What’s New in Geithner’s Financial Reform

What should financial regulatory reform look like? Treasury Secretary Timothy F. Geithner has announced the outlines of a plan, and Federal Reserve Chairman Ben Bernanke has testified to its benefits. There is a lot to their proposal, parts of which are quite new, and other parts that have been around for some time.

Financial reform always works this way. It follow crises, like the panic of 1907 that led to the establishment of the Federal Reserve, the 1929 stock market crash that lead to the creation of the Securities and Exchange Commission, and the collapse of Enron and WorldCom that resulted in the passage of Sarbanes-Oxley in 2002. Reform proposals, on the other hand, are less cyclical, and so they tend to accumulate in the  crisis interstices, waiting for the critical legislative mass for enactment that only a panic, apparently, can bring.

The legislative cycle means that one of the fundamental ideas in Geithner’s plan has been around for some time. The consolidation of regulation and creation of a systemic regulator is something that Americans have been talking about for years. The Europeans have urged it upon us for at least as long. On the other hand, a second reform proposal, that banks should be permanently de-levered, strikes me as quite new, quite tailored to the particular perceived flaws that led to the current crisis, and decidedly un-European. Both reforms have some slightly counter intuitive implications.

Leverage Caps

The locus of a not-very-European rule that would impose leverage caps on banks could be, interestingly enough, in Switzerland, where the Basel Committee on Banking Supervision can be found. Why would Basel be the place for the de-levering regime, rather than the Fed? It could be that American regulators believe that, in the end, putting together the domestic political will to cut down monster banks would be, in the end, quite difficult. Or it could be that the prospect of competing with super-large European and Japanese institutions is unpalatable, creating the need for a global rule.

Basel is not without its accomplishments, and, somewhat counter intuitively, the fact that some of the failures of regulation during the financial crisis attest to this. After all, the first financial institutions to fail were, at least in the view of the SEC, adequately capitalized under Basel II up to the moment they failed. This was the case for both Bear Stearns and Lehman Brothers. There is no question that the Basel II will be reevaluated sooner than later, but perhaps one lesson of the crisis is how important this relatively young international institution is: It was the Basel Committee that set the standards that Bear Stearns, Lehman Brothers, and the big European banks met in practice, and it was Basel II that did not, in the end, sufficiently keep the banks solvent.

Nonetheless, Basel has been very quiet since the failure of Bear Stearns. It has produced speeches on the importance of coordinated supervision, and has announced far-off deadline plans to rethink the basics of capital adequacy supervision. Its recent decision to expand the size of the group to something that resembles the G20 underscores just how important the G20 has become vis a vis Basel. What Basel has not done is provide a means of coordinated crisis response. That silence at Basel on that score is quite notable, since Basel was created to do something about international banking crises, and the prevention of them is its raison d’etre.

For that reason, as well as for the rule-oriented leverage-cap concept, a decision to give the Basel Committee something to do is quite notable in and of itself. But the substantial importance of the rule makes it only more so. Even though the Basel Committee has played a relatively minor role thus far in responding to the crisis, the decision will cheer proponents of global coordination to hear that it may be tasked with an important part of the solution. Leverage caps means that Basel does not appear to be gone from an important place on the national stage.

Systemic Regulator

What about the older idea: a consolidated regulator modeled on Britain’s Financial Services Authority? The politics of making such a regulator happen may turn on who trusts the Federal Reserve. It is a likely home for a systemic regulator, though Geithner’s proposal has been coy about where, exactly, that regulator might be.

The Fed is not the only home that has been proposed. In Henry Paulson's blueprint, financial regulation would have – it seems, at least – been centralized in the Treasury Department. Paul Volcker, with Geithner's pre-appointment approval, also wanted to centralize and consolidate the American regulatory apparatus, but apparently in an independent regulator – he may have been thinking of the Fed -- more resistant to the political winds than Treasury.

If one way to understand the Geithner plan, and financial reform more generally, is to think of it as a set of options, three options look like this: keep the regulatory system as either fragmented, the way it was, semi-centralized, the way it has become during this crisis, or bureaucratized and rationalized, along the lines that Paulson, Volcker, and now Bernanke and Geithner seem to suggest.

A lot of people want that Weberian rationalization. But really, there is a very long pedigree for the system we used to have - decentralized, functionalist, open to regulatory competition and races to the top. Amid all the cries for reform, the advantages of mess -- that is, a system where small states like Delaware play roles along with the federal government, where agencies like the SEC and the Commodity Futures Trading Commission (CFTC) compete for business - are easy to overlook.

After all, super-regulators don't face competitive pressure to be good regulators, unless you believe that globalization can provide that competition.

But there is a final candidate for the home of the systemic regulator, and it is looking like quite a strong one. The President's Working Group already requires the patchwork quilt of regulators that we now have to meet. Perhaps the President's Working Group will be given the job of systemic regulation, which would make this reform just regulation by committee with monthly meetings.

Entrusting the President’s Working Group with the role of systemic risk regulation is not likely to create over-regulation, or overweening, powerful financial bureaucrats. And it is less independent, and bank-focused, than the Fed.

The problem, however, is that it may not be much of a change at all.

Author bio

David Zaring is Assistant Professor of Law at the Wharton School of Business. His research is focused on international economic regulation and administrative law. He has published articles in the NYU, Michigan, and UCLA law reviews, and in peer-reviewed journals including the Annual Review of Law & Social Science, the Journal of Tort Law and the Journal of Empirical Legal Studies. He clerked on the D.C. Circuit, worked at the Department of Justice, and was educated at Harvard Law School and Swarthmore College.