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Administration’s Regulatory Overhaul a Tall Order

June 16, 2009

I heard about it on the way home from my cousin’s graduation from UC San Diego on Sunday. In between sleep (my aunt made Jell-O shots for some reason) and my nephew’s sugar-induced rambling on the way home from San Diego, I heard it: the Obama administration announced that it would put forth a plan to “modernize financial regulation and supervision.”

The 1,004-word outline of the plan, which appeared in the Washington Post on June 15, was co-written by Treasury Secretary Timothy Geithner and Lawrence Summers, director of the National Economic Council. And let me tell you, there were some interesting takes on why the administration was rolling out a plan to overhaul the financial regulatory system when the crisis hasn’t fully abated.

One report said the outline was more of a defense of the administration’s recent actions. Another said the outline was a response to “criticism that [the administration’s policies] amounted to a ‘kind of back-door socialism.’” There were plenty more that said what the administration is trying to do is exactly what’s needed. Whatever the case is, it’s clear the administration wasn’t happy about having to choose between bailouts and financial collapse.

Now, I agreed with the outline’s statement that the financial system failed to perform its function as a reducer and distributer of risk. I agreed with the statement that the crisis was rooted in the global imbalance in saving and consumption, shortsightedness and excessive leverage at financial institutions. I also agreed that the crisis was the product of basic failures in financial supervision and regulations.

However, I was a little iffy on the belief that this crisis was the result of poorly understood financial instruments. I think people did understand. I mean, why else was the asset-backed securities market used like a game of musical chairs, with Main Street being the one left standing.

Now, good luck to the administration in putting forth a plan that is able secure the benefits of financial innovation while guarding the system against its own excess, as Geithner and Summers stated in their op-ed piece. I just don’t think that’s possible.

The unfortunate truth is, the financial system has been righting itself since December 2007. That’s why it’s so difficult to secure financing for your borderline customers. Heck, I remember being at the Vehicle Finance Conference in January 2008, and hearing one panelist compare the loans being underwritten then to how safe plane flights are right after a crash. Unfortunately, it was too little, too late.

Now here’s a breakdown of what the administration is proposing:

Stated Problem 1: Existing regulation focuses on safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress.

The Fix: The administration proposes raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms. Those large firms whose failure could threaten the stability of the system will be subject to consolidated supervision by the Federal Reserve. Additionally, the administration will establish a council of regulators with broader coordinating responsibility across the financial system.

Stated Problem 2: The structure of the financial system has shifted, with drastic growth in financial activity outside the traditional banking system, such as in the market for asset-backed securities. This led to an erosion of lending standards, resulting in a market failure that fed the housing boom and deepened the housing bust.

The Fix: The administration will impose robust requirements on the issuers of asset-backed securities; reduce investors’ and regulators’ reliance on credit-rating agencies; and require the originator, sponsor or broker of a securitization to retain a financial interest in its performance.

The plan also calls for harmonizing the regulation of futures and securities, for more robust safeguards of payment and settlement systems, and strong oversight of “over the counter” derivatives. Basically, all derivative contracts will be subject to regulation and supervision.

Stated Problem 3: The current system does not offer consumer protections.

The Fix: Building on recent measures taken to fight predatory lending and unfair practices in the credit card industry, the administration will offer a stronger framework for consumer and investor protection across the board.

Stated Problem 4: The federal government does not have the tools it needs to contain and manage financial crises.

The Fix: Establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system.

Stated Problem 5: Living in a globalized world, the actions taken by the administration will have little effect on international standards.

The Fix: Lead the effort to improve regulation and supervision across the world.

I don’t think anyone can deny that something needs to be done. Let’s just hope that what’s done doesn’t bring the financial system to a complete halt.

To view the op-ed piece written by Geithner and Summers, click here.

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