Week in Review | Rearranging the Regulatory Structure

EVANS: This is David Evans from FinReg21.com. It's Friday, November 20. I'm joined today by Bob Litan of the Kauffman Foundation and Brookings. He's actually sitting over at Brookings, I believe.

LITAN: Yes.

EVANS: John Taylor, of Stanford and Hoover, with the bright California sunshine behind him, as we've just pointed out, and Larry White, from New York University.

The program today is going to discuss Senator Dodd's plan for reforming regulation, which he released last week. It's hefty, weighing at 1,136 pages, called Restoring American Financial Stability, its subtitle announcing its ambition to, quote, Create a Sound Economic Foundation to Grow Jobs, Protect Consumers, Reign in Wall Street, End Too Big to Fail, and Prevent Another Financial Crisis .

So we're going to talk about that today. But before we do that, let's talk about Ron Paul's bill yesterday, which passed the House Finance Committee 43 to 26. Also known as the Paul/Grayson Amendment, it lets the General Accountability Office, the GAO, audit pretty much everything involving the Federal Reserve Board.

Anyone concerned? John?

TAYLOR: Yeah, I'm concerned. I think it goes way too far. I think the great interest you're seeing in it is, I think, something you should take note. This bill has been around for a while, but this year it's passing with a big margin. And I think that reflects a lot of concerns with the Fed's interventions, like during the crisis, and maybe some kinds of concerns about - they did on regulation.

But I think it goes way too far. I think it's very important to have the ability to deliberate and set interest rates, and raise them when it's necessary, cut them when it's necessary.

So I'd like to see - ultimately, I suppose, it's going to have to be modified, as it's in the bill at this point.

One thing they just think about - I think some people proposed this, is some kind of auditing of the Section 13-3, Operations, these unusual loans that have been done. And sometimes what you're seeing, I think, is a healthy examination - for example, this week, this SIGTARP reports on the - how some of the creditors of AIG and their counterparties fared. That kind of thing seems to be useful, and more of that, I think, would be productive. So perhaps the interest can be directed in that direction, which I think would be fruitful.

EVANS: Yeah, the AIG report is really interesting, isn't it? Bob, what's your thought on the Paul/Grayson Amendment?

LITAN: Well, I think I'll join the chorus here. I think we all three of us think it's a bad idea -

WHITE: Oh, wait! Don't put words in my mouth, Bob. I'll chime in.

LITAN: Oh, my God, you're going to horrify me.

OK, well, in any event. So my two cents are, look, having the GAO or anybody audit, quote, interest rate policy, it seems to me is a bad idea, for all the reasons that John talks about. We clearly need the Fed's independence.

The other part of the Paul bill would require a lot more disclosure of individual Fed loans to individual institutions. I assume, just normal discount window lending, as opposed to the special operations that we're talking about.

Contemporaneously, I think that's a bad idea also, because the Fed, I think, has a legitimate concern that real time disclosure of banks borrowing to the discount window could provoke runs. This is not an experiment I think we want to run.

On the other hand, I think maybe one way to compromise here, and the media indicates that the Fed may be willing to accept it, is that with some suitable time lag, whether it's six months or 12 months, something after the fact, having disclosure about these kinds of loans - I can see that that would be OK, but I would object to it being contemporaneously.

EVANS: And Larry, you want to disagree?

WHITE: All right. Look, first, I think at least partly, the vote is sort of a venting and a signal of frustration. And second, I will be the first to agree that one cannot do government in a fishbowl, and that some degree of confidentiality and - well, you can't do government in a fishbowl.

I had thought that there was delay built in. Maybe I haven't looked at the Paul proposal closely enough. I thought there - basically everything did have a six month lag. And some of the things that John said about, maybe greater examination, more open discussion of some of these things - again, with a lag, and again, you don't want individuals' specific conversations or suggestions revealed, because I think you do get greater forthcomingness - that's not very felicitous, but I'll have to live with it for the moment. But if people can say what's on their minds, and gee, maybe in retrospect, the next morning in the shower, they might think, aw, gee, I wish I hadn't quite phrased it that way - you don't want that level of specificity.

But the kinds of revelations - again, with a lag - you know, we do live in a democratic society. And I'm not sure that there ought to be some kind of hallowedness built into the Fed. And this - the Fed is just another governmental organization. We have - I don't know, it may be one of the few governmental organizations that doesn't have an Inspector General. You know, that wouldn't be such a bad thing. I'd like to see more - again, with a suitable lag - more exposure.

EVANS: OK. My guess is, we could debate this probably for the next hour, but we can't do that. So I want to turn to the Dodd plan, which if it were passed, it actually would give the GAO sort of a lot less to audit, since the Fed wouldn't be doing anything. (laughter).

The plan would create a Financial Institutions Regulatory Administration, and that's kind of like - that's kind of where I'd like to start. That would become the prudential regulator. The Fed would end up focusing, really, primarily, and maybe exclusively, on monetary policy. And the FDIC would, I gather, be basically a resolution authority.

Good idea? Bad idea? Larry, do you just want to continue this one on, too?

WHITE: Sure. And here, I'm going to be the contrarian again. I like the diversity of different regulatory agencies. There's duplication, there's - it's impossible to describe, it is more costly, but it has an important saving grace. And that is, somebody with a good idea - and whether that idea involves a new financial product or a new way of regulating, there's more than one place where that idea could germinate and take hold. With a single regulator, a single no, and the good idea dies.

And so, I'm willing to put up with a lot of complicatedness, extra costs, in return for getting opportunities for diversity.

EVANS: Bob, what do you say?

LITAN: Well, Larry laid out the tradeoff exactly right. I guess I come down slightly differently. I think it's time we clean up the mess. I think all of us would agree - maybe Larry wouldn't - but I really do. I really do believe that if we were starting from scratch, that we'd never end up with this mess, the way that we have it.

WHITE: Bob, you are probably right, and that would be a mistake. Think about designing a complicated jet airliner airplane. And you have duplication deliberately built in at the beginning, because failure is such a horrendous thing.

And so, you're probably right - we wouldn't have duplication built in if we were designing it anew, and that would be a mistake. And a financial system is very complicated. I - like I said, I like the overlap and the duplication.

LITAN: Well, just to continue the point, I can't think of, really, any other sector of the economy, with the exception of antitrust - so Larry and I know this well. There are two federal agencies and 50 state agencies that do antitrust.

But if you think about most areas of the economy, we don't have this competition in regulation, and I think that's a good outcome. And so, I think that actually, this is a case where the crisis provides us an opportunity to clean up the mess, although realistically, politically, I think we can agree that the Dodd proposal, at least in this respect, faces a very strong uphill battle, because -

WHITE: I will agree with you on that, Bob.

LITAN: Yeah, because I doubt that it's going to happen.

EVANS: Well, I want to turn to John, but let me toss out one other question before I turn the mike over to John. Was the division of regulatory authority the source of the problems that led to the financial crisis? Is that what we ought to be focused on trying to solve at this point, is - so, if you want to comment on that, plus just the general question of whether this is a good idea.

TAYLOR: I can jump in on that. I think the proposals to merge, or at least, some merge - I mean, there's the OTS/OCC merger proposal, which certainly makes sense to me. But in general, you're talking about rearranging the chairs on the deck. I don't see how that's going to solve the problems that we had in the financial crisis. Some things fell between the cracks, to be sure, but this idea of a council to coordinate the actions of the different agencies, like the National Security Council does for the different agencies involved in national security, I think would be just fine.

And so I'm a little wary about going in this direction. There are some advantages - turf battles, perhaps, will be reduced. When someone needs to go to talk to a regulator, they don't have to see everyone and get different answers from all of them. But by and large, it seems to me, that's not the problem in this financial crisis.

And it's probably just like what Bob was saying. It's using the crisis to get some reforms, the opportunity. But I just - I don't think it's the right direction to be going, at this point. It doesn't deal with the serious problems we still face.

EVANS: Bob, do you think Congress and the White House would have more political influence over the new agency, at least, as it's currently devised? And if so, would that be such a bad thing?

LITAN: Well, if the agency is going to be reporting to the Treasury, then I don't think that would be a good idea. I think it needs to have - if you're going to create it, I mean, this is all, again, hypothetical, it needs to be independent.

But in any event, just to get to your other question about whether this regulatory hodgepodge was a contributor to the crisis, I think all three of us are going to agree, it was not a major contributor to the crisis -

WHITE: That's right.

LITAN: - and that we need to fix the content of the rules, not the actual rule makers, the rule making, or the changing of the chairs on the deck, is - it's sort of a housekeeping detail relative to the content of the rules, but allow too much leverage. We liberalized our loan to value ratios, obviously, excessively. And that's the heart of the crisis.

EVANS: Shouldn't the Fed - just kind of sticking on cleaning up the regulatory agencies, shouldn't the Fed face some consequences for letting the economy get into the crisis in the first place? So if we're not going to replace it as the regulator, what should Congress do to get the Fed under control? And I guess maybe this turns back to the Paul/Grayson bill.

But what do we think, on the role of the Fed, and reforming the regulatory agencies?

TAYLOR: You know, I've written a lot about the Fed actually being the cause at the beginning of this, with these very low rates, and there's also some of the regulatory issues. But you've had problems with monetary policy in the past. Remember the '70s, where policy was conducted in a very poor way, and people pointed it out, and you got some great leadership like Paul Volcker, and with support from the right political entities, and things improved.

So I think with respect to monetary policy more generally, the more you can have a good discussion of what went wrong. And going back to this idea of reviews, you have this Financial Crisis Inquiry Commission, the Angelides Commission, they're supposed to be working on and then reporting on, and it doesn't come until December of next year. That's the kind of evidence and debate we should be having right now, before we go ahead and try to make these changes.

But I think the more we discuss it more broadly, too, it's still - monetary policy is quite a technical, arcane subject. But the more broadly we can discuss it and come to a conclusion, do people agree with me that those very low rates were a significant source of the housing boom and bust and the financial crisis, or - and if they do, then how do we give the right incentives, if you like, the accountability to the Fed not to do that again?

EVANS: Larry, anything you want to add on that?

WHITE: No. I mean, I agree with John. And I do agree that housing - that interest rate policy was too low for too long. The Fed then, I think, still does have an excessive focus on deflation and the possible problems that might accompany deflation, too much attention to Japan and the experience of the 1990s, not enough on the - sort of the real problems that it, in a service-oriented economy, John and I are in one service sector that keeps on raising its prices, keeps on getting criticized for raising its prices. The medical sector now occupying a sixth of the economy. We're spending major amounts of legislative and executive branch time trying to deal with the problem of rising prices in that sector.

I don't see the deflation worries as being very serious, and I truly believe the Fed has been unnecessarily diverted - its attention sort of has been focused in the wrong area.

EVANS: So let's move on to - and I'll start with you on this, Bob. The other new agency that we get is the - under the Dodd proposal, is the Agency for Financial Stability. So in addition to the prudential regulator, we get a systemic risk regulator.

Once again, the Fed loses powers that would have gotten under the administration's plan, as it's currently constituted in the - in Barney Frank's committee. It seems like the new agency, under the Dodd plan - and I have to admit, and I suspect this is true for the rest of you, that I have not read the 1,136 pages yet.

But it seems like the new agency will have quite wide latitude, and perhaps most significantly, it has the power to break up companies that get too big, in addition to having a bunch of incentives there for discouraging companies from getting too big.

Is this a better or worse approach for dealing with systemic risk than what the administration has proposed?

LITAN: Well, that's a complicated question, and I will confess, I haven't read all 1,130 pages. So I think we do need somebody doing systemic risk monitoring. We can't expect it to be perfect, but basically, it's going to look out in the future for future asset levels, will try to recommend counter-cyclical policies to the extent that it can, and again, we can't expect perfection here.

EVANS: Under the administration's plan, the Fed largely gets to do that with this oversight council kind of whispering in its ears. I mean, do you like the Dodd idea of a new agency to do that, versus what the administration has come up with?

LITAN: Well, I think having a whole new agency to do this, when largely this is what the Fed is normally doing anyhow, I think is duplication. And I don't see the case for having a separate agency.

I am for having an agency that is able to exert counter-cyclical forces - so, to raise capital standards across the board in much the same way that we raise interest rates, and to do it in a finely gradated way, not in a way that will precipitate a crisis.

But whether that has to be done by the Fed, or whether it should be done in coordination with an oversight council, which is probably the direction the Hill is going to go in anyhow - I think we're going to end up with an oversight council. And then the question is going to be, how much authority or weight will the Fed have on that council? By virtue of its staff, the Fed is going to have, I think, a significant impact, as it should. It's got the horsepower, it has the economists, and so forth.

So I guess I'm more comfortable with an oversight council and a strong Fed contribution than having a completely new systemic agency.

EVANS: John?

TAYLOR: I just - I think that the administration's proposal had the Fed designating the financial holding companies of significant risk of some kind, and then regulating them. And then those would be the ones that would be most susceptible to the resolution authority, which was located somehow in the Treasury.

So this proposal, seems to me, combines those two things together. The resolution authority is contained in this new agency, as I understand it, and that's part of the breaking up idea, part of the intervention part. And I think I expressed great concerns about both designating institutions as systemic, when we can't define the term yet, and there's great debate about what that really means. You've seen that in this investigation of the AIG situation.

Now, plus the great power that a regulatory - a resolution authority would have to intervene. Again, I would go back is, we need to study carefully what happened with the FDIC interventions with Washington Mutual. I think there's some questions there. When we get the answers, it will help.

So I really - in terms of a systemic risk monitor, as Bob was indicating, that's fine. You look at what's happening in the economy, and you report the Fed - that it already says it does that anyway, so making sure it does it is fine.

And I would just add one thing. I'm quite frankly wary of the counter-cyclical capital ratio moving around. I don't think we have studied that very much. There was a great deal of interest in that about 10 or 15 years ago - people had models. It's not clear that that's needed, and also could cause some problems in itself if they were moved around in an arbitrary or incorrect way.

EVANS: Larry, anything else you want to add on this one?

WHITE: Yes, I would just add, when I think of capital requirements - boy, that's the heart of prudential regulation of financial institutions. And so, if we're going to have - and I agree with John. I'm not wholly comfortable with this issue of pro-cyclicality of capital requirements. You've got to be careful, etc., but I think it requires a whole lot more study.

But when we're talking capital requirements, that's got to be the domain of the prudential regulator. And to somehow have at least some influence on that outside of the prudential regulator, I think is just not good policy.

EVANS: Let's move on to the third pillar. So, Dodd's plan also calls - as does the Obama plan, for increased consumer protection, and more or less follows the administration's proposal to create a new Consumer Financial Protection Agency.

One could ask about the statement in the Dodd plan that failed consumer protection caused the crisis, but I think that's a subject we probably all agree on, and have beaten up already.

But the last time we talked about this CFPA - and I think this was with all three of you - Bob was, I think, pretty enthusiastic about the administration's proposal, Larry was middling, and I think John didn't really like it.

Now, in the last few months, Larry, have you warmed up to the administration's proposals? Have you become more concerned? Any thoughts on what you know about the Dodd plan?

WHITE: I know - first, I too have not looked at the details, and so I don't know any more about the Dodd plan.

No. I, if anything, I have - I would say I'm closer to John on this. I am very concerned about what happens to financial innovation in a setting where you have this separate agency responsible for consumer protection.

It's clear that there are too many households that got bamboozled - no, that was not the major cause of what went wrong, but clearly, there are too many households who do have too much difficulty in wrapping their heads around financial things. They need help. They need some protection. I would get there by beefing up the existing consumer protection functions in the various agencies, and just putting more money into counseling of individuals who are up against various kinds of financial product circumstances.

But I really have problems with a whole new agency. I think, in this case, it would be for the worst.

EVANS: And Bob, are you still an enthusiastic supporter?

LITAN: Under certain conditions, and that is - look, I start from the proposition, the banking agencies will never give a consumer protection the priority that it deserves, even if you throw more money at it. It's just not part of the ethos and the culture of the prudential regulator to really give a lot of points and a lot of attention to consumer protection.

So I'm just - from a real politic point of view, I think it ought to be a separate agency.

Now, here's where the difficulty comes. What does that agency actually do? The part that I'm comfortable with is that if it makes its function a streamlining of disclosures, which now are a mess, and basically focuses on simplifying disclosures, and basically doesn't do much else, I'm OK with it.

WHITE: Write that into the US Constitution, and you will get my vote immediately.

LITAN: (laughter) But -

EVANS: I was going to say, Bob, that's quite different than either of the plans -

LITAN: Well, now, the plans - the plans talked about disclosure. I don't think the plans right now currently envision a preemptive regulation where the agency is going to actually approve products, because there, I will fully agree with John - I'm sure he would agree with this, and also Larry - that we do not want such an agency basically signing off on financial products before they come to market. That would be a very bad idea, for all the reasons that Larry laid out.

I - on the other hand, I don't have a problem with the agency seeing a potential - a particular product that looks like a disaster saying, you've got to have a new warning sticker on this product, or something like that, before people buy it - sort of like cigarettes. If something turns out to be the equivalent of cigarettes, well, then, I think the agency has to do it, but we only know that after the fact.

EVANS: OK. Well, one other question on that, Bob. You were talking about antitrust. One friend of mine suggested that the right solution is to get the FTC out of the antitrust business, so we just have one agency there, and turn them into the new Consumer Protection Agency. What do you think?

LITAN: Well, it's not completely crazy. It's not. I mean, I think there is duplication at antitrust, and Larry and I know there's a lot of competition between DOJ and FTC. It's not a completely crazy idea. And after all, the FTC's job is consumer protection -

EVANS: And the two new commissioners that Obama just appointed, I think yesterday or the day before, come with a consumer protection background.

LITAN: Right, so -

EVANS: Anyway, let's move on to something that's actually more pertinent. Part of the emphasis, at least in my mind - or from what I've seen, behind the CFPA, is this view - and you get a lot of this from behavioral (inaudible) folks, is that the Americans consume too much debt. And that part of the reason they consume too much debt is, the financial institutions cater to short sighted consumers who eventually found a - either regret their profligate ways, or as we've said, have been bamboozled to understand they've made a mistake.

I mean, do you guys think that Americans consume too much debt, and that's a problem that we ought to be dealing with?

TAYLOR: I just - I think our savings rates have been so low for a while, that's - how do you get those low savings rates? But you have a chance to borrow - you've got home equity, etc., etc.

So I think it is a problem. I think the savings rates problem is related to the taxes, tax reform, consumption tax, things like that would help that considerably.

This crisis itself, by the way, may lead to a higher savings rate by the time we're finished. That would be a good thing.

I'd say, one thing I did notice in the Dodd bill is - skimming through it, is this idea of focus on financial literacy. I don't know what - how much funds are associated with it, but actually, that's something, if you think about the Feds, and the district Feds, they do spend some time on communicating about basic financial literacy. And I wouldn't mind if they did a lot more of that. I think we - or this - of course, a lot of that could be done through foundations and the private sector as well.

But financial literacy, I think, would go a long way to helping people understand rates of return, compound interest, manner of saving - it's remarkable. I'm teaching Economics 1 now, I have to teach that a little bit, even here.

But I think it's a good idea to do some of that - maybe you could pull that out of the Dodd bill.

EVANS: Where is all this going? Bob, do you have any inside, or non-inside knowledge on this? I have heard some statements today in DC that the Dodd bill is more or less dead on arrival.

LITAN: Certainly the idea of the consolidation doesn't seem like it's going anywhere. But look, I will tell you one thing. I think this whole train is moving faster than I would have expected three months ago. Three months ago, we thought, I think, all of this was going to take until next election, or right before the election. And the House looks like it's trying to get a vote on the thing before the end of the year or early next year. And Dodd wants to move more quickly.

And so, this train is moving. The question is, where? (laughter) And I'm not - I really - I don't know. I mean, I have as much uncertainty about the destination of this train as I do the healthcare train - let's put it that way. I don't know where it's going.

EVANS: Larry, any thoughts on that?

WHITE: Oh, I - well. This is not my strong suit to begin with, but I agree. And this morning's Wall Street Journal had a story about how there's now at least a two week delay in the House Financial Services committee's taking up of the legislation. So I'm not sure the train is moving quite as fast as Bob has indicated, and for sure, the direction is a mystery to me.

EVANS: John, do you have any final words for us?

TAYLOR: I think we should act as if the train is moving fast and I appreciate your organizing these kinds of discussions, David. I think it's very helpful, and the more of this you can do, the more you'll be able to either slow the train down, which I think is the best thing to do now, or drive it in a more sensible direction than it's moving.

So anyway, thank you for doing this.

EVANS: Thank you very much, John. And I don't think any of us wants to throw ourselves in front of the train, but perhaps we can all figure out a way to move it in the right direction.

So, thank you guys very much - really appreciated, and hope to talk to you real soon.

WHITE: Thank you, David.

TAYLOR: Thank you.