23 Apr 2008  Op-Ed

The Gap in the U.S. Treasury Recommendations

U.S. Treasury recommendations for strengthening the regulation of the financial system are a good start but fall short, says Harvard Business School professor emeritus Dwight B. Crane. Here's his suggestion for bringing regulation into the 21st century. Key concepts include:

  • The Treasury proposal recognizes that fundamental change in the regulatory structure is required for managing risk in the financial system.
  • The difficulty with the approach is that the risk in the financial system will not disappear—it will simply move to the non-prudentially regulated firms.
  • The United States should include all financial service firms under the regulatory authority of the new prudential regulator.

 

The U.S. Treasury recommendations for restructuring the nation's system of financial regulation are an important start in the process of strengthening the United States financial system. The proposal is to be commended for some of its recommendations, most importantly for recognizing that fundamental change in the regulatory structure is required for managing risk in the financial system. That said, there is still a fundamental gap in the recommended structure because it leaves some financial firms out of "prudential regulation," to use the report's terminology.

The optimal regulatory structure proposed by the Treasury would consist of three key parts. In addition to its role as the nation's central bank, the Federal Reserve would act as a market stability regulator, focusing on systemic risk. It would take regulatory action at the individual institution level only if the firm's actions were threatening the system.

A newly formed prudential regulator would regulate financial institutions that had some type of explicit government guarantee such as deposit insurance. In that role it would supersede existing bank and thrift institution regulators such as the Comptroller of the Currency, which regulates national banks.

Finally, there would be a regulator that would monitor the business conduct of all firms in the financial service industry. This regulator would set standards for each type of financial service firm to be licensed in its business, but would not have the same financial oversight as the prudential regulator.

Risk still in play

The difficulty with this approach is that even if the prudential regulator does its job of managing risk well, the risk in the financial system will not disappear. It will simply move to the non-prudentially regulated firms. This is one of the major lessons of the current U.S. financial crisis, a lesson that should not be forgotten.

The new prudential regulatory body would in essence be a bigger, more inclusive version of the current bank regulators. What's different is that it would regulate all bank-like institutions, not just what are known now as commercial banks. Like the current bank regulators, however, the new prudential regulator would protect its own territory, trying to make sure disaster does not strike on its watch.

During the U.S. recession of the early 1990s, large loan losses caused more than 800 banks to fail, including several relatively large ones. Not surprisingly, bank regulators responded by tightening credit standards and strengthening capital requirements. This worked well for the banking system. When the economy turned down again at the beginning of this century, amid the worst three years for the U.S. stock market since the Great Depression, only 18 banks failed, and thus far into the current crisis, only 5 have gone under, all of them relatively small.

Some bank regulators may have breathed a sigh of relief, but what about the rest of the financial system? The credit risk did not disappear. With tightened credit standards and higher capital requirements on loans, it became more profitable for banks to package loans as securities and sell the credit risk to the buyers of securities in the domestic and international financial markets.

Prudential bank regulators took appropriate action to manage credit risk in their domain, but as a result, credit risk was shifted to institutions and markets that were less heavily regulated. The same phenomenon will continue to occur under the Treasury proposals.

Learning from the United Kingdom

In designing a new regulatory structure, we could usefully draw on the experience of the United Kingdom with its Financial Services Authority (FSA), a body that replaced all of the previous institutionally oriented regulators. The FSA regulates all firms that perform a financial service, with the level and type of regulation designed to fit the scale and nature of the firm. Beyond managing risk at the firm level, the FSA is also responsible for systemic risk. Thus, it monitors trends in the financial markets across the individual firms.

Consistent with U.S. concerns about concentrating too much power in the hands of one agency, the Treasury proposes separating regulation of systemic risk from financial risk at the firm level, putting systemic risk under management of the Federal Reserve. On prudential regulation, however, the United States should follow the lead of the FSA and include all financial service firms under the regulatory authority of the new prudential regulator. Not to do so would simply push financial risk out of the regulated firms to the others.

It takes a financial crisis to illustrate the inadequacies of the existing system and provide the motivation for bringing together disparate interests—political and bureaucratic—to effect fundamental change. The United States should not miss the important opportunity provided by the current crisis to bring its financial regulatory system into the 21st century.