Notes on Financial Reform

boardroom.jpgFinancial system reform debates are about to take place in earnest. For some, these may involve standard oppositions between those with more confidence in markets compared to those with more confidence in regulation. But superior policy may result from substantive analysis of issues that transcend such philosophical, political or ideological dispositions.

Two of the more important proposals may appear to be competitors reflecting polar dispositions. One, championed by outgoing Treasury Secretary, Henry Paulson, imagines a consolidated oversight structure with considerable latitude to promote US capital market competiveness. Another, championed by incoming Obama advisor, Paul Volcker, former Federal Reserve Chair, likewise outlines a consolidated structure, but with far more stringent controls intended to limit the size and risks of US financial institutions.

Despite the evident philosophical and perhaps political opposition that the Paulson and Volcker proposals may reflect, astute participants in policy debate will recognize both as essentially opening positions in the forthcoming public policy negotiations. For them, needed is balance between spontaneous market coordination and planned regulatory moderation. The exact balance may differ across different kinds of markets and constituents. In general, the following clusters of topics will be implicated.


Participants must face the traditional fragmented regulatory system prevalent in the United States. Oversight roles are split between state and federal authorities, within the federal government, and across various financial services sectors, banking, insurance, securities and futures. An emerging consensus, including between the Paulson and Volcker proposals, appears to doubt the efficacy of this fragmented structure, which undoubtedly poses costs. But there is also value to such dispersion of regulatory authority.

Debate will have to deal with reforms to the financial regulatory system that have been forged, on an ad hoc basis, by the extensive federal government interventions, since March 2008, into all those financial services markets, plus the corporate commercial paper market. Functional reform has occurred but its exact resulting shape is difficult to spell out precisely. Lessons from that ad hoc approach may be relevant to gauging what regulation should be implemented ex ante and what to supply ad hoc or ex post. Yet it may be too soon to discern those lessons.

Analysis must contend with the consequences of globalization. This is a new phenomenon, whose effects can cut multiple ways for the United States. Successful proponents of tighter US federal regulation may be disappointed if it remains possible for US enterprises to operate with more flexibility in other markets. They may wish to search for a super transnational regulator. Market devotees may more willingly accept federal preemption or intervention, compared to promoting state authorities, in the name of boosting US capital market competiveness along with increased global regulatory competition.

Discussion likely will debate the nature of authority that should be exercised. Examples of competing approaches include prudential, supervisory, regulatory or enforcement-oriented. Other expressions talk of light touch or principles based regulation compared to intensive or rules based regulation. These various approaches are designed to achieve different purposes and may vary with the industry under discussion.

Participants may also disagree on the extent to which self-regulatory industry organizations should be used. Examples include the Securities Exchange Commission’s delegation of authority to the New York Stock Exchange and the Financial Industry Regulatory Authority. To what extent are these optimal vehicles in a financial regulatory system?

Ultimately, attention must be given to objectives. In theory, at least, unbridled free markets may yield a wider range of outcomes over time, from extraordinary prosperity to considerable despair; markets constrained by substantial regulation may yield a far narrower range of outcomes. Preferences may vary for high volatility and greater upside versus high stability and lesser upside. In general, the United States has shown a stronger appetite for the former compared to many other nations. Even so, the trade-offs suggest there may also be important distributional considerations at stake.

Again, the optimal balance may also vary with particular markets, such as banking, insurance, securities and futures. This issue may return to practical questions concerning whether it is desirable to consolidate governmental authority in a single or few agencies or embrace the traditional fragmentary approach. It may also suggest why many of these issues lend themselves to broader philosophical, political and ideological dispositions. Pragmatists conducting deeper levels of analysis may have their work cut out for them when grappling with those dispositions in debate getting underway.

Hat Tip: Stephanie Cuba

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