Who Regulates the Regulators?

After months of discussions between Treasury officials, federal regulators, members of Congress, the financial industry, consumer stakeholders, academics, and President Barack Obama himself, the administration released a Financial Regulatory Reform plan on Wednesday.

In 87 pages, the proposal covers nearly every aspect of the financial system, making it the most comprehensive regulatory overhaul since Franklin Delano Roosevelt's post-Depression restructuring. But despite its broad strokes, it's not the kind of radical change that many on the left had been hoping for -- not a new New Deal, or even, as its title trumpets, a New Foundation. But every expert I spoke with said that it is a positive step for the country's financial health. The question now is whether Congress, making the proposal law, will improve it or make it worse.

Some observers, like Robert Reich, Simon Johnson, and Joe Nocera, are disappointed the plan does not do more to address the broad-based problems of the financial system -- chiefly, they believe that there are still too many incentives for the risky bets that necessitated government bailouts.

The scope of the proposed reforms reflects the administration's awareness of what Congress would support, what regulatory agencies would concede, and how much money -- millions of dollars -- the financial industry would spend to prevent reform. "The administration had a sense of realism -- you can't start from scratch," one Democratic congressional aide told me. "The reality is, we're not starting over. The administration came at this from 'we need to fill the holes here; we need to fix the problems.'"

The plan addresses many of the institutional lapses that created the current crisis but not necessarily the underlying structures of the financial sector the left has criticized since the 1980s. Rather than produce a perfect vision, the administration has chosen to make what changes it can, recognizing that time is of the essence -- banks are still free to pursue bad practices that led to the crisis.

The most important part of the plan for progressives  is the creation of a Consumer Financial Protection Agency, which consolidates oversight of consumer protection --mortgages, credit cards, and similar products -- currently under seven different government organs into one central office and grants the new agency robust rulemaking and enforcement authority. Elizabeth Warren, the chair of the congressional panel that oversees bailouts, came up with the concept in a widely read 2007 essay. Her panel also released a well-received regulatory plan in February.

"Past experience has taught us that the agency that has bank supervision and monetary policy and consumer protection -- the Fed -- ends up not caring very much about consumer protection," Warren told the Prospect. "Consumer Protection has been the regulatory stepchild. We must not forget that the Fed, the Office of the Comptroller of Currency, and the Office of Thrift Supervision have the power to prevent much of the current economic crisis by putting some minimal regulations in place on consumer products, and they simply failed to do that."

The most sweeping change is empowering the Federal Reserve to be the systemic risk regulator, charged with identifying any firm whose combination of "size, leverage, and interconnectedness" qualifies it to be a "Tier 1 Financial Holding Company" -- essentially, a company that is too big to fail. These companies would be subject to more onerous capital and leverage requirements and closer government supervision. Some have suggested that these requirements would dissuade firms from becoming too big to fail, but it is more likely that the new regulations would dampen both profit-making and risk-taking, making these large companies safer. But that's not the kind of anti-trust action that some think would truly eliminate the problem.

The Fed's role as systemic risk regulator also touches on the proposed expansion of resolution authorities -- mechanisms for dismantling a failed bank. Under the administration's plan, the FDIC would gain authority to seize any failing financial institution -- an expansion beyond the deposit banks they currently take over -- and distribute their assets and debts appropriately. Ideally, the combination of the new requirements for the Tier 1 FHCs and the authority to break them up when they become insolvent will eliminate the false choice between an economically catastrophic failure or an expensive bailout for firms like American International Group.

Putting the Fed in charge of systemic risk presents new concerns because it is more independent from the government -- and the public -- than other agencies. Influential members of Congress have already suggested that if the administration's plan is implemented, it would change the Fed's authority to make it more responsive to Congress. But that may undercut the independence it needs to be an effective central bank. Nonetheless, as many point out, the Fed is only really independent from Congress, not the banking industry -- its regional branches, which are critical to its regulatory mission, are governed by representatives of those same banks.

One other important move is the elimination of the Office of the Comptroller of Currency and the Office of Thrift Supervision, both known for their lax approach, and replacing them with the newly created National Bank Supervisor, which should eliminate some problematic regulatory competition. However, other needed consolidations of duplicate authority didn't occur. For instance, the oversight of derivatives shared by the Securities and Exchange Commission and the Commission for Commodities Futures Trading, although the administration proposes "harmonizing" that authority.

Questions still remain. Congress will have to decide how to improve the financial products built from mortgage loans, possibly by making lenders hold on to a small share of financial risk. It will also need to address how to define derivatives -- financial bets that helped catalyze the crisis. The administration's plan also leaves unaddressed the conflict-of-interest problems in the securities rating system, which graded dangerous financial products as safe bets. There is also the looming question of international regulation -- the administration's proposal calls for a "leveling up" of regulations within the entire global financial order.

But the key concern for both the administration and Democrats in Congress is avoiding the typical, failing pattern of legislation over the last six months: A House bill that looks similar to an administration proposal gets watered down or simply shut down in the Senate. One small advantage is that there are so many different moving parts that it will be hard for financial interests to make a concerted stand against all of them. One thing is for sure: They will fight, tooth and nail, against the Consumer Financial Protection Agency. "It's very important progressives defend what Obama is proposing in that area," said Damon Silver, the AFL-CIO’s financial markets expert.

But even as activists, legislators, and journalists are up to their shoulders in acronyms and agencies, one thing to keep in mind is that structural reform will not succeed without regulators dedicated to protecting investors, consumers, and the broader economy from the excesses of the financial system. The tragedy of this financial crisis is that there were existing authorities that had the oversight to address the housing bubble but failed to do so. Sometimes the most important question to answer is, who will regulate the regulators?

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