Wall Street Needs New Regulations

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In remaking the regulatory architecture, we will need to update the regulatory mandate to deal with 21st-century financial products. Accounting rules should be tightened to prevent anything from being moved off the balance sheet unless there is a true sale of the assets. No entity or instrument should be untouched by some form of regulation.

Regulators need to monitor positions taken by banks, other financial institutions, and major investors, including hedge funds. To its credit, the S.E.C. did attempt in recent years a modest hedge fund registration requirement. The courts struck it down. Congress will have to expand the regulatory mandate to include private investment partnerships, or at least those of a certain size.

Clearly, the regulators will need new powers. We must install higher capital requirements for all financial institutions. Given the disastrous incompetence of the rating agencies, Congress will have to undertake the enormous task of decoupling our regulatory framework from its dependence on ratings. Right now, ratings are written into the fabric of thousands of laws and regulations. Instead, market prices should be used.

There is wide consensus, as there should be, that derivatives will be brought under the umbrella. In the 1990s, the definitive fight was over the regulation of derivatives. Brooksley Born, then the head of the C.F.T.C., pushed to regulate them. Alan Greenspan, Robert Rubin, and Lawrence Summers fought her. She was right. It’s encouraging that people like former S.E.C. commissioner Levitt, who sided with the crowd that argued that regulation would plunge the market into legal chaos, are now having second thoughts. Let’s hope the same is true for Summers, who is now in Obama’s inner circle. “I have regrets that I didn’t use that as an opportunity to say, ‘Wait a second, maybe it will create uncertainty, but what about going forward? And what about mandating a clearinghouse?’ ” Levitt says. “I could have and should have, and I regret not doing it.”

Other problems are thornier. Can we do something about outrageous compensation for executives and Wall Street? Can we prevent institutions from becoming too big to fail or, worse, too interconnected to fail? Right now, unfortunately, regulators are encouraging mergers, giving us a land of one-eyed institutions buying blind ones. They have to be followed by a complete re-thinking of our capital requirements. Stronger capital requirements might help with excessive bonuses too. They will make financial firms more stable, less profitable, and therefore more parsimonious with their own employees in order to leave more for shareholders.

But a revitalized regulatory sector won’t be enough. We need more dissidents. We need to make the world a safer place for short-sellers to criticize companies. Regulators should publicly praise short-sellers, rather than periodically ban their activities. Critics and whistle­blowers, no matter how self-motivated, should be regularly consulted about suspicious companies, not dismissed as cranks once they expose wrongdoing.

And then we need to bring back plaintiffs’ lawyers. In the past decade and a half, Republicans not only weakened regulation but also led an attack on these lawyers. Corporate America hated them—and why not? They seem like parasites, ready to pounce on every corporate mistake. But they are vital to keeping capital markets functioning because they keep boardrooms scared. Frank Partnoy, a University of San Diego law professor and prescient critic of the fragile financial markets, says that “it’s crucial that standards not stand alone and they be enforced with real teeth. We need public enforcement and private litigation.”

The current catastrophe presents us with an opportunity. But the Obama administration and a Barney Frank-led congressional effort have to be aggressive and ambitious. Reforms can always be scaled back if they overshoot the mark. But the reform-minded cannot enter the debate in a defensive crouch. As new chief of staff Rahm Emanuel says, Don’t let a crisis go to waste.

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