Financial Regulatory Reform: A New Foundation: Rebuilding Supervision and Regulation
Practically everyone now agrees that the steep recession of the last two years was caused, at least in part, by lack of government oversight of the financial industry. The half-dozen or so federal agencies that are responsible for regulating the financial community ignored the dangerously risky activities of bankers and traders; so did the Federal Reserve and the US Treasury.
It is true that these agencies faced a tangle of complexities. The institutions deeply involved in the recent crisis include traditional commercial banks that take savers’ deposits as well as investment banks, mortgage brokers, credit-rating agencies, hedge funds, money market mutual funds, insurance companies, and government-sponsored enterprises such as the Federal National Mortgage Association (Fannie Mae).
Among them, these entities control many trillions of dollars, a large portion of which is in the form of derivatives contracts, investment vehicles that enable banks and other investors to buy and sell securities with little capital and also manage risk. (As just one example, if I believe the price of gold will go up, I do not have to buy the bars of gold: for much less money, I can buy a contract—a derivative—that is accepted by a “counterparty,” who will pay me if the gold price rises within a certain period of time, but will keep my payment for the contract if the price falls.) These derivatives, however, are traded over the counter and out of sight of regulators. In recent years special kinds of derivatives, known as credit default swaps, were sold in enormous volume as insurance against risky, mortgage-backed investments but with no government regulations to help insure that counterparties would meet their obligations to pay. Moreover, the interests of all these institutions are well represented in Washington by influential lobbyists. According to the Center for Responsive Economics, the finance, insurance, and real estate industry spent $223 million on lobbying in the first half of 2009, second only to the health care industry.1
President Obama promised soon after taking office to reregulate the financial markets in a comprehensive regulatory bill. The administration released its proposals on June 14 in “Financial Regulatory Reform: A New Foundation,” a lengthy white paper—not extensively covered by the press—that was overseen by Treasury Secretary Timothy Geithner and Lawrence Summers, the director of the National Economic Council, who served as Treasury secretary during the Clinton administration.2 Rarely has an administration had a better opportunity to explore deeply how modern financial markets work and have evolved, and how readily they can be abused.
On balance, the white paper, though it contains several worthy ideas, was disappointing. Offering little more than a wide-ranging summary of existing regulatory proposals, it did not attempt to analyze why the crisis occurred…
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