US FINANCIAL REGULATION: How to fix it

03/10/2009 | Taimur Ahmad, Barney Frank

Barney Frank, chairman of the US House Financial Services Committee, spells out his vision for how the finance industry should be regulated

EM: Two years since the financial crisis erupted, what are the main lessons learnt?

BF: When you have innovation in the private sector, it is by definition outside of regulation because it’s innovative. It’s important for the public sector to stay abreast of what’s happening and adopt regulations which create a kind of framework in which this new activity can go forward. We were too long delayed in that because of the deep conservatism of the people in power.

Specifically what we’ve learned is that there was a discipline in the lender/borrower relationship that we’ve seen eroded by securitization, and that a misalignment of the impact of risk on individuals and on the organizations and on the society are serious problems. We have individuals who were incentivized to take risks because they didn’t feel any of the negatives and so they took too many risks.

EM: The Obama administration has put forth plans for regulatory overhaul, but critics say that the plans don’t go far enough in terms of fixing the problems that precipitated the crisis. Is the administration being soft on regulatory reform?

BF: No. This job is going to be very tough, we are going beyond [the administration’s proposals]. There are people who like to make these bland assertions. I certainly think the administration has addressed every specific aspect of the problem that’s occurred to us, and in some cases we’re going to go a little further; in some cases maybe not as far. But the suggestion there is that there are some major things that we should be doing that we are not, and I’m not aware what they are.

EM: The concern is that there is not enough focus in terms of dealing with ‘too big to fail’ banks – specifically that the Geithner plan would force banks to hold more capital, when it was the activities of the banks, not their lack of capital, that was at issue.

BF: The plan allows them to restrict certain activities. In the first place there were certain restrictions on derivatives over and above the requirements for more capital and less leverage. In general, there will be an effort to push derivatives onto either exchanges or clearing houses and to require particular heavy capital for OTC [over the counter] derivatives. So that’s a part of it. Secondly, the systemic risk regulator, whoever it turns out to be, will be able to issue other cease and desist orders with regards to the banks. Finally for non-banks, where the problem arose with Lehman Brothers and AIG, we’re going to give new powers to the federal government to dissolve agencies, to put them out of business. That was part of the concern about too big to fail because you had to choose between paying everybody and paying nobody. That will be averted. We will also be restricting this notion of making loans and then selling 100% of the loan to somebody else. You have to have some risk retention. That reduces risk everywhere. So these are the issues. 100% securitized loans or derivatives are two examples of activities we will be restricting.

EM: But one of the worries is the de facto creation of a category of systemically important banks will, in effect, perpetuate the idea of too big to fail.

BF: We’re not going to create that category. There won’t be such a category. The systemic risk regulator will be empowered to order more capital or cut back in activities for any entity that it thinks is becoming risky. There won’t be a pre-ordained list.

EM: People are objecting to the idea of giving the Federal Reserve the authority to supervise systemically important banks, especially given its contribution to the financial crisis.

BF: There are people who have questions over the competency of the Fed, but I think what you’re likely to see is a council of regulators doing it, not the Fed.

EM: You’ve been pushing this idea of a council of regulators to monitor financial firms. Why is this approach superior to a single bank regulator?

BF: The answer is it has to be somebody. There is concern about the Fed being the sole regulator. My own view is that these concerns are exaggerated in terms of the impact they will make. I think the functions are more important than who wields them. I think any of several entities given the authority to look at what AIG was doing etc, they would have said we ought to reel them in.

EM: So you don’t believe that the Fed is ideally suited to the role of risk regulator?

BF: I would have been happy with the Fed alone, but I think there’s been political resistance to the idea of the Fed doing it, that grew out of control with AIG. And I think a council approach with some executive leadership is the best way to deal with it. But I repeat – empowering any responsible set of individuals with that function is the major increment of difference, and exactly who wields it is less important.

EM: The Federal Reserve has reportedly rejected Secretary Geithner’s request for a public review of the Fed’s structure and governance, and that the Fed has rejected this request. Was it right to do so?

BF: I don’t pay much attention to it. We are going to increase the auditing of the Fed, and I think there is reason to look at the appointment of regional bank presidents, and the fact that they are appointed in a purely private way but then have a vote on an important public issue. We’ll get to that next year.

Beyond that – and overlooked by many of the critics – is that one of the major pieces of the administration’s approach takes powers away from the Fed. People only want to have a one-sided view. The biggest transfer of authority into the consumer agency will come from the Federal Reserve. The Federal Reserve will be the major loser of existing authority when the consumer authority is transferred into the consumer agency. We also plan to put some restrictions on the Fed under Section 13/3, the power to lend money to anybody they want.

EM: Given the competing proposal by senator Chris Dodd for a single bank regulator, are you concerned that having a rival plan may slow the process of getting this reform done?

BF: No. The function is more important than the structure. I just left a very cordial meeting with Secretary Geithner and Senator Dodd. That won’t be an obstacle to getting this done. It’s not a first-order issue.

My own view is that the opposition of the smaller banks and the local banks make [a single bank regulator] impractical. We will consolidate the two national bank regulators but we won’t throw the FDIC [Federal Deposit Insurance Corporation] in.

EM: When do you expect a bill to get passed?

BF: I think the president will get it in December; the house will finish it in November. Senator Dodd is shooting for November as well.

EM: You’re confident it will go through by the end of the year?

BF: Yes.

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