Major Overhaul of Financial Regulations Is Expected

If the banking crisis of 2008 fails to do the trick, then there is little hope Washington will ever summon the will to reorganize its creaking, disjointed system of financial regulation.

After years of failed attempts to modernize how the government oversees Wall Street and the banks, and with the U.S. election just days away, financial industry lobbyists and legislative aides were saying 2009 will likely be the year.

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No matter who wins the White House, Congress is expected to make a serious run at a top-to-bottom restructuring of the government's seven big financial oversight agencies and their more than 15,000 employees, said lobbyists and aides.

Starting in the House Financial Services Committee chaired by Massachusetts Democratic Rep. Barney Frank, the agencies will face pressure to justify their roles amid accusations that they once again failed to detect and prevent a major financial debacle.

"There will be a significant push for regulatory reform," Martin Baily, former chairman of the Council of Economic Advisers in the Clinton administration, said in an interview.

"We've learned that the way we've had things didn't work very well," said Baily, a senior fellow at the Brookings Institution, a Washington, D.C. think tank.

The $700-billion bank bailout program approved earlier this month ordered a report to Congress by April 30 from the Treasury secretary—presumably whoever replaces Henry Paulson—on market conditions and the financial regulatory system.

That report will follow an earlier reform blueprint put forth seven months ago by Paulson that Senate Banking Committee Chairman Christopher Dodd at the time called "a wild pitch ... not even close to the strike zone."

Paulson recommended formalizing and expanding the President's Working Group on Financial Markets, which is now only an informal inter-agency committee; giving the Federal Reserve more power to manage "systemic risk" in the economy; and setting up a national insurance regulator.

He also called for merging two bank regulators—the Office of Thrift Supervision, and the Office of the Comptroller of the Currency—as well as merging two market regulators—the Commodity Futures Trading Commission (CFTC), and the Securities and Exchange Commission (SEC).

Uphill Struggle

Potential moves like these are still alive as Congress looks ahead.

The Democratic candidate for president, Barack Obama, and Republican candidate John McCain, have talked about shaking up the financial regulatory system, while offering few specifics.

If Democrats make big gains in Congress, as is widely expected, they will probably claim "authority to do something major on regulation," Baily said.

"Frank is going to hold some hearings ... This will be a priority." But some experts warned that pulling off real change in the federal bureaucracy is not as easy as it sounds.

"The politics of Congress and the agencies themselves tend to fortify inertia," said Joel Seligman, an expert on the history of financial regulation and president of the University of Rochester, at a congressional hearing last week.

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For instance, after the October 1987 stock market crash, a presidential task force recommended that the Fed take on new intermarket regulatory powers and change appeared likely.

But, Seligman recalled, "Within one month, this proposal was effectively dead," torpedoed by unenthusiastic testimony on it from former Fed Chairman Alan Greenspan, as well as competing oversight jurisdictions by two congressional committees that prevented the proposal from making progress.

To prevent the same outcome this time, Seligman said, Congress should form a select committee to handle the issue, which may have more momentum than in 1987 due to the current crisis' severity and wider stock ownership by voters today.

Frank—who has long advocated structural change among regulators—last week called the suggestion of a select committee "a reasonable idea."

Recent Market Events

Earlier this month, the President's Working Group—which includes Paulson, Fed Chairman Ben Bernanke and SEC Chairman Christopher Cox—said "recent market events" highlighted the need for an overhaul of rules on financial behavior.

Cox said last week that regulatory gaps need to be closed and that he supports merging his agency with the CFTC.

The "recent market events" cited, of course, referred to the worst U.S. financial crisis since the Great Depression.

Triggered by the collapse of an historic home price bubble, the housing market has plunged and foreclosures have soared, breaking the backs of over-optimistic mortgage-backed bonds and other exotic securities that have left global credit markets paralyzed by fear and uncertainty.

Stock markets have swooned, hammering equity investors, and the Bush administration has responded with a dizzying array of programs, costing billions of tax dollars and injecting the government into the economy to an extent not seen in decades.

In the process, the old investment banking model has faded almost out of sight with the bankruptcy of Lehman Brothers , the acquisitions of Merrill Lynch and Bear Stearns, and the reorganization into bank holding companies of Goldman Sachs and Morgan Stanley .

The bubble, its excesses and the seismic shifts in the financial terrain that followed only underscore the hopelessly inadequate state of financial regulation, said Connecticut Republican Rep.

Christopher Shays at a hearing last week.

"The jerry-built network of national and global market watchdogs clearly lacked the information, coordination and agility necessary to keep pace with the blindingly complex machinations of the modern financial bazaar," Shays said.

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