Washington Split Over Regulating Wall Street

WASHINGTON — As Congress and the Bush administration struggle to contain the housing and credit crises — and prevent more Wall Street firms from collapsing as Bear Stearns did — a split is forming over how to strengthen oversight of financial institutions after decades of deregulation.

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AP

Democratic lawmakers in Congress and the Bush administration agree that the meltdown in credit markets exposed weaknesses in the nation’s tangled web of federal and state regulators, which failed to anticipate the effect of so many new players in the industry.

In Congress, Democratic lawmakers are drafting bills that would create a powerful new regulator — or simply confer new powers on the Federal Reserve — to oversee practices across the entire array of commercial banks, Wall Street firms, hedge funds and nonbank financial companies.

The Treasury Department is rushing to complete its own blueprint for overhauling what is now an alphabet soup of federal and state regulators that often compete against each other and protect their particular slices of the industry as if they were constituents.

But the two sides strongly disagree about whether, after decades of a freewheeling encouragement of exotic new services and new players like hedge funds, the pendulum should swing back to tighter control.

One central battle is likely to be over tightening supervision of the risk-management practices of Wall Street investment banks and perhaps requiring them to keep higher cash reserves as a cushion against unexpected trading losses.

The Democratic proposals would subject Wall Street firms to the kind of strict oversight that banks have had for decades. If firms like Goldman Sachs and Merrill Lynch were required to set aside substantially bigger capital reserves, they would have that much less available for lending, trading and underwriting new securities.

Wall Street firms played a central role in packaging and financing trillions of dollars in high-risk home mortgages, and the losses tied to those mortgages are at the heart of the deepening crisis in the financial markets that has pushed the economy to the brink of a recession.

“You need regulation that is adequate to the scope of innovation and to the scope of activity,” said Representative Barney Frank, the Democrat of Massachusetts who is chairman of the House Financial Services Committee.

Mr. Frank said last week that Congress should consider creating a new regulator — or giving the Federal Reserve greater powers — to oversee all financial markets and intervene when necessary.

Mr. Frank, saying that government had failed to keep up with the explosion of new financial instruments, said regulators needed to re-examine capital reserves, risk-management practices and consumer protection without regard to whether companies were commercial banks, investment banks or nonbank mortgage lenders.

“You do it right, and it’s pro-market,” Mr. Frank said in an interview. “Right now, we have an investors’ strike going on, and restoring investor confidence is a top priority.”

But industry groups warn that heavy-handed regulation could dry up investment capital just when the economy needs it most.

“If we don’t tread very carefully on restructuring a very complex financial system, we might stifle the necessary animal instincts of a free market,” said Mark A. Bloomfield, president of the American Council for Capital Formation, a business advocacy group. “Every day, the cries of populism grow stronger and could trample good economic policy.”

Wall Street firms have also been major contributors to both political parties, and they are certain to oppose tough new restrictions. The Treasury Department appears torn.

On the one hand, Treasury officials say they are convinced that today’s regulatory system is fragmented and out of date. The Treasury secretary, Henry M. Paulson Jr., has talked about the need to re-examine capital requirements for financial institutions.

Philosophical Opposition To Restrictions

But both President Bush and Mr. Paulson, a former chief executive of Goldman Sachs, remain philosophically opposed to restrictions and requirements that might hamper economic activity.

“What we’re looking at in our blueprint is how to make our regulatory structure more efficient, less duplicative and more in line with today’s capital markets,” said David G. Nason, assistant secretary of the Treasury for financial institutions. “We’ve got five regulatory agencies focused on depository institutions. We’re one of the only countries in the world that separates securities from futures, and our regulation of insurance is solely at the state level.”

But the entire discussion took a stunning turn last week after the Federal Reserve abruptly stepped in to prevent a systemic collapse on Wall Street.

Invoking its authority as the nation’s lender of last resort, the Fed offered a $30 billion credit line to JPMorgan Chase to help it take over Bear Stearns, which was about to go bankrupt. Even more significant, the central bank announced that it would lend hundreds of billions of dollars to big investment banks through its “discount window” — an emergency loan program that had been reserved strictly for commercial banks.

The Fed’s involvement highlighted what many experts see as the growing disparity in regulation between Wall Street firms and commercial banks. Commercial banks submit to greater regulation, partly in exchange for the privilege of being able to borrow from the Fed’s discount window.

But starting last week, Wall Street firms were getting the same protection without subjecting themselves to additional scrutiny. Some administration officials said they had little choice but to regulate Wall Street firms more closely.

“In the short term, it would make sense to have one umbrella regulatory agency,” said Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corporation, which insures deposits at banks and thrift institutions and is one of several federal bank regulatory agencies. “Capital levels are the most important tool we have at the F.D.I.C., and investment banks have lower capital levels than commercial banks.”

Among Democrats and Republicans alike, there is a growing consensus that the existing regulatory structure, involving more than half a dozen federal agencies as well state offices, were not equipped to prevent a host of questionable practices that aggravated the housing and mortgage meltdowns.

The practices included abusive loans by independent mortgage brokers; risky and opaque transactions by financial institutions; credit-rating decisions that turned out to be wildly optimistic; and the underwriting of loans by mortgage brokers that were often based on fraudulent or inaccurate information.

Just as the Sept. 11, 2001, attacks highlighted deep cracks between the nation’s intelligence and law enforcement agencies, the credit and housing crises are forcing policy makers to scrutinize cracks between oversight agencies that aggressive mortgage brokers and deal makers were able to exploit.

“To anyone who looks at the regulatory system over the last few months, it is quite clear that the financial world has evolved dramatically and the regulatory system has not caught up,” said Senator Charles E. Schumer, the Democrat of New York who is the chairman of the Joint Economic Committee.

Even though Mr. Schumer represents Wall Street’s home state and has many financial supporters on Wall Street, he said he was on “the same page” as Mr. Frank and was preparing his own plan for regulatory overhaul. Senator Christopher J. Dodd, the Democrat of Connecticut who is the chairman of the Senate Banking Committee, is preparing legislation as well.

A Deregulatory Mind-Set

But Mr. Schumer cautioned that the Bush administration’s deregulatory mind-set could make it difficult to do anything this year.

The Treasury Department is hoping to unveil its own blueprint for regulatory overhaul in the next few weeks. Last week, Mr. Paulson acknowledged that the problems exposed by the housing crisis were diffuse and complex and could not be solved with a single action. But he suggested that he did not want to take any drastic regulatory steps while the financial markets remained in turmoil.

“The objective here is to get the balance right,” Mr. Paulson said last week. “Regulation needs to catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient or cut off credit to those who need it.”

Given the philosophical differences about the value of government regulations, some experts were skeptical that Congress and the Bush administration would agree on more than cosmetic changes.

“There is a political will, but I’m not certain that it can overcome longstanding philosophic objections to dealing with free markets in a crisis environment,” said Arthur Levitt Jr., the chairman of the Securities and Exchange Commission under President Bill Clinton.

The Federal Reserve’s recent decisions to lend hundreds of billions of dollars to the nation’s biggest investment banks, and to underwrite JPMorgan Chase’s takeover of Bear Stearns, may have changed the balance of power.

The Fed reported on Thursday that investment banks had quickly taken advantage of the lending program and had taken out $28.8 billion in new loans by Wednesday. That did not include any loans that JPMorgan Chase took on through the $30 billion credit line it received as part of its deal to acquire Bear Stearns.

Goldman Sachs, Lehman Brothers and Morgan Stanley voluntarily disclosed that they had taken loans under the Fed’s new program, in part to reduce any stigma about it. But the volume of borrowing suggests that many other Wall Street firms took advantage as well.

The new borrowing could strengthen Mr. Frank’s hand in calling for tougher regulation, because it immediately raises the question of why investment banks should be allowed to borrow from the Fed without subjecting themselves to the same kind of oversight that commercial banks face.

But the broader issue for both Congress and the Bush administration is that even bank regulators did little to slow the explosive growth of high-risk subprime mortgages, many of which were “liar’s loans” that did not require borrowers to verify their incomes.

At least four federal agencies — the Federal Reserve, the F.D.I.C., the Office of the Comptroller of the Currency and the Office of Thrift Supervision — have some jurisdiction over mortgage lending. Making matters more difficult, state banking regulators had jurisdiction over the fast-growing array of nonbank mortgage lenders, which accounted for about 40 percent of new subprime loans before that market collapsed last August.

Except for the Federal Reserve, all of the federal bank agencies receive funding from fees paid by member institutions, and some specialists have long argued that the agencies competed with each other to woo institutions with lighter regulation.

“There was no federal coordinated oversight, and as a result there was a competition to reach the bottom, both in federal and state organizations,” said Brian C. McCormally, a former enforcement chief at the Office of the Comptroller of the Currency.

Ms. Bair of the F.D.I.C. cautioned that industry and government turf battles would make it difficult to agree on a single regulator, especially a strong one. But she said the need for one was clear.

“We need to go in the direction of more regulatory consolidation,” Ms. Bair said. “It would make more sense to have some type of umbrella agency, if for no other reason than facilitating information.”