Hope vs. Financial Experience

Next time, we're told, the regulators will have 20-20 foresight.

The main idea behind the Obama Administration's new financial revamp is essentially this: With more power and a modest reshuffling of the bureaucratic furniture, the same regulators who missed the last credit mania will somehow prevent the next one. If nothing else, this concept is certainly true to President Obama's campaign theme of "hope."

In its analysis of what went wrong and in its prescriptions, the proposal also remains true to the current Washington consensus that the bankers caused the whole mess. They did so, we are told, by cleverly running around and through Washington's already vast regulatory army of the Federal Reserve, the Treasury's Office of the Comptroller, the OTS, the FDIC, the NCUA (credit unions), the SEC, the CFTC and, who could forget, the FHFA (Fannie Mae). Who'd have thought these massed legions were little more than a Maginot Line against the banker blitzkrieg?

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"Gaps and weaknesses in the supervision and regulation of financial firms presented challenges to our government's ability to monitor, prevent, or address risks as they built up in the system," says the Treasury white paper. "No regulator saw its job as protecting the economy and financial system as a whole." The result was "a credit boom" that "accompanied a housing bubble," which the bankers were able to exploit for riches until they drove into a ditch.

This "gaps and weaknesses" theory has the political benefit of ignoring the role that Washington played in creating the credit bubble. There's not a word in the 85 pages about the Fed's years of negative real interest rates, and the only mention of Fannie Mae and Freddie Mac is a placeholder paragraph noting that reform of those housing giants will come later. Also nowhere in sight is any explanation for how the Fed, which had every power imaginable to regulate Citigroup, could have allowed Citi to sell tens of billions of dollars of off-balance-sheet mortgage products.

However, the "gaps" theory does neatly set the stage for Treasury's regulator ex machina: new powers to monitor "systemic risk." Never mind that the most crucial defense against a credit mania is careful monetary policy. The Fed is nonetheless failing upward and would get new authority to inspect any financial institution in the world whose failure it believes might lead to other failures. How systemically risky institutions would be defined isn't clear -- except that, like the Supreme Court and pornography, the regulators will know it when they see it.

To assist the Fed in this 20-20 foresight, Treasury is also proposing a new Financial Services Oversight Council, composed of various financial regulators. This body will "identify emerging risks in firms and market activities." Amid the fine print, we learn the council will be chaired by Treasury and "supported by a permanent, full-time expert staff at Treasury." (What is the current staff, nonexpert?)

Treasury is of course a political body subject to political pressure. One reason "emerging risks" are often overlooked is that regulators have to be brave enough, and independent enough, to stop the music in the middle of the credit party. This tends to make a regulator very unpopular, much as those pleading with the Fed to tighten money from 2003-2005 were dismissed as spoilsports and cranks. The new systemic regulator, in short, may end up making the system less safe by making it more susceptible to political intervention.

And what if this new regulatory czar is wrong about the safety of some financial practice or trend? Then every part of the financial system may be vulnerable to damage because the regulator has blessed the behavior. Exhibit A: The Basel capital standards were written by the Fed and other regulators precisely to make the system safer, yet they proved to be inadequate when the Fed deferred to Moody's and other credit raters to judge what qualified as bank capital.

For all of its systemic worry, the Treasury proposal doesn't really address the biggest cause of risky financial business: the fact that some institutions have become too big to fail. Regulators would be able to force large institutions to hold more capital and abide by leverage limits. But large banks that hold insured deposits and have already been rescued by the taxpayers -- Citi and Goldman Sachs, for example -- would still be able to engage in such lucrative but risky behavior as trading for their own account.

The danger is that once the market understands these banks are too big to fail, the banks themselves and their lenders will begin to consider them to be like Fannie and Freddie. Their cost of funds would become cheaper than those of smaller competitors, and the incentive could be for more and more institutions to get bigger to rate the "systemic" brand of too big to fail.

This is the moral hazard that Paul Volcker mentioned in recent remarks that we excerpted Tuesday but that goes unaddressed in the Obama plan. Mr. Volcker would address this by barring deposit-taking institutions from engaging in certain financial practices, such as proprietary trading. We think Congress should explore former SEC Chairman Richard Breeden's proposal for a special bankruptcy court that could resolve financial institutions, even large ones, more carefully than Lehman Brothers was allowed to collapse. This would re-introduce the discipline of failure -- in contrast to the serial rescues of Citigroup.

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The larger question is why all of this regulatory reshuffling needs to be done so quickly, when we are still too close to the mania and panic to have truly absorbed their policy implications. The political class wants to rush through something to claim it has solved the problem, even if it means creating new and different problems later. Meanwhile, the bankers are relieved that Treasury's proposal would leave their business models intact, even if they have to wear tighter chastity belts. This truly is the triumph of hope over financial experience, and someone in Congress should slow this down and make sure we do it right.