Video: Geithner calls for financial reform

By John W. Schoen Senior producer
updated 3/26/2009 5:39:05 PM ET 2009-03-26T21:39:05

The global market meltdown has created broad consensus that tough new  rules are needed to prevent anything like this from happening again. But as Congress and the White House begin getting down to details, that’s pretty much as far as the consensus goes.

The scope of the undertaking came into clearer focus this week as Treasury Secretary Geithner unveiled a long list of broad principles that the administration says should guide the proposed changes.

"Over the past 18 months, we have faced the most severe global financial crisis in generations," Geithner told the House Financial Services Committee. "To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game."

On top of Geithner’s wish list is an expansion of the government’s power to rein in financial companies that get so big they pose a “systemic risk” to the entire financial system. The Obama administration also wants broader powers to clean up the financial mess created when one of those firms fails and better protection for consumers against abusive lending practices by mortgage lenders and credit card companies. The administration says oversight gaps between the dozens of existing state and federal financial regulators need to be closed. And all of this needs to be better coordinated with dozens of financial regulators around the world.

It’s a monumental task. By putting so much on the table at once, the administration may be trying to avoid the intense backlash generated at various critical stages of the financial rescue plan engineered by the Treasury and the Federal Reserve over the past six months.  But drawing up the blueprint for which agency regulates what is sure to ignite a series of political battles that will draw in some of the most powerful lobbying groups in Washington.

Unlike the rapid pace of bailout measures announced over the past six months, the process of overhauling regulations enforced by dozens of agencies won’t happen quickly. Given the stakes, that may not be such a bad thing, according to former Fed Chairman Paul Volcker.

"There's a great urge to get it done," Volcker told a conference on regulatory overhaul this week. "My personal feeling is 'not too fast'."

There’s no shortage of good ideas on how to create an uber-regulator to rein in firms before they take on so much risk they pose the threat of widespread collateral damage. Some have suggested the Fed take on the role.

Sen. Susan Collins, R-Maine, has introduced a bill calling for a “council of regulators” from existing agencies headed by an independent chairman. Sen. Chris Dodd, D-Conn., head of the Senate Banking Committee, said last week he thinks the Fed already has its hands full and the task should go to a separate agency.

Some members of Congress fear the Fed may already have too much power. Since the financial crisis began, the central bank has dramatically expanded its role based on a single clause in the 1913 law that created it, which grants it virtually unchecked lending power in times of “exigent circumstances.”

“The thing that worries me about the Fed is they have this tremendous power under (the law) to loan money to just about anybody on terms that they think are sufficiently secured,” said Rep. Brad  Sherman, D-Calif. “The more we make them a regulator, the more inclined they'll be to say, ‘We don't want anybody to say we screwed up as a regulator, so let's keep the  company alive by making it some loans.”

Major Market Indices

Other members have expressed strong doubts about handing such powers to the Treasury Department. Memories are still fresh of the $700 billion Congress handed former Treasury Secretary Hank Paulson to buy up “toxic assets” clogging the banking system, only to see him unilaterally change course and use the money to buy bank stock.  House Republican Leader John Boehner called parts of the Treasury’s latest proposal "an unprecedented grab of power."

"Before that occurs, there ought to be a real debate about whether we give that authority to the Treasury secretary," he said Wednesday.

Regulatory arbitrage
The need to streamline the sprawling complex of state and federal oversight has long been clear as decades of tinkering with financial regulations left authority dispersed among many state and federal agencies. The result has been the practice of “regulatory arbitrage” — where professional investors and firms work the system to maneuver as far as possible from regulators’ reach. When the stock and housing markets were booming, there was little political enthusiasm for requiring more disclosure or otherwise tightening the rules.

Now the financial crisis has brought the scope of the problem into sharp focus, most notably with the collapse of insurance giant AIG, largely due to unregulated derivative securities. Though the Fed has broad power to regulate the nation’s banks, it has no oversight over “non-banks” like AIG.

AIG's dozens of insurance subsidiaries are regulated by 50 state insurance commissioners. The tiny, London-based corner of AIG that created the half-trillion-dollar mess the government is now cleaning up was largely overlooked by regulators on both sides of the Atlantic. The unit’s regulator of record was the relatively obscure Office of Thrift Supervision, the successor to a Depression-era agency set up to promote mortgage lending by savings and loans.

Bank regulations are also diffused among dozens of agencies. Credit Unions have their own regulator. Financial firms that aren’t banks are overseen by other corners of the sprawling regulatory complex.

Stocks and bonds are overseen by the Securities and Exchange Commission along with 50 state securities regulators. Stock exchanges are policed by a “self-regulatory” agency called the Financial Industry Regulatory Authority, made up of exchange officials and other industry representatives. Yet another agency, the Commodity Futures Trading Commission, handles trading in commodities like grains and oil, along with financial instruments like futures contracts.

Consolidating the regulatory maze won’t be easy, as existing agencies vigorously defend their turf. The new head of the Securities and Exchange Commission, Mary Schapiro, said Thursday her agency’s role as market supervisor and investor protector should be preserved if Congress decides to create a single entity to oversee all risk in the financial system.

"Even as attention focuses on reconsidering the management of systemic risk, investor protection and capital formation ... cannot be compromised as a product of any reform effort," she told a Senate panel.

With the financial system still extremely fragile, one of the Treasury’s most immediate goals is to prepare for further damage from the possible failure of another large player. To do so, Geithner is pressing for greater ability to take over ailing financial institutions.

Currently, the Federal Deposit Insurance Corp., which insures bank deposits, has authority to step in and undertake such damage control — but only in the case of regulated banks. The Obama administration wants to expand that authority to include other, large non-bank companies like insurance companies, stock brokerages and hedge funds.

The debate over the details of such powers will likely be fierce. It’s not clear, for example, just how big a financial player would need to be to qualify for a government takeover. Nor is it clear how U.S. subsidiaries of foreign-based institutions would be dealt with. And while the plan calls for a takeover under "appropriately limited" circumstances, it’s not clear what those circumstances would be.

The new powers would be sweeping. On Tuesday, FDIC Chair Sheila Bair told CNBC the new authority would allow the government to undertake a “controlled orderly unwinding” of a failing financial company.

“It would enable the government to come in, repudiate employment contracts, pick and choose who you want to keep, who you want to get rid of, what you want to pay them, replace the management, get rid of the boards and bring in better management,” she said.

Even if Congress eventually comes up with a new set of rules, regulators face the more daunting task of coordinating financial oversight and enforcement with their global counterparts. As the current crisis has demonstrated, trouble in one part of an increasingly interconnected global financial system can quickly spread around the world.

That’s why regulatory overhaul will be at the top of the agenda when President Obama and other Group of 20 leaders meet next week. Despite widespread agreement on the need to coordinate policies and rules, the track record of global financial regulation to date has been mixed at best.

After years of negotiation, for example, a global committee of central bankers finally agreed last year to a common set of standards governing how much capital banks should hold and how tightly they should be regulated. But implementation was left to bank regulators in each country, undermining the rules' effectiveness, according to Sebastian Mallaby, a senior fellow at the Council on Foreign Relations.

“So Deutsche Bank went to the German banking authorities and said, ‘Hello I think you should count this bunch of bonds I’ve got as high-quality capital,’” he said. “’Because if you what? If you don’t let me do that I’m going to lose business to Credit Suisse and Societe General.’  So the Germans said, ‘Gee, I don’t want my bank to lose business to those nasty Swiss and French. So I better give DB a break.’ So each bank kind of captured its own regulators by arguing that it would be at a competitive disadvantage.”

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