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And while he argues that the current regulatory structure is outdated, Mr.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.”