Updating the regulatory system

Judging by the thundering impact of the housing collapse, something is wrong with financial regulation. Securities and Exchange Commission Chairman Christopher Cox hit the nail on the head recently when he described the current structure of financial regulation as “stovepiping.” Another way of describing it would be “channeling.”

Legislators and regulators have assumed that different parts of the financial system are like streams or irrigation channels, watering different parts of the economy, each of which is largely independent of the other except when they meet in a few limited, well-contained areas.

Each part, therefore, is regulated as if its operations rarely affect the other channels.

That view is obsolete, rendered so by financial innovation, legislative myopia and deregulation, including the abolition of the Glass-Steagall Act and the integration of the securities and commercial banking businesses.

Financial innovation – as evidenced by derivative instruments such as credit default swaps, collateralized debt obligations and collateralized mortgage obligations, which cross traditional boundaries of insurance, banking and securities – has ensured that a failure in one part of the system can quickly overflow its channel into others, as the mortgage meltdown demonstrated.

Legislative myopia led to overlapping responsibilities, especially between the Federal Reserve and the Comptroller of the Currency in the banking area. When two or more agencies have overlapping responsibilities, confusion and poor supervision result. And instead of too much regulation, overlaps can lead to regulatory gaps. For instance, two areas that have been implicated in the current crisis, mortgage brokerage and hedge funds, are largely unregulated.

While major changes in the regulation of the financial system are needed, they must be preceded by a thorough review of what went wrong in our current financial crisis, where our regulatory system is weak and the changes that are necessary to stabilize the system permanently.

Congress also should take care not to regulate so tightly that it chokes off financial innovation.

Perhaps the first step is to identify and eliminate areas of overlapping responsibilities. Another key step is to see if the operations of some of the regulatory bodies can be consolidated to develop broad rivers of regulation rather than narrow channels.

After that, the proposal by Rep. Barney Frank, D-Mass., that the Federal Reserve be given the authority to monitor risks that threaten the broad financial system, should be seriously debated.

Some agency should have that responsibility, and the Fed, with all of its data sources, is the logical candidate.

However, if the Fed is given that responsibility, it must be able to require regular reporting of salient information from the investment banks so that it can have better insight into their financial health and their risk positions.

In fact, consideration should be given to moving supervision of investment banks to the Federal Reserve from the SEC.

Hedge fund regulation should be given to the SEC, and at the very least the commission ought to be authorized to collect more information from the funds about the risks they are taking.

Finally, Congress should consider ways to encourage regular information sharing among the many regulators of the financial system.

It’s time for our nation’s regulatory system to get past channeling and to start focusing on the bigger picture.