Should We Reform Regulation Now? Yes.

I’ve been pondering something Secretary Geithner wrote yesterday in his WaPost op-ed:

“Some people will say that this is not the time to debate the future of financial sector regulation, that this debate should wait until the crisis is fully behind us. Such critics misunderstand the nature of the challenges we face. Like all financial crisis, the current crisis is a crisis of confidence and trust. Reassuring the American people that our financial system will be better controlled is critical to our economic recovery.”

I think I agree with him, sort of. I don’t think we should necessarily wait for a year to figure out how to fix a broken regulatory system. We can do it now. But my reasons are different from Secretary Geithner. I think we have the tools at hand now to avoid another major bubble and crash (well, to avoid the severity of this crash, in a business cycle, downturns are inevitable and healthy). As Dallas Fed President Richard Fisher told The WSJ, regulators had enough authority to prevent a crisis. They simply failed. “The regulators didn’t do their job,” he said, “including the Federal Reserve.” (And yes, that is about the umpteenth time I’ve used that quote.)

Richard Posner said back in April in an interview, “most of the goals of tighter regulation could probably be achieved just by more assiduous enforcement of existing regulations.” We can make the changes necessary today because the most important thing doesn’t require the creation of a new agency. The most radical change to the way Wall Street conducts business can come through the ending of the government’s implicit (and now explicit) guarantee for firms too interconnected to fail. Much of the rest of change can be achieved by simply enforcing the law better.

I think Geithner, Summers, the GOP, and many of the heavy hitters for the Dems on the House financial services committee would concur with the position that taxpayers should never again be on the hook for bailout out a company. However, nearly all of those people also support “resolution” power for the government to take over struggling financial institutions and wind them down. If this authority that the FDIC has over banks is extended to all financial firms but without teeth it would create major problems. The wind down process for a bankrupt firm should not be comfortable, and it should cost the operators dearly. This is the proper alignment of interests.

Ironically Posner followed his above quote by saying, “I would urge that the proposal of new regulations be deferred for a year, to provide time for a calm and thorough appraisal of the regulatory options.” Again, I don’t agree with this and stand with Geithner who wants to move the process along (even though Congress won’t really take up the issue until after the August recess). Getting regulation right in the short-term will help restore confidence.

In this way tend to gently disagree with my Reason colleague Tim Cavanaugh over at Reason magazine who wrote yesterday, “The crisis in confidence and trust is the cure, not the disease.” Geithner is correct is his position that greater confidence will help move the country forward. Investor confidence creates more stable businesses. Consumer confidence moves more money around the economy. But increasing financial sector regulations may not have the effect that that Geithner believes because if regs make life harder for banks and the laws more ambiguous, it will strike a blow at confidence.

Banks can create systems to work around/with regulations—in fact it can be a competitive advantage. But banks hate ambiguity in the law. Financial institutions that don’t know what their activity will spark with regulators either tread timidly (destroying value) or shoot from the hip and just wait for an inevitable slap on the wrist from the SEC, Fed, or FDIC. The creation of a “systemic risk regulator” and wide reaching resolution authority will not stoke investor confidence if the role of the government is not very, very clearly outlined. Then again, if the taxpayers are put more firmly on the hook for Wall Street’s mistakes, it might encourage short term confidence, but not the healthy kind.

Ultimately, though, we all have to know that neither financial sector regulation nor confidence are quick fixes. Tim is right when he says: “Banks are not lending because there are are too many bad risks out there. People aren’t getting loans because they can’t establish their creditworthiness. And the reason for that isn’t some baloney about mass psychology or people needing to be protected from themselves. It’s because about 20 percent of Americans have demonstrated that they must never be loaned money on any terms.” We can’t go back to the days of the bubble period where life was green fields and flowing money because that is neither healthy nor sustainable.