Treasury Secretary Timothy Geithner and Securities and Exchange Commission Chairman Mary Schapiro each testified before different congressional committees today to disclose their recommendations on regulatory reform of US financial markets.
Geithner, who spoke to the House Financial Services Committee, offered a six-point proposal to address oversight of major players in the finance markets and prevent many of the problems that led to panic in financial markets last year:
Identify a single regulator to supervise financial firms of all kinds and make sure that they do not take on excessive financial risks.
Increase the capital reserves that large financial institutions are required to maintain.
Tighten existing regulation of money market funds to avoid disruptions like the one that took place last year.
Create a centralized clearinghouse for derivatives, including credit default swaps, so that the degree of exposure taken by large financial institutions can be more easily determined.
Require large hedge funds to register with the SEC and disclose information on their portfolios.
Create regulatory authority to make it possible for the government to take over large financial institutions, even if they are not banks.
Geithner’s proposals, several of which closely resemble recommendations prepared for the G20 Summit meeting next month, will undoubtedly be heavily debated in coming weeks. The last recommendation would provide broad powers for the government to take over failing companies that are not currently regulated on the national level, like insurance companies (remember AIG?), non-bank lenders (think GMAC) and large financial firms. If Treasury had possessed this kind of power last year, its options for dealing with AIG, Lehman Brothers and Bear Stearns would have been quite different.
There will probably be some jockeying among different government agencies (my guesses: Treasury, FDIC, SEC) to determine which agencies take a share in the expanded regulatory powers.
Geithner also indicated a need to crack down on money laundering and tax evasion loopholes.
As CalculatedRisk.com and economist Susan Lee point out, having a regulator with wide powers to manage the risks being taken by financial firms is only useful if the regulator actually knows how spot dangerous, risky situations and deal with them. As late as 2007, the Federal Reserve’s public position was that the subprime problem was troubling, but manageable. The SEC, which had the power to audit Bernie Madoff, never got around to it, despite the fact that their records indicated that he had custody of almost $20 billion in investor funds.
The presence of a uber-regulator could, in principle, help rein in undue speculation by large financial firms, thereby reducing the risk of another major meltdown. But given the interconnectedness of world financial markets, big-league risk-taking could shift to financial markets elsewhere in the world (China?). In that event, such a regulator still might not be able to shield the US economy from future financial crises.
Schapiro, who testified before the Senate Committee on Banking, Housing, and Urban Affairs, discussed a number of regulatory changes that she is pursuing as head of the SEC.
Shapiro, like Geithner, spoke about closer regulation of the money market funds, which currently hold about $4 trillion in assets. The SEC is also examining further regulation of hedge funds, including registration of hedge fund investment advisers (currently these advisers are not regulated by the SEC). In a nod to the Madoff scandal, the agency is considering independent surprise audits for investment advisers who hold client assets (of course, audits only help if you actually do them).
Other proposed changes included rules to make it easier for shareholders to nominate corporate board members and SEC oversight of municipal bonds.
Like Geithner, Shapiro urged Congress to establish a central clearinghouse for derivatives. In a move endorsed by Banking Committee chairman Christopher Dodd, she indicated that the SEC will be proposing the restoration of the so-called “uptick rule.” It’s been argued that the SEC’s decision to eliminate this rule in July 2007 led to excessive short selling of some financial companies over the last year.
What does all this mean to the little guys?
These changes, if implemented, should tend to make U.S. financial firms smaller, less dangerous, and less profitable. There will be new disincentives for excessive risk-taking. There may also be less innovation in the creation of new financial products, provided regulators are smart enough to understand the risks associated with such products. Some risk is necessary to have functioning financial markets, but the elimination of foolish, poorly-disclosed risk-taking can only be good for investors. The changes proposed by the SEC look like steps in the right direction for an agency that was mostly missing-in-action during the financial meltdown that took place last year.
If these added regulations come to pass, investors will still have to be vigilant. Increased regulation can impede the ability of the financial industry to do dangerous things, but financial institutions possess a perverse capability for inventing financial instruments that are profitable for them and dangerous for the people who invest in them. Caveat emptor will be a useful slogan as long as human nature remains in place.