WASHINGTON — There have been dozens of attempts at regulatory restructuring over the past five decades, but this year may be the one where efforts finally make some headway.
System failures have transformed the issue into an imperative, paving the way in 2009 for the beginnings of a substantive debate on the topic.
While virtually everyone — lawmakers, regulators, academics, and the industry itself — views an overhaul as vital to the future of the system, reaching consensus on how to fix it will be a gigantic challenge likely to take more than one year. Policymakers must continue to grapple with the poor economy, a battered financial services industry, and competing political interests that have their own ideas on how to reform the system.
Still, lawmakers say the financial crisis has focused their attention on the topic, and they predict reform will happen.
"There are a lot of people who have had their come-to-Jesus meeting in the last several months on these points, so philosophically people aren't as locked in to the positions as they once were," Rep. Paul Kanjorski, the chairman of the House capital markets subcommittee, said in an interview. "They see there are failures in the system; they see there are weaknesses in the system; and they see the possibility that some of these things can only be resolved and changed by governmental action."
(This story concludes a three-part a series examining the legislative priorities for 2009. The first part, published Tuesday, focused on efforts to prevent foreclosures. The second, published Wednesday, focused on a legislative drive to overhaul the credit card industry.)
No one expects reform to be easy, however. The regulatory overhaul blueprint that Treasury Secretary Henry Paulson unveiled in March was roundly criticized from all sides. No other comprehensive road map exists, and most players in the debate have their own ideas about how regulatory agencies should be reshaped.
"Everybody is in agreement that there has to be regulatory reform, but I think nobody is entirely in agreement as to exactly what shape that regulatory reform should take," said James Barth, a senior finance fellow at the Milken Institute in Santa Monica, Calif. "The lobbying and the politics are going to slow things down quite a bit. It's easy to talk about a stimulus package when unemployment is rising … but I think regulatory reform is a much more difficult issue to deal with. It involves so many more different players, and the public doesn't fully understand, perhaps, the need for regulatory reform."
Of the key players, House Financial Services Committee Chairman Barney Frank has provided the most clues thus far as to how he would like to reform the system. In a speech last month he said his panel is "determined … to separate out the function of systemic risk protection and investors/consumer protection."
"Those two things have to be kept in separate institutional areas, because otherwise the investor protections will lose out in some cases to the concerns for systemic risk," Rep. Frank said. "Clearly there are going to be capital requirements, and one of the things we are going to say is that you are regulated by your activity, not by your entity."
By comparison, Senate Banking Committee Chairman Chris Dodd has said very little other than to note it is a top priority of his panel. President-elect Obama has said that he plans to unveil his own detailed plan soon and that it is important financial companies outside the banking system be brought under the same regulatory umbrella.
If there is any kind of agreement so far, it is this: that there needs to be a systemic risk regulator, a streamlining of regulatory agencies, and the creation of uniform oversight of financial activity regardless of institution type.
But sorting out exactly who does what is likely to involve a series of congressional hearings, reports, and public debate. With so many variables in play, reform is likely to take a long time, observers said.
"The broad legislative response — that's still at least a year away," said Jaret Seiberg, an analyst with Stanford Group Co. "In terms of implementing massive reform, 2009 is going to be about setting the stage for action in 2010 or 2011."
Even once consensus is reached, figuring out individual details could be a political challenge.
When it comes to regulatory reform, "it's easier to talk about than do," said John Douglas, a partner and the chairman of the global bank regulatory practice at Paul, Hastings, Janofsky & Walker in Georgia. "One of the reasons is there is a tremendous vested interest in the structure the way it is. People have figured out how to make it work for them, and thus every time you tinker with it you've created some degree of uncertainty with regard to some participant, and there is tremendous incentive to make sure that it doesn't happen."
A key focus is likely to be ways to mitigate systemic risk and limit the "too big to fail" phenomenon. With so many bailouts and backstops of major financial services companies last year, policymakers want to find a way to convince investors that the government will not always step in to save an ailing large corporation.
"Ultimately you may be able to limit the number of concerns that are systemically important," said Richard Spillenkothen, a former director of banking supervision and regulation for the Federal Reserve Board who is now with the Deloitte Center for Banking Solutions.
Still, gauging how far to take regulation will be tricky, he said.
"The question is how tight, how strict should the regulatory system be and to what extent should it limit risk taking and how strict should those limits be?" Mr. Spillenkothen said. "Obviously you have this balancing act between wanting to have sufficient regulation to prevent these kinds of things from ever happening again. At the same time, you don't want to stifle all innovation in the financial system."
The conventional wisdom at the moment is that the Fed will be given systemic risk oversight of all important players in the financial system. Though President-elect Obama has steered clear of advocating specific reforms, his choice for Treasury secretary, Timothy Geithner, has already endorsed giving the central bank more power.
"The Federal Reserve should be granted explicit responsibility and clear authority over systemically important payment and settlement systems and the ability to continue to encourage broader improvements in the over-the-counter derivatives markets," Mr. Geithner, currently the president of the Federal Reserve Bank of New York, said at a July hearing.
He also endorsed giving the Fed some supervision of any institution with access to the central bank's liquidity facilities.
"Our ability to directly oversee the risk profile of these institutions is essential to our capacity to make the judgments necessary for using our lender-of-last-resort tools, including critical judgments about liquidity and solvency for individual institutions and for the system as a whole," Mr. Geithner said.
Though Mr. Paulson recommended giving the Fed systemic oversight, the current administration has also suggested removing the central bank's day-to-day supervisory responsibilities of banks, leaving that to another regulator. Mr. Geithner has already rejected that idea.
"Replacing our ongoing role as consolidated supervisor with standby, contingent authority to intervene would risk exacerbating moral hazard and adding to uncertainty about the rules of the game," he said.
If confirmed, Mr. Geithner will be required to develop and present to Congress a regulatory reform blueprint in April (the Treasury was mandated to create the plan by the bailout law passed Oct. 3). He is also likely to face questions on reform issues at his confirmation hearing.
Some observers said Congress could address systemic risk issues before deciding how to overhaul the rest of the system.
"Something related to grand systemic risk, capital markets, information-flow kind of thing will happen reasonably quickly — and I believe this is the right result," said Ellen Seidman, the financial services policy director of the New America Foundation and a former director of the Office of Thrift Supervision. "But issues relating to how we reconstruct an entirely new regulatory system that has consistency across entities, that have effective enforcement, that really gets at risk management issues. … All those things are going to take time to figure out."
The idea of the Fed as systemic risk regulator has gained traction, but lawmakers have yet to agree on what to do with the other regulatory agencies.
One agency likely headed for extinction is the OTS. The Treasury already recommended combining it with the Office of the Comptroller of the Currency, and the thrift agency's handling of the failures of Washington Mutual, IndyMac, and Downey Savings Bank have likely only hastened its demise, observers said.
Some have also seen signs that the Obama administration plans to merge the Commodity Futures Trading Commission and Securities and Exchange Commission.
But other issues are also in play. Some observers said Rep. Frank could opt to attach subprime underwriting reform to the restructuring bill. The Massachusetts Democrat has said he plans to strengthen his mortgage reform bill that the House passed in November 2007 and try to bring it to enactment this year.
That bill principally sought to establish baseline underwriting standards for subprime loans and provide stronger consumer protections. It also included provisions to provide legal liability to securitizers.
Other lawmakers agree that issue must be addressed.
"We have really got to define what predatory lending is and put an end to many of these practices," said Rep. Maxine Waters.
The California Democrat also said she wants to examine consolidating regulatory agencies and hinted at capital requirements for credit-default swaps.
"I'm looking at other things in the financial services community such as credit-default swaps and paper programs that have no basis for being there," she said. "They have no collateral. They have nothing to support them. It's just smoke and mirrors, so we are looking at those."
Rep. Waters said she favors having regulators vet new products before they hit the street.
"I am absolutely convinced that every new product must be reviewed," she said.
Rep. Kanjorski said stronger prudential supervision is needed and called for more transparency in derivatives at the very least.
"The reality is you are not going to have a good credit market moving unless people understand what the hell they're involved in and what's being sold and being purchased and what their obligations are," he said. "To a large extent, that lack of transparency has gotten us into the frozen market we're in."
He added, "We've got to find a way and install something in place — and the industry itself is beginning to work on that — and have an inventory of what's out there."
Rep. Kanjorski also said the American International Group bailout forces policymakers to re-evaluate whether to create a federal insurance charter, with a new agency to run it.
"It's … a very high priority because it is part of the collapse of the credit market with AIG and other insurance carriers at risk," he said.
That idea is supported by some Republicans, including outgoing Sen. John Sununu, R-N.H., who is helping to craft a regulatory restructuring proposal due to Congress Jan. 20 as part of the congressionally appointed panel overseeing the Troubled Asset Relief Program. He said legislation he introduced with Sen. Tim Johnson, D-S.D., to create a federal insurance regulator would have helped in the current crisis if it had been enacted.
"The legislation would have … given the federal government a voice in the oversight of national insurance companies," he said. "While it might not have prevented specific problems over the past year, it certainly would have provided a voice and an agency that might have been better equipped to deal with the problems of AIG."
Sen. Sununu, like many others, said that lawmakers have to be cautious in addressing reform so as not to hinder market innovation.
"The goal should be to do the job right, not to do the job in a rush," he said. "We look back all too often and find that legislation that has been pushed through in a rush tends to have created unintended consequences and counterproductive effects."