A Review of the Republican’s Plan to Overhaul Financial Sector Regulation

The House Republicans released their plan to overhaul financial sector regulation yesterday, ahead of the White House’s revised plan due out next week (which we will look at in full). The principals of the GOP’s plan are strong: no more bailouts, no more government picking winners and losers in market, and clarifying the role of government towards firms previously considered too big to fail. These are key components for realigning Wall Street incentives towards risk management and, most importantly, getting the taxpayer’s wallet off the hook.

The most important thing to come out of regulatory change should be a clear position from the government that they will not rescue companies in the future. This will define risk management and profoundly affect market activity. The rest is just degrees of limitation on the creation of wealth—not that this is unimportant.

The while the core is strong, GOP’s plan is far from perfect. Regulation overhaul should not be looking to put new systems or agencies in place, as much as it should strengthen the enforcement of law and establish clear consequences for investment failure that doesn’t involve government rescue. Parts of the Republican plan do not completely live up to that test.

For instance, the GOP’s plan includes the creation of a “Market Stability and Capital Adequacy Board” that would have oversight of the entire financial system, plus government policies that intersect. According to the GOPs press release:

“The Board will report on any potential risks that might be looming but will not have independent enforcement authority. In order to address regulatory gaps, each functional regulator would be required to assess the effects of their regulated entities’ activities on macroeconomic stability and review how entities under their regulatory purview interact with entities outside their purview. The periodic reporting will help Congress and relevant regulators to decide upon appropriate actions to address threats to financial stability. The Treasury Secretary would chair the Board, and it will be comprised of outside experts and financial regulators.”

The President hasn’t released his plan yet, but I’d be willing to bet that you’ll find a similar proposal from the White House next week. This is the “systemic risk regulator” that has been thrown around in different forms. Certain proposals have taken this idea so far as to make it a super regulator with oversight and authority. The GOPs plan stops short of giving this Board direct power and instead uses the power of the various agencies to continue their duties. Most importantly, the stability board can’t take over any financial institution (one proposal out there) and it has to work through the agencies and Congress. However, the creation of any organization like this opens a door for the “Stability Board” to develop significant enough clout that it begins using the different regulatory agencies as actors to carry out its authoritative will.

The plan also does not address what systemic risk really is, but rather leaves it up to the Board to define the term—probably with a wide definition to accrue as much oversight as possible. Complicating matters is the enormity of “macroprudential” oversight of the financial future of the entire American economy. Wall Street analysts have a hard enough time trying to forecast the market. History has taught that changes in the market are rapid, continuous and uncertain. As economist Frank Knight wrote, not only are the odds of events unknown, the odds cannot be known. This Board is destined to fail to stop the next recession.

Still, the GOP plan does address a number of key concerns well. It consolidates the bureaucratic web of regulators by combing the Comptroller (OCC) and Thrift Supervision (OTS) offices within the Treasury Department. This should reduce gaps in oversight of conglomerated firms whose subsidiaries are governed by different regulators. It would give the regulating authority a better macro perspective on the health of the banking industry to aid the oversight of systemic risk. And it would reduce ambiguity for the banks themselves who sometimes have to deal with multiple regulators.

Worrisome though is how the structure of this agency would look, because the GOPs plan also calls for pulling bank regulatory powers from Fed and FDIC and putting them with this new combined agency. A key downside of creating a single bank regulator is that it would eliminate choice for banks that, under the current system, can select their regulating authority. The FDIC, OTS, and OCC compete for business from banks that pay fees for government oversight approval. This has the advantage of letting banks pick a regulator based on their specific type of business practice, as opposed to accepting a one-size-regulator-fits-all system. However, the trade off of less bureaucracy is probably is worth making.

The plan refocuses the Fed on monetary policy. This will not end problems, because it was failed monetary policy that played a critical role in the financial crisis. Yet, there is still heavy debate as to what the consequences would have been if the Greenspan Fed had tightened the money supply, and the GOP is wise not to try and restrict that out of political concern.

The GOP’s plan also provides more resources for the SEC to do their job of anti-fraud enforcement. Given the failure to catch Madoff, there is probably legitimate need here for helping the SEC just do its job better without having to create a lot more rules. Still, I doubt that SEC has really been using its current resources to the best of its ability (not that government agencies ever do).

The best part about the plan is probably that it pulls the government away from the rating agencies. As is pointed out by House Republicans in their plan, there has been too much blind reliance on ratings supplied by the major credit rating agencies, and government has, to its detriment, supported the oligopoly of rating agencies and their products. The GOP would remove all references to ratings throughout Federal law and regulation so that there is no required action by government agencies based on credit ratings.

Obviously, this plan stand no chance of getting brought to the floor of the House, but it gives insight to the thinking of Republicans as they engage in the regulatory overhaul. It is not perfect, but it’s heading in the right direction. Next week, we’ll review the Democrat’s plan after it is released and their perspective on financial sector regulation change.