WASHINGTON — A fatal flaw in the Obama administration's proposed regulatory revamp may be that it does nothing to force industry overseers to use their power when problems arise.
"This is a culture where the regulators had authorities but were afraid to exercise those and interfere with the growth of their regulated entities," said Josh Rosner, managing director of Graham Fisher & Co. Inc.
The administration's plan would, among many other things, hand federal regulators wider and deeper power over systemically important institutions, including the ability to toughen capital and liquidity standards.
But it does not specify which institutions are systemically important, whether and how they should be resolved and the scope and size of any new operating restrictions.
Similarly, a proposed consumer protection agency would have vast powers to examine mortgage, credit card and other financial markets to set new rules — but it would have wide discretion over what to target and how.
Some observers said that giving such broad latitude may work fine in the years immediately following the crisis, but that eventually regulators will become lax again.
"The lesson of this financial crisis is that in a period of prolonged upward economic activity … regulators and the industries involved just forget that what goes up can come down," said V. Gerard Comizio, a partner at Paul, Hastings, Janofsky & Walker LLP. "Something has to be built into the system to make sure that the industries involved and the regulators just don't forget."
Lawmakers may be preparing to do just that. Several indicated last week that they will go beyond granting powers and dictate how they should be used.
Senate Banking Committee Chairman Chris Dodd said he is considering adding mortgage reforms to the restructuring bill rather than leaving that up to the new consumer protection agency.
"Merely designating someone to do a job does not guarantee a job gets done," he said. "There is a strong interest in this committee to deal with the mortgage reform elements in this bill."
Sen. Richard Shelby, R-Ala., the panel's ranking member, also said that simply giving regulators more power is insufficient.
"A lot of the regulators had the powers — they didn't use them," he said on CNBC. "They didn't know what was going on or looked the other way. … Another layer of bureaucratic responsibility on the Fed and the other agencies is not going to cure the problem."
There is a precedent for Congress mandating regulatory action.
Under the Federal Deposit Insurance Corp. Improvement Act of 1991, Congress created "prompt corrective action," a regimented set of steps regulators had to take when a bank's capital fell.
Though many protested at the time that it would remove regulators' flexibility and undercut the financial system, prompt corrective action has generally been seen as successful in forcing banks and their supervisors to confront problems. But as the savings and loan crisis became a memory, so did PCA.
"We had prompt corrective action, which turned into slow inaction on the part of the regulators," said James Barth, a senior fellow at the Milken Institute.
Under the Obama plan, the Treasury Department would lead a working group of regulators to set new, tougher capital requirements. But Barth warned that would not be enough.
"The regulatory authorities always had the authority to impose higher capital requirements," he said. "They never did it. The problem isn't that their hands were tied. Their hands were basically extended to the institutions."
Though the Federal Reserve Board had power to clamp down on abusive lending practices, it failed to do so until last year. Many critics said it is clear consumer protection took a back seat to monetary policy and safety and soundness concerns.
The Fed's consumer protection history "is exactly why" the administration "called for a new agency," said Robert Litan, a senior fellow at the Brookings Institution and the head of research at the Ewing Marion Kauffman Foundation. "The proposal recognizes that the Fed is probably not the best policer of mortgage products or consumer products, and that's why they've recommended that the Fed concentrate on systemic risk, which is more of its specialty, and leave the consumer product regulation to a new agency."
Comizio said the administration's plan broadly would create a system of checks and balances, where authorities from different agencies overlap, so one regulator can always come in and be more aggressive when another regulator pulls back.
The proposal also would effectively remove federal preemption, allowing state regulators to enforce federal and state laws against all commercial banks.
"It's intended to be a system where every regulator is looking over their shoulder at another regulator that may be enforcing the laws against their regulated institutions," Comizio said. "What it seems to be doing is incentivizing regulators to be as hands-on as possible to avoid the intervention of another regulator."
To be sure, some contend there were true gaps in regulatory authority that prevented the agencies from acting — a problem they say the administration's plan would solve.
"I just think that we have a regulatory architecture that was not necessarily designed to deal with the fact that we now have vertical and horizontal integration of financial activities," said David Min, an associate director for financial markets policy at the Center for American Progress.
"Would the gaps have been a little smaller if the regulators had done their job? … Probably. But would the gaps have still existed? I would say yes. The fact is: Our financial system has changed a lot. Our regulatory structure has not."
But others note that the teams of examiners who reported for duty daily at some of the most troubled companies failed to do their jobs on either a micro or a macro level.
"How many enforcement actions were there against Citi during the past four years?" Rosner said. "We still don't have a single industrywide standard of delinquency and default in this country. That's as much a part of the crisis as anything else."
Even those who view the proposed revamp as a step in the right direction agree that an improved structure is not enough if officials inserted in leadership positions at the agencies keep the tool chest closed.
"All this can do is set up the institutional structure for doing the right thing, but you have to have the right people — in both Congress and the Fed — to make sure the right thing is done," Litan said. "You can't hardwire the right result by … definition."