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When the Financial Accounting Standards Board released its exposure draft of new accounting rules for special-purpose entities (SPEs), in late 2002, the nation's financial regulators sent FASB chairman Robert H. Herz decidedly mixed signals.

On the one hand, the Securities and Exchange Commission wanted Herz to make the rules effective as soon as possible. SPEs were the prime vehicle for the fraud that brought Enron down, and were widely used by other companies to take liabilities off their balance sheets, obscure their financial condition, and obtain lower-cost financing than they deserved. Not surprisingly, the SEC was anxious to head off other financial fiascos resulting from such abuse.

At the same time, however, the Federal Reserve Board pressed Herz to slow down. That's because the new rules threatened to complicate the lives of the Fed's most important charges: large, multibusiness bank holding companies that happen to earn sizable fees by arranging deals involving SPEs. Stuck between this regulatory rock and hard place, Herz told the Fed and the SEC to get together and work out a timetable that satisfied both constituencies.

And they did. But the rules, known as FIN 46 (FASB Interpretation No. 46), have only recently taken effect in some cases, and have yet to do so in others. While the delay in the rules' effective date may reflect the complexity of the transactions covered by FIN 46 as much as the controversy generated by the rules themselves, the conflict between the Fed and the SEC over the matter stems from a deeper problem: the Fed and the SEC have very different regulatory missions that can sometimes come into serious conflict.

The problem surfaced in December 2002 during congressional hearings on the extensive role that certain banks—including Citigroup, J.P. Morgan Chase & Co., and Merrill Lynch & Co.—played in deceptive transactions involving Enron SPEs. Those hearings by the Senate Permanent Subcommittee on Investigations, led by Sen. Carl Levin (D-Mich.), identified what he and then­ranking minority member Sen. Susan M. Collins (R-Maine) termed "a current gap in federal oversight" of the banks that helped them aid and abet Enron's fraud. "The SEC does not generally regulate banks, and bank regulators do not generally regulate accounting practices overseen by the SEC," notes the report, which went on to say that this "is a major problem and needs immediate correction."

That correction has yet to be made. The onus of doing so is on the Fed, as the chief regulator of the nation's financial system. Yet Fed chairman Alan Greenspan shows little inclination to do much about the problem.

Yes, the markets have recovered from Enron, at least for the time being. But the penalties and other punishment that regulators meted out to the banks for their role in the fraud display at best a worrisome inconsistency. And that suggests that problems arising from the regulatory gap identified by senators Levin and Collins could recur. Unless the gap is closed, it could undermine other regulatory efforts aimed at improving corporate governance. That, in turn, might have a short-term impact on investor confidence, still fragile some two years after Enron's failure. And in the long term, future Enrons could slip through the gap undetected.

If nothing else, the question of what should be done about it deserves a place on the agenda when the Senate considers Greenspan's nomination for a fifth term, as is expected after his current four-year stint ends in June.

No Firewalls
To be sure, both Citigroup and Chase agreed, after their role at Enron was exposed, to avoid new financing arrangements that pose similar legal and reputational risk. And under FIN 46, all deals involving SPEs must be disclosed on the balance sheet of either the bank, the borrower, or a third party. But it remains to be seen how effective the new rules will be in preventing future off-balance-sheet frauds (see "Longer Paper Routes").

Complicating matters is the combination of commercial and investment banking and insurance blessed by the Gramm-Leach-Bliley Act of 1999, which ended the last vestiges of separation enacted by the Glass-Steagall Act and made the Fed the financial system's primary regulator. But while the central bank supervises private banks involved in these lines of business, including Citigroup and Chase, the Fed's primary interest isn't stopping financial fraud, but making sure the U.S. banking system remains safe and sound. "The Fed doesn't even believe in firewalls," says Dimitri B. Papadimitriou, president of the Levy Economics Institute at Bard College.

In contrast to the multiline banks (called "universal," in industry parlance), monoline investment banks such as Merrill are subject to regulation by the SEC, whose regulatory mission is the protection of public investors. With that in mind, the commission sets reserve requirements for Merrill as well as for the broker-dealer affiliates of Citigroup and Chase, along with those of such foreign institutions as the Canadian Imperial Bank of Commerce (CIBC). But the SEC, unlike the Fed, doesn't inspect their operations.

Thus, to prosecute violations of securities law by banks, the SEC depends on bank supervisors to turn over evidence of such activity. Yet the Fed clearly has a reason to look the other way—that is, to ensure the profitability of the banks it oversees. "In doing so, it doesn't care very much about" the interests of investors, charges Papadimitriou. In fact, Chase and Citigroup were treated much more leniently than Merrill and CIBC (see "Unequal Treatment," at the end of this article).

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