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Making Financial Regulation Work: A Breakdown of the Options

This is part of a series on The Hearing called "Making Financial Regulation Work." This guest post was written by University of Pennsylvania professor David Zaring.

There are many, many proposals for reforming the financial regulatory system, from Congress, experts, academics, industry groups – you name it. How should we think about them?

I’d look to the fundamentals. The options can be broken down into three or four categories. For today, let's go with old and new -- or, at least, events-driven – and Democratic and Republican. There may be other ways to organize regulatory reform, but thinking about the matter along the lines of a few principal choices is a lot easier than addressing each of the myriad recommendations on their own.

First, there is the old, pre-crisis regulatory system, often termed “creaky” or fragmented, but also familiar. If the most recent rumors from Capitol Hill are to be believed, the old ways have real survival potential. And they should. The system had its merits and has long had its defenders, particularly those who believe that a little competition between regulators is a good thing.

The old system involved a highly fragmented set of overseers, distributing authority between federal and state governments and across various agencies within both levels. The system was disorganized but battle-tested and built out of repeated reforms in a patchwork effort not to repeat the mistakes of the last business cycle. It brought, at its best, creative, competitive and disaggregated oversight to the financial system. You do not hear much praise for this system from the experts, but dismantling it wholesale, given the way it presided over a lot of good years for finance, should not be done lightly.

Second, there is the reformed-on-the-fly system that the current crisis has created, a kind of de facto quasi-centralization of financial supervision, enabled by government debt and equity financing. The bailouts have made the Treasury and the Federal Reserve the closely coordinated twin peaks of financial supervision.

The government’s crisis response changed the organization of financial institutions, shutting down investment banks and federalizing and nationalizing other firms, including insurance companies and money-market funds. It shunted the Securities and Exchange Commission to the side and created a de facto hierarchy of banking regulators, with the Fed and Treasury at the top. The approach is ad hoc but has added to the arsenal market intervention, nationalization and, above all, deals.

Third, there are the proposals, including the Treasury’s so-called Paulson plan, authored during the last administration. The blueprint would rationalize and centralize financial supervision, housing, it appears, much of the supervisory power in the Treasury Department, a politically accountable institution.

The Paulson blueprint also contemplated the delegation of much of this newly obtained authority back to industry itself, presuming that self-regulation through stock exchanges, professional associations and open markets might do better than the sorts of rule-based oversight that institutions like the SEC used to provide.

And not so different, but perhaps fourth, there is the Paulson plan’s Democratic alternative. Pending release of a formal proposal by the Obama administration, it can perhaps be represented by a report on financial regulatory reform issued by the Group of Thirty, which was chaired at the time by Obama adviser Paul Volcker. Volcker’s vision also prescribes formal centralization of financial regulation, though it appears to prefer centralization in an independent, less politically accountable and more expert regulatory institution. Volcker’s model appears to be the Federal Reserve, rather than the Treasury, and rather than delegating regulation to the private sector, he suggests that a more traditional command-and-control model might be appropriate.

These solutions to our problems with financial oversight are not just alternatives. They essay different ways of thinking about financial markets and their imperfections. They include the old way of regulating markets, the crisis-driven way and the hopes for different ways in the future. Each offers a vision of not just what can go wrong, but also what is valuable about finance, along with a theory of regulation that either embraces or holds suspect disinterested regulatory expertise and politically responsive governance.

Which should we choose? That is what Washington politicians will be debating for much of the rest of the year. As the debate unfolds, you can see which political actors push for which of the approaches listed above. And if you want to read more, I have written a paper with Larry Cunningham of George Washington University on these approaches. You can download it here.

-- David Zaring is an assistant professor of legal studies at the University of Pennsylvania's Wharton School of Business. He also blogs at the Conglomerate.

By Tim Lawson  |  June 5, 2009; 10:15 AM ET
Categories:  Banking , Regulation  
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The hearing that Simon Johnson posted about yesterday can be found here:

The video is about three hours long, and very instructive. What's a bit scary is that a Farm-oriented committee was holding this hearing.

Prof. Lynn Stout's testimony provided the best "big picture" of the history derivatives and the issues to be dealt with. The other panelists were well spoken, but three of them were from organizations involved deeply with derivatives, and seemed to tailor their testimony only to the value of these "products" as applied to their particular situations. None seemed totalk about the role of CDSs (in particular) in the "meltdown". Towards the end of Panel #2's time, Ms. Stout very forcefully reminded her fellow Panelists of the trillions of taxpayer dollars that had to be pumped into the financial system to backstop the system's collapse. This fact did not seem to be on the horizon for the derivatives users on the Panel.

The good news is that everyone on the Panel was in favor of regulation of some sort or another.

Posted by: wmartin46 | June 5, 2009 12:25 PM | Report abuse

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