Financial Regulation Reform — But Not Paulson’s — Likely in 2009

By and | August 25, 2008

Efforts to overhaul U.S. financial regulation are seen gathering pace early next year, as a new Congress and administration seek to safeguard public money put at risk by recent rescue measures.

The Federal Reserve’s extension of emergency credit to investment banks, and fears of a deeper slide in home prices, will drive calls for reform in what is expected to be a Democratic-led Congress.

Major changes would also allow a new administration, whether the president is Democrat Barack Obama or Republican John McCain, to distance themselves from the current government and the mess left behind by the credit crisis.

“For the Democrats, this really hits on all cylinders for them,” said Andrew Busch, a BMO Capital analyst who has advised McCain. “They want to re-regulate the financial industry.”

A U.S. Treasury Department “blueprint” for reform was conceived under the Republican administration of President Bush and Treasury Secretary Henry Paulson at a time when the pendulum was swinging towards less reform.

But by the time it was issued at the end of March — just after the Treasury and Fed’s emergency sale of investment bank Bear Stearns to JPMorgan — the atmosphere had been transformed. Banking regulators are now more likely to face criticism for doing too little and being asleep at the wheel rather than being too strict.

Few expect the 218-page document to be the roadmap to eventual changes, though the proposals to create a “market stability regulator” and cut the number of bank regulators have broad appeal.

Other ideas, like merging the Securities and Exchange Commission with the Commodity Futures Trading Commission, have been floated before in Washington and not gone forward. This time it might not be any different.

It also recommends the creation of an optional federal charter for insurance companies, similar to the current dual-chartering system for banking, and the phasing out of the thrift charter.

Still, there is likely to be a shake-up, it just may not be the one Paulson envisioned.

“The worst of the housing crisis is going to come next year… and it will call all of the financial regulation into deeper question,” said William Spriggs, who chairs Howard University’s Department of Economics.

There is a general consensus that investment banks should get greater supervision in exchange for access to cash from the Fed.

And many think the role of market stability regulator will go to the Federal Reserve, which has already taken on the responsibility in an ad hoc fashion after opening credit lines to the investment banks and housing finance giants Fannie Mae and Freddie Mac.

Rep. Barney Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, has called on Congress to establish a “Financial Services Risk Regulator” or give that power to the Fed.

Frank is expected to retain his post next year and has also said lawmakers need to consolidate duplicative regulators, and reassess capital, margin and leverage requirements. Frank did not respond to a request for comment for this story.

“(Fed) Chairman Bernanke is not going anywhere and Barney Frank is not going anywhere. And whoever is Treasury Secretary is going to be sympathetic (to start a reform movement),” said Mark Zandi of Moody’s, who has advised McCain.

There are other signs that changes to financial regulation will come next year despite a history of Congress moving slowly, such as the decades it took to hammer out the 1999 relaxation of Depression-era laws against combining banking, investment banking and insurance businesses.

The congressional watchdog, the Government Accountability Office, has recently been meeting with industry groups, including the American Bankers Association, to research a report on how best to evaluate overhaul plans.

“We thought it’d be particularly timely for Congress’ consumption right around the time they come back,” following the election, said Richard Hillman, GAO’s managing director for financial markets and community investments.

GAO intends to meet with financial services regulators early next month and “a number of different luminaries in the financial services sector,” he said.

The Financial Services Roundtable, a trade group for a wide swath of the sector from commercial and investment banks, to insurance companies, is circulating its own draft proposal.

Number one on its list is naming the Fed as the primary systemic risk regulator and letting investment banks opt in to use the Fed discount lending window under nonemergency circumstances.

In exchange, the banks would be subject to modestly tightened supervision from the central bank including minimum capital standards, according to the plan, being circulated to members of Frank’s financial services panel.

Some fear the politicians will go much further.

“We’re going to get more regulation,” BMO Capital’s Busch said. “This is how the political process works, they don’t react until it’s too late and then they overreact.”

But sweeping reforms like those in Paulson’s blueprint, with its three new agencies and amalgamation of several more, could take years.

“It puts everybody’s regulatory turf in play. You take a couple of years and then maybe after emergency legislation in 2009, you can have serious discussion about broader regulatory reform in 2010 or 2011,” said Charles Gabriel, an analyst at Capital Alpha Partners, a D.C.-based investment advice firm.

John Dearie, who worked at the New York Fed for nine years in various roles, said he hopes regulators will avoid rushing into a solution like the 2002 Sarbanes-Oxley law.

That legislation was a response to Enron and other high-profile accounting scandals, but critics say it burdened companies with excessive and costly regulation.

“We are learning through this crisis,” said Dearie, now senior vice president for policy at the Financial Services Forum, which represents CEOs from two dozen big companies including Lehman Brothers and Bank of America.

“Let’s get through this and wait until the dust settles,” to enact big changes, he added.

(Editing by Tim Dobbyn)

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