecting its laissez-faire origins. “The Treasury’s report is an important step in reconciling America’s confusing and often overlapping regulatory regimes,” Robert G. Pickel, chief executive of the International Swaps and Derivatives Association, said on Saturday. “Hopefully this report can help streamline and improve the competitiveness of America’s financial services sector.”
But while the long-term proposals are unlikely to become law quickly, the Treasury hopes to impose some changes on its own, and to get Congress to approve others this year. Some of those changes seem designed to increase the Treasury’s ability to influence other regulators.
During the Great Depression, Congress forced the separation of the investment banking and commercial banking industries and set up different regulatory systems for each, which seemed appropriate since the government guaranteed deposits in commercial banks but provided no similar benefit for investment banks.
The wall between the two businesses eroded and was eventually taken down by Congress in the 1990s, and the Bear Stearns case indicates that, at least for some investment banks, the risk of a default is too great to allow.
But the Paulson proposal would not give regulators new powers over other investment banks. The proposed prudential regulator would not have authority, since there is no explicit guarantee of its liabilities, and the Fed would be expected to step in to limit risk taking only if the stability of the financial system were threatened.
The proposal also calls for an early merger of the S.E.C. and the Commodities Futures Trading Commission, reflecting the reality that the markets and products they regulate often overlap or compete with one another. The Treasury wants to assure a combined agency would adopt the gentler regulatory approach of the C.F.T.C., which has exempted from regulation many derivatives products that are traded over the counter. The plan also would eliminate the Office of Thrift Supervision, which now oversees savings institutions.
The report drew cautious praise from the hedge fund industry. “The general tone is positive, and moving toward a consolidated regulatory structure is reasonable,” said Richard Baker, a former senior Republican member of the House Financial Services committee who is now chief executive of the Managed Funds Association.
Christopher Cox, the chairman of the S.E.C., also backed the proposal. “The need for better integration of financial services regulation in the United States has never been clearer,” he said.