Digesting the Paulson Plan

History shows that initiatives to regulate the US financial system, though well intentioned, typically originate in the wake of market meltdowns. By many accounts, this reactionary approach has proved unsatisfactory: Once regulation catches up with financial innovation, market participants gallop off in a new direction--complaining all the while about being saddled with another burdensome requirement.

Proponents of a free and self-regulating market routinely cite the Sarbanes Oxley Act of 2002, which was drafted and approved in only five months, as a prime example of a heavy-handed and overzealous regulatory response. Critics argue that such overregulation places US companies at a competitive disadvantage and drives others to do business in foreign markets where the rules are less prescriptive.

At the same time, given the current market turmoil, it’s abundantly clear that additional regulation and oversight--especially of mortgage originators and investment banks--are necessary to prevent future crises.

This fundamental tension between prevention and excessive restrictions is at the heart of all financial rulemaking.

To some degree, reaction to the US Dept of the Treasury’s “Blueprint for a Modernized Financial Regulatory Structure” has likewise polarized into two corresponding camps: those in favor of deregulation and those in favor of further regulation.

Supporters of deregulation have generally lauded the Treasury’s plan for streamlining what many consider an arcane and inefficient regulatory system plagued by redundancies and superfluous requirements.

On the other hand, advocates for increased regulation of the mortgage industry have criticized any moves to scale back the number of regulators. After all, they reason, more stringent regulations and proactive scrutiny of market participants are the best response to the worst market meltdown in recent memory.

The Abridged Version

Let’s take a quick look at some of the proposal’s key recommendations.

In the short-term, the plan advocates expanding the membership and scope of the President’s Working Group on Financial Markets to facilitate interagency communication and coordination.

To improve oversight of mortgage originators, many of which aren’t subject to direct supervision, the Treasury recommends creating a federal commission that would evaluate, rate and report on the adequacy of each state’s system of licensing and regulating participants in loan production process.

Another short-term proposal involves the Federal Reserve articulating a transparent policy for future lending to non-depository institutions and, accordingly, an appropriate supervisory regimen to ensure the safe and sound operation of this sector.

The Treasury’s suggestions for the intermediate-term are slightly more sweeping. There are currently five federal regulators for each different class of financial institution, in addition to supervision at the state level. The Treasury’s blueprint recommends merging the Office of Thrift Supervision, which oversees the safety and soundness of a dwindling number of savings and loan institutions, with the Office of the Comptroller of the Currency, which has jurisdiction over nationally chartered banks.

Likewise, the plan proposes to streamline the supervision of state-chartered banks that are insured by the Federal Deposit Insurance Corporation (FDIC). Currently, these institutions are subject to supervision and regulation at both the state and federal level.

Similar changes would occur in the insurance field, which is currently subject to a patchwork of state regulations. The industry has responded enthusiastically to the creation of an optional federal charter; this change would reduce compliance headaches for nationally chartered insurers and ostensibly improve efficiency and facilitate product innovation.

Consolidation in the securities and futures markets is also on the menu, with the Commodity Futures Trading Commission and the Securities and Exchange Commission merging into a single entity.

The Treasury’s “long-term optimal regulatory structure recommendation” would completely do away with the current system in favor of an objective-based division of responsibilities. Instead of divvying up supervisory authority by function (for example, banking, insurance and securities), the Treasury proposes shifting to three regulators: one that is in charge of the overall market stability; one that has supervisory authority to ensure market discipline; and a business conduct regulator to address business practices.

Soothing the Dyspepsia

Before we can rationally discuss the import of the Treasury’s Blueprint, we need to move beyond gut reactions either for or against more regulation.

The fact remains that the plan deals primarily with regulatory structure, not regulation itself. In other words, although the proposal would result in increased oversight of mortgage originators and investment banks, it is difficult to gauge the extent to which its intermediate- and long-term recommendations would, in and of themselves, promote market stability.

Regardless of structure, regulators require sufficient tools--timely market intelligence, thoughtful regulation and effective supervisory guidance--to prevent future meltdowns.

Those who are interested in monitoring legislative and regulatory responses to the current market turmoil should pay attention to developments in Congress and refer to the recent policy statement released by the President’s Working Group on Financial Markets. (Oddly enough, this document is almost 200 pages shorter than the Treasury’s plan.)

Some pundits have dismissed the Blueprint as not only immaterial to the current market crisis, but irrelevant on the whole. After all, many of its longer-term proposals have failed to gain acceptance in the past, and any consolidation will encounter strong resistance from both the states and the endangered regulatory agencies, not to mention their supporters in Congress.

Even Treasury Secretary Henry Paulson acknowledged, “With few exceptions the recommendations in this Blueprint should not and will not be implemented until after the present market difficulties are past.” Paulson likewise admitted, “These long-term ideas require thoughtful discussion and will not be resolved this month or even this year.”

What, then, is the significance of the Paulson Plan? Although the Treasury Secretary insists that the blueprint is not a response to our current travails, the market’s troubles provide an ideal launch pad for reforms that have traditionally been proposed under more benign economic conditions.

In some ways, Paulson and his cohorts have provided the media with exactly what they anticipate in the wake of any financial crisis: a revolutionary proposal, albeit not necessarily in the area that most would expect. Certainly, the credibility of the current regulatory regime is in tatters, and it’s not too much of a leap to attribute these failures--especially given their scope--to the regulatory structure as a whole.

Aside from promoting an overhaul of the regulatory system itself, Paulson’s plan may shape forthcoming regulatory and legislative proposals in a more subtle fashion, shifting the discourse from short-term, localized fixes to longer-term, bigger-picture solutions.

In and of itself, this may result in the measured regulatory response that this complex and multilevel meltdown requires.