Why it Makes Sense to Give the Fed More Regulatory Powers

Bethany McLean makes a seemingly salient point in the latest Fortune: a year ago, in the Bloomberg-Schumer report, Chuck Schumer was saying that there was too much regulatory red tape on Wall Street. Today, he seems to support Hank Paulson's attempts to beef up the Fed's regulatory powers.

In reality, however, there's no contradiction there. The problem as diagnosed in the Bloomberg-Schumer report was not that regulation was too heavy-handed, but rather that there were too many regulators. If anything, the Paulson plan is entirely in line with the Bloomberg-Schumer plan: make it obvious who the regulator is, and give that regulator broad authority to make sure that financial institutions do what's right rather than just what fits in the letter of the law. The main difference between now and then, as I see it, is that now there's a move to increase the number of financial institutions which fall under the Fed's regulatory umbrella: if you regulate only banks, then you leave unregulated the much larger "shadow banking system", with potentially disastrous effects.

The downside to this idea, as glossed by Alan Greenspan in his interview with Greg Ip today, is that "shady operations could portray their Fed-regulated status as a seal of approval, giving them unearned credibility with customers." I'm far from convinced. Given the amount of harm that the shadow banking system can do, it's foolish to leave it unregulated on the grounds that people might otherwise trust it more. I mean, it's not like nobody trusts Goldman Sachs or Pimco, yet both of them are pretty largely unregulated at the moment.

McLean, cheered on by Alan Meckler, also takes the opportunity to bash Sarbanes-Oxley. It "was enacted to restore investor confidence after little hiccups like Enron and WorldCom," she writes. "But the authors missed the bigger problem." Well, yes, but Sarbox wasn't designed to deal with systemic risks, it was designed to deal with what happens when public companies turn out to be run by criminals.

Where McLean performs a very useful service is in going back to the Bloomberg-Schumer report and noting how blasé it was about the very things which ended up bringing the financial system to its knees. She notes that the authors

...completely missed the opportunity to think critically about where innovation might have gotten ahead of regulation. In today's harsh light, their blithe attitude seems astonishing. For instance, McKinsey wrote that over-the-counter derivatives "help foster the kind of continuous innovation that contributes heavily to financial services leadership." (Tell that to Bear Stearns.) McKinsey also complained that higher capital requirements for U.S. banks would put them at a "competitive disadvantage." (Hello, Citigroup!)

Who got this kind of thing right? Well, Tim Geithner of the New York Fed, for one. It seems to me that if we'd given him and his Fed colleagues a bit more power earlier on, some (if not all) of the present crisis might have been avoided.

(HT: Wiesenthal)