The Fed and the SEC: Perfect together

The Federal Reserve Board and the Securities and Exchange Commission met last week to hash out a way to fill the regulatory gaps revealed by the mortgage bubble and its consequences.

We say it is about time.

The need for the coordination of the two agencies in the regulation of the banking and financial sectors after the abolition of the bank holding company constraints of the Glass-Steagall Act seems obvious now, and 20-20 hindsight is always wonderful, but after the repeal the regulators should have adopted Ronald Reagan’s dictum, “Trust, but verify.”

The Glass-Steagall Act was passed in the middle of the Great Depression because many people thought that bank underwriting activities had put deposits and depositors at risk and contributed to the economic collapse.

It forced banks to decide whether they would take deposits or underwrite securities. Investment banks were prohibited from taking deposits, and deposit-taking banks, or commercial banks, were prohibited from underwriting securities.

The law’s repeal in 1999 allowed Citigroup Inc., JPMorgan Chase & Co., both of New York, and other commercial lenders to underwrite mortgage-backed securities and collateralized debt obligations — the activities that have caused them to take huge write-offs this year.

As a result, many economists and analysts think that the repeal of Glass-Steagall helped create the mortgage bubble, though it was by no means the only cause.

The ideas behind the repeal of Glass-Steagall were that additional competition between commercial banks and investment banks would be good for consumers and that the greater transparency of modern financial reporting would keep the commercial banks from taking on too much risk.

The losses that the banks have incurred amid the mortgage crisis this year show that as water finds cracks in walls or floors, so the financial services industry finds gaps in regulation or oversight and that competition can sometimes lead to unsound practices.

Both commercial and investment banks found the gaps in between the Fed’s oversight of commercial banking activities and the SEC’s oversight of investment banking activities, and they also found creative ways to keep liabilities off their books — structured investment vehicles, for example — while avoiding clear disclosure of their risk positions.

Their losses also show that both commercial and investment bankers overestimated the sophistication of their risk control techniques and had forgotten the history of the 1930s.

Greater coordination between the Fed and the SEC probably would include the exchange of more information.

For example, the Fed would reportedly receive information from the SEC on investment banks’ trading positions, their leverage and their capital requirements.

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This is an obvious improvement, given that the Fed has now become the lender of last resort to the major investment banks.

The SEC would receive information from the Fed on short-term financing from the banks that clear trades and hold collateral for securities firms.

Most likely, this will be a stop-gap measure until Congress gets around to revamping the regulation of the financial services industry.

That will be a major project that must be preceded by academic studies of exactly how the mortgage bubble occurred and how much carelessness, misaligned risk and rewards, and outright fraud each contributed to the disaster. Congressional hearings aimed at devising sound solutions should also be held. It is unlikely to happen until this year’s elections are well behind us.

Meanwhile, the Fed and the SEC could pool their resources to prevent further damage while doing their own research into where the weaknesses in the regulations are and how those weaknesses can be eliminated.

In fact, the closer coordination of the two powerful agencies should throw into clear relief where changes in regulation and disclosure are necessary.

It is to be hoped that when reform comes out of Congress it will make permanent the new coordination between the Fed and the SEC.