Financial Regulatory Reform
Of all the questions circling the halls of congress, the question of whether or not to reform financial regulation seems to be one that is generally agreeable—finally we’ve found something. Unfortunately, the larger question is, “Exactly how should the vast regulatory framework of the United States be changed in order to more effectively regulate the financial services industry?” The answer to the question lies in an evaluation of what parts of the system failed.
First, the Securities and Exchange Commission (SEC), Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) all have rules and regulations that somehow failed in their application. The rules were good, the laws were good; however, the application of the rules failed to identify risks and violations on the part of some industry participants.
If the rules are there and were somehow not applied, we can hardly believe that additional rules will fix the problem. There must be a better way to identify problem areas and apply rules that we already have. Rather than create new rules, can’t we just enforce the rules we have?
Second, the large banking institutions found themselves in trouble, in large part, because of the large amounts of leverage in their investment structures that were allowed to exist because regulators allowed it. Invariably, investments will sometimes, not turn out the way they were originally intended. As parts of these highly leveraged institutions began to have trouble, it caused a ripple effect throughout the institution that grew and became contagious.
If the regulation can effectively manage or enforce rules regarding investment and institutional leverage, the larger risks of the financial markets would be reduced exponentially. The current rules and regulations allow regulators to establish limits on leverage in most markets. If these current rules had been effectively used, it may have minimized or eliminated the problem as well as the inter-firm ripple effects.
Third, because of the size of financial leverage and the transactions in the system, firms found themselves exposed—directly and indirectly—to problems at competitor banks. If one bank went down, others were also exposed in a significant way. This exposure existed because certain, very large, transactional instruments (primarily swaps) were held as privately negotiated transactions. As one firm owed another firm a large amount on the basis of a transaction, the potential default of the owing firm would have caused a sizeable problem for the receiving firm. This is because the contracts were not standardized, cleared on a formal exchange or structured with an intermediary guarantor.
By bringing these securities onto formal exchanges and standardizing the contracts, an intermediary counterparty could essentially eliminate this counterparty risk. Based on the experience of the past two years, this is one change that could be significant and effective.
The proposed 1,300 page bill in congress is more an attempt to prevent all future recessions and less an attempt at a solution to the core problem. The significant danger in a bill of this type is that as more regulation is created, more work-around systems will also be created and more rules will not be enforced because of the complexity of the regulatory system. It seems that as we create more regulation, we make it more difficult to identify the next disaster.
The solution to the regulatory problem is first, enforce the laws already on the books; second, reduce the amount of leverage in the system; and third, bring all products—including products that have yet to be created—onto regulated exchanges, in standardized contracts with clearinghouse services.
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