The New Environment for Financial Regulation

It seems as if almost everyone agrees that the United States should take a long look at the system that regulates its financial institutions. Many argue for the need to reform or modify the system so as to take account of the existence of new financial instruments and the new, global nature of financial institutions and relationships. However, this is not going to happen overnight. First, we have to get beyond the current period of financial market disarray. Second, we have to elect a new President and a new Congress. Third, we need to have a substantial debate and dialogue concerning the nature of the new regulatory system.

Furthermore, these events are all going to take place within a time period where discipline must be brought to the Federal budget in order to strengthen the value of the United States dollar. (See “What is Possible in the Next Four (Eight) Years?” http://masepoliticalcommentary.blogspot.com/.) It is going to take time to create the ‘new’ regulatory structure and this is not necessarily a bad thing. In fact, it is much to be preferred to a ‘quick fix’ solution. Rushing to implement a new regulatory system is not going to ease the current situation, but we can’t let the discussion of what this system should look like fade away.
There is no doubt that the regulatory system that exists in the United States needs to be reviewed and reconstituted. Much of the existing system goes back to at least the 1930s if not before. Little or nothing in the system relates to the events and innovations of the last ten to fifteen years. And, we still don’t fully understand many of the instruments and the risks that are related to them that have been constructed during this time.

The Treasury plan introduced this week provides us with a starting point. It presents something in black and white that can lead to discussion and dialogue. I think it was smart of the administration to get such a proposal out into the open to foster the interchange that is going to take place. I don’t believe it is anywhere near what will result from such deliberations. But, we had to start somewhere.

That said, I would like to add three points to the discussion that seem to me to be very relevant.

First, we need to be very wary in terms of acting ‘during’ a financial crisis. This seems obvious, but needs to be reiterated over and over again. People tend to over-react in such situations…especially politicians. We don’t fully understand what has happened over the past year or two and what this implies for specific suggestions about the regulatory environment. There are a lot of questions that must be asked and many of them we can’t really articulate at the present time. We need time to reflect on the ramifications connected with the changes that might be selected. A time when emotions are high is not the time to overhaul or revamp the financial regulatory system. We also need to be wary of politicians who like to hog the spotlight during periods such as these and bask in the drama of the situation.

Second, we need to take full consideration of the fact that we are a member of the world financial community and not act in a unilateral fashion. A major reason we are in the current situation is that the Bush administration acted in a unilateral way with regard to its conduct of monetary and fiscal policy (as well as with regard to its conduct of foreign policy). In working through a restructuring of the United States regulatory environment, major thought needs to be given to how a ‘new’ regulatory system will exist within the operation of world financial markets. Any resulting regulatory system that is achieved without including discussions with other nations will not only create further resentment towards the United States, but will not be nearly as effective as it might be. It seems to me that a good start has been made in this direction in the efforts of the Federal Reserve System to bring foreign central banks into the effort to calm world financial markets through a common borrowing facility. The only way a truly effective system can be constructed is with input from the different players in the world’s financial markets.

Third, in developing a regulatory system for financial institutions, consideration must be given to the speed at which new financial innovations are brought to market and the speed at which markets move. Oversight is always ‘after the fact’ and regulatory enforcement is usually slow and cumbersome. This is true in almost all other areas of the modern economy and is not just present in the financial industry. As a consequence, the regulatory system will always lag behind the actions of financial institutions. Thus, the evolution of the regulatory system must be more toward a ‘principles-based system’ rather than just a ‘rules based system.’ People and organizations respond to incentives and a ‘rules-based system’ tends to create incentives for people and organizations to work around or create new instruments or structures to avoid the existing rules. This not only is costly to those ‘getting around’ the rules, but it puts a lot of pressure on the regulatory system to ‘catch up’ with these ‘avoiders’. Then, when the regulators do ‘catch up’ with the innovators, the innovators have usually moved on to something else. A ‘principles-based system’ is more concerned with process than it is with specific outcomes or rules and hence avoids this problem.

Regulatory reform of the United States financial system is going to take place in some fashion. Let’s hope that it is achieved with due deliberation and is inclusive, not only of all that are affected in the United States itself, but of those nations that play a role in world financial markets.