Intended to prevent recurrence of the turmoil triggered by the bursting of the housing bubble, the administration proposes to restructure the responsibilities of the agencies who now oversee U.S. financial market operations, in ways that supposedly would promote regulatory information-sharing, cooperation and coordination.
In an earlier crisis atmosphere, similar goals justified cobbling together the Brobdingnagian Department of Homeland Security, which just goes to show that, while interagency information-sharing and coordination sound good in theory, they are unlikely to be achieved in actual bureaucratic practice.
But the most troubling aspects of the Treasurys blueprint for reforming financial market regulation are found in the far greater powers it assigns to the Federal Reserve.
One part of the plan simply affirms actions the Fed already has taken.
Apparently concluding that Bear Stearns was too big to be allowed to fail, the Fed, for the first time in its history, granted to such non-bank financial institutions access to loans at its "discount window" loans previously restricted to commercial banks and guaranteed $29 billion in illiquid assets to broker Stearnss purchase by JPMorgan Chase.
So now that the Fed has lent those billions more to Goldman Sachs, Lehman Brothers, Morgan Stanley, and other Wall Street securities brokers, the Treasury proposal would permit the central bank to conduct on-site inspections and impose conditions, including capital requirements, on such borrowers which it now is doing without explicit authority.
And most worrisome, the regulatory reform plan also empowers the Fed to ensure "market stability," watching for threats originating anywhere within the financial system, be it from commercial banks, investment banks, mortgage lenders, hedge funds or insurance companies.
As economists have asked: if smart, highly paid Wall Street investment bankers with huge financial positions on the line failed to foresee the risk to which subprime mortgages exposed them, how can one expect a regulatory agency to do so? And, what steps will the central bank take to "stabilize" markets, if it does perceive a threat? Will it continue to bail out institutions who run into financial trouble?
The prospect of being rescued by taxpayers encourages risk-taking. So, transforming the Fed into a market-stability watchdog may create more market instability not less.
To implement this plan, many new regulations would have to be written and costs would be imposed on financial institutions to comply with them.
In collaboration with Burak Dolar of Augustana College, I examined the costs of complying with USA PATRIOT Acts Title III, which required banks and thrifts to be more active in deterring money laundering and disrupting terrorist financing. While the law imposed substantial compliance costs on the entire financial services industry $11 billion in 2002 alone large institutions had two distinct advantages: they could spread the costs over greater numbers of customers and transactions, and many already had anti-money laundering procedures in place. In fact, rather than reinvent the wheel, regulators based their rules for PATRIOT Act compliance on the methods already in place and in the budget at the large financial institutions.
As a result, their smaller competitors were hit with disproportionate compliance costs draining as much as 20 percent of their profits.
Thousands of small banks and thrifts closed their doors in the following years, many after being bought out by bigger ones.
So, in addition to substantial growth in the federal bureaucracy, one likely "unintended consequence" of the Treasurys regulatory reform plan is greater consolidation of the financial services industry, creating more institutions too big to be allowed to fail and further erosion of the discipline essential to the operation of competitive markets.