Congress must enact regulatory reforms carefully

President Obama’s regulatory reform proposals provided a broad outline and left many of the details to Congress. Ideally, before filling in those details, Congress will gather evidence on what caused the financial crisis, and where regulation actually broke down.

Congress needs to take the time to hear expert advice on how to fix regulation, so as to prevent similar crises without stifling the financial markets and significantly raising the cost of capital. Only then should it begin drafting legislation.

Unfortunately, neither the Obama administration nor Congress has taken the time to study the evidence. Rather, they have made assumptions about what caused the crisis and where the weaknesses in the regulatory framework lay, and congressional committees are rushing to draft regulatory reform bills.

This is like trying to improve the safety of the space shuttle fleet after the Challenger disaster of 1986 without holding hearings into the causes and developing a detailed plan to make the necessary repairs and improvements.

The National Aeronautics and Space Administration held exhaustive hearings into the causes of the fatal explosion before making repairs and letting shuttles fly again. The same should be done by Congress before making detailed changes to the regulatory system.

So far, Congress has not even developed a clear set of principles to guide it in deciding what each part of the reform agenda should accomplish.

One of the key goals of the reforms should be to eliminate overlaps and gaps in regulatory authority. Congress should look at whether President Obama’s proposals go far enough toward achieving that goal.

Some argue the overlaps and gaps could be reduced by cutting the number of agencies, and that this would also improve the clarity and coherence of the regulations and make it harder for regulators to avoid responsibility for failures.

Meanwhile, others argue that concentrating authority in fewer agencies might make it easier for industries to “capture” the regulators and weaken the force of their mandate. Congress should hear from experts on which of these possibilities is more likely.

Mr. Obama’s framework for reform proposes that those who create and sell financial products should be required to hold 5% of an issue on their books so they have “skin in the game,” and therefore will be more careful in the kinds of investments they create and sell to others.

But is 5% really enough? Perhaps they should be required to hold 10%. Are there ways for investment bankers to get around this requirement, for example, by hedging? Again, Congress should hear from the experts.

Whatever changes in regulatation emerge from Congress, there will likely be unintended consequences. It is probable that among the causes of the financial crisis are the unintended consequences of previous attempts at regulatory reform.

For example, Congress’ attempt to cap chief executives’ salaries by eliminating the tax deductibility of any payment over $1 million, unless it was performance-based, had the unintended consequence of pushing companies to adopt stock-option-based compensation plans.

This, in turn, contributed to short-term corporate thinking, as CEOs and others looked to drive stock prices higher so they could cash in their options.

Taking the time to think regulatory reform through, to consider the less obvious consequences of any regulatory change, would reduce the likelihood of unintended damage to the financial system and the economy.

In particular, Congress must be careful not to stifle financial innovation and to drive financial activity offshore. As we said in an earlier editorial, the country needs better, smarter regulation, not more. Congress won’t provide that by rushing to draft new regulations without planning and thought.