Washington Backwards on Fin Reg

money-in-dcIf Treasury Secretary Timothy Geithher has his way, two big mistakes appear to be forthcoming from the Obama Administration on financial regulation, born of an atmosphere in which any kind of reform seems possible. A quick quiz illuminates:

1.  Suppose someone you put in charge of overseeing banks did a terrible job supervising them while someone you put in charge of mutual funds did a reasonably good job supervising them. If banks failed while mutual funds prospered, would you (a) increase the power of the bank supervisor and decrease that of the fund supervisor or (b) correct the failings of the bank supervisor and reward and maintain the fund supervisor? The correct answer is (b) but the Administration is about to propose (a), by stripping the Securities and Exchange Commission of power and expanding the Federal Reserve’s power.

2.  Suppose a system-wide financial crisis spread across the land that gave you an opportunity to revise the prevailing oversight system of relevant financial institutions. Would you (a) authorize a formal investigation of the source of problems to identify tailored solutions and follow up with legislative corrections or (b) begin with legislative overhauls followed by a formal investigation? The correct answers is (a) but the government is choosing (b). The House and Senate have approved legislation now heading to the President’s desk for signature to start the investigation, while simultaneously writing legislation to be enacted long before investigation is complete.

The case to expand the Fed’s powers will be made under the fashionable heading of the need to have a single super-senior risk regulator able to oversee all institutions posing systemic risk. Participants should not be misled. In effect, what appears to be happening is the banking industry exercising its considerable influence to regain market share it has lost to the mutual fund industry in recent decades.

The Fed, with Mr. Geithner as a senior official, did a terrible job that enabled the financial crisis. The Fed had oversight of commercial banks that made the mortgage loans and side bets that cost the economy. The Fed led the bailout of those very institutions, among others, in what so far are unsuccessful or costly efforts. The Fed has never had much interest in protecting investors, having a mandate for systemic safety and soundness. It does not have an aggressive enforcement record. (Note how few of the hundreds of failed or rescued banks have been faced with Fed enforcement actions for unsound or unsafe lending practices.)

 

True, the SEC, under former Chair Christopher Cox, did a terrible job overseeing the investment banks that promoted those mortgage loans through side bets that also went sour. On the other hand, the SEC has had essentially no role in the bailouts. It has a strong tradition of investor protection, having precisely that mandate. Despite Cox’s laxity, the SEC is traditionally a strong enforcement agency and certainly has the power quickly to reestablish that reputation.

More generally, notice where the failures have been concentrated. More than 100 banks, all subject to Fed oversight, have failed and scores have received massive infusions of capital from the Fed and the US Treasury. Many closed entirely. Of money market mutual funds, all subject to SEC oversight, only one has failed (Reserve Fund, which failed mainly because of excessive exposure to debt of Lehman Brothers, which the Fed and Treasury mistakenly allowed to fail).

In recent decades, a gradual but massive shift in market power has occurred from the Fed’s commercial banks to the SEC’s mutual funds. Some 40 million individuals own mutual fund money market interests, representing about $3 trillion. Growth in money market funds represents decline in bank deposits. In turn, those funds invest that money in corporate commercial paper, a further competitive threat to banks that traditionally played leading roles in the commercial paper market.

Banks are lobbying the Obama Administration and Congress to increase Fed powers and reduce SEC powers. Is it too cynical to suppose this would improve banks’ ability to recapture some of that market share lost to mutual funds in recent decades? It is not surprising that Tim Geithner, consummate banking industry insider, supports this, or that he could get backing from his long-time friend and Obama advisor Paul Volcker. Less supportive is likely to be Arthur Levitt and other former SEC officials, although it does not appear that current SEC Chair Mary Schapiro has spoken publicly on the coming proposals. Yet somebody needs to stand up for investors.

HT: Lynn Turner, former SEC Chief Accountant

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1 Response

  1. Suppose “a formal investigation of the source of problems” would find you were one of them?