Capital Markets

More Than Just Repairs

The Obama administration unveils core elements of its financial-regulation agenda.
Economist StaffMarch 27, 2009

Tim Geithner has not had an easy time of it, but he is probably too busy to dwell on his tribulations. Three days after unveiling a plan to cleanse banks of their troubled loans and securities, America’s treasury secretary was back in front of a congressional committee outlining proposals to extend the government’s grip on the financial system. These would mark the biggest expansion of federal regulation since the 1930s.

The new framework has four parts: containing systemic risks; protecting consumers and investors; streamlining the regulatory structure; and international co-ordination. Mr. Geithner had little to say about the last three, promising details in the coming weeks. Instead he focused on systemic risk, in part because that will be a focus of discussion at the G20 summit in London next week-and European countries have been pressing the Americans to tackle the issue-but also because the Obama government itself sees it as the priority in the wake of Lehman Brothers’ failure and the messy rescue of American International Group (AIG).

Mr. Geithner urged Congress to help him enact “new rules of the game”, not “repairs at the margin”. His priorities are twofold. First, the government needs the authority to take over troubled non-banks whose failure could destabilise markets and to wind them down in an orderly way by selling assets, renegotiating contracts and so on. It is largely because it lacked such power that the AIG bail-out has been a fiasco. The Treasury, which has financial heft, suggests sharing this authority with the Federal Deposit Insurance Corporation, which has experience handling failed banks.

The other pressing issue is the creation of a “systemic-risk regulator”. This would help to police large financial firms of all stripes and keep a lookout for emerging dangers across the system, such as the shoddy loan underwriting and credit bubble that helped to cause this crisis. Government officials want the Federal Reserve to take the job on, but its central role in the AIG scandal has weakened its credentials in congressional eyes.

One way to strengthen the system, Mr. Geithner believes, is to force banks to plump up their capital cushions. They should do this “counter-cyclically”, building up their defences in good times so they have more protection against losses in downturns, thus dampening rather than amplifying credit cycles. The rules currently work the other way, allowing banks to sail closer to the wind when times are good.

For the first time, the administration also plans to throw a regulatory net over non-bank pools of capital, such as hedge funds. They may not have caused the crisis, contrary to fears beforehand; indeed, they have been hurt more by the demise of banks and investment banks than the other way round. Nevertheless, the government wants all funds over a certain size to register with the Securities and Exchange Commission and provide it with more information about their assets and leverage. The very largest, if deemed systemically important, could become subject to “stringent” capital requirements. These rules may be extended to money-market funds-a huge and supposedly stable industry that wobbled alarmingly after Lehman’s fall.

The last plank of the proposed systemic framework is stronger oversight of derivatives, such as the credit-default swaps that detonated within AIG. Those that are traded over the counter (away from exchanges) will face federal regulation, and supervision of dealers will be tightened. To cut “counterparty risk”, all standardised over-the-counter contracts will have to be cleared through a central entity. Firms are already jostling to win this business. “The days when a major insurance company could bet the house on credit-default swaps with no one watching and no credible backing…must end,” said Mr. Geithner in his testimony.

Many details remain to be hammered out. It is not clear, for example, who would pay the costs of handling bust non-banks; one idea is to charge a fee to all firms deemed systemically important. Some question whether a risk regulator would really be able to do much about looming dangers it identifies in good times, when everyone else is too busy enjoying themselves. Moreover, the politics of regulatory reform are sure to be messy-and most of the government’s proposals require legislation.

There is also a debate to be had about where regulation needs to be tougher, and where it should simply be smarter. As Mr. Geithner acknowledged, “there were failures where regulation was extensive and failures where it was absent.” Banks, after all, blew up spectacularly despite being covered in red tape. Nevertheless, this week’s proposals make clear that the accent for years to come will be on re-regulation more than innovation. For the past quarter of a century, politicians and regulators stood back from financial markets, trusting them to set their own tolerance for risk. They are now wading back in.