Think Twice Finance

The Shape of Regulators to Come.

Secretary of the Treasury Hank Paulson, speaking on March 26th, began to reveal the details of coming regulatory reform. Two factors stand out. First, the regulatory apparatus will be made simpler, probably involving the Federal Reserve swallowing The Comptroller of the Currency and The FDIC and perhaps assuming some of the duties of the SEC. Second, there will be an expansion in bank regulatory turf. The investment banks, and perhaps other financial entities such as private equity and hedge funds, will come under the Fed’s aegis. Neither development should come as any surprise.

There is little to say about the slimming down of the regulatory apparatus other than to drop your jaw in amazement at the power of a silly bureaucratic structure to survive for decades after it became obvious to any student of Finance 101 that this system made no sense whatever. Literally a system that is there today because it was there yesterday.

However, any redrawing of the borderline between the SEC and the Federal Reserve will be interesting indeed. The real issue there is not the struggle between two federal agencies – the SEC and the Fed – for power. The real issue is the struggle between two professions, the predominately private accounting system and the governmental bank regulatory system, with the outcome determining how banks will tell us what they are up to. Both the accounting system and the bank regulatory system are easily corrupted and manipulated by the banks. However, I believe the accounting profession has showed us some marginal tendency to self-cleanse under pressure over the past twenty-five years, while I have seen no such tendency within the federal regulatory system.

The second regulatory change, the gain in the Fed’s influence over the investment banks, is really more like continental drift than volcanic eruption. That the investment banks fall under the safety net of Federal protection against non-equity investor loss to a degree has been evident for at least a decade, having been a prominent factor in the rescue of the claimants to Long Term Capital’s losses. There is a sense one receives from news accounts of the bail-out of Bear Stearns. One senses that the Fed woke up last weekend to discover that in the light of this problem, it has suddenly become apparent that the Fed needs greater powers. Bollocks. They have had these powers de facto for a decade. Cause and effect are the reverse of the journalist’s depiction. The powers that be are using the Bear Stearns collapse as a revelation to the public of a policy that has been in place for some time, and simultaneously as a justification of for an expansion in federal power that the public would normally distrust. Not that one should distrust expansion of federal power. I, for one, can’t get enough of expanding federal power.

If you want to understand the real reason for the expansion of power, look to the original post-depression federal regulatory mandate. The mandate is a long-enduring promise to the public that the government will protect the brainless small investor from the consequences of blind assumptions that certain investments will “always” pay off. As investors expanded the class of investments that they took to be safe beyond deposits and to various mutual funds and other more bizarre vehicles, pressure grew among financial institutions to bury greater risk inside these investments. Having succumbed to this pressure (with the unsavory assistance of the Fed) financial institutions have placed the Fed in a position to reassume control of the purveyors of these presumably safe investments of the masses.

And so be it. The Feds should reassume this long-standing accountability in its newer form, or do away with it all together. But I wonder, this time, will they use their new power to protect investors; or will regulators follow the path of the past, using their power to subsidize a now broader group of inefficient financial institutions, transferring the resulting damage from investors to taxpayers?