Obama Plan Improves Regulatory Structure but Doesn't Address Accountability

There are many useful features of President Obama's proposals for the reform of the regulatory system. Most notably, the plan to establish an agency to ensure that financial products are fair and transparent to consumers is a big step forward. Such an agency might have prevented many of the worst abuses in the subprime market.

The proposal to provide regulatory authorities with resolution powers for non-bank financial institutions is also a useful reform. Such powers would have greatly facilitated regulators' efforts to deal with the collapse of Bear Stearns, Lehman Brothers, and AIG.

This plan should also go far toward eliminating the sort of regulatory arbitrage that allowed firms to seek out the weakest regulators. It would have been desirable to have also included some sort of national consolidation of regulation of insurers, but that would have faced enormous political opposition.

The requirement that hedge funds and private equity funds register with the SEC is also a step forward in transparency, although it is not clear how much, if any, of this information will be made available to the public. Requiring that derivatives be traded through clearing houses will also prevent some of the worst abuses in this area. However, it would have been preferable to require that they be exchange-traded and that non-standardized derivative instruments be strongly discouraged. This would be a further gain of transparency and also lead to lower transactions costs.

The principles for altering executive compensation are also useful, but it remains to be seen how effectively these can be enforced to change entrenched practices.

There are some areas in which the proposal does not take some obvious steps, perhaps most notably by not directly addressing the conflict of interest that exists when a company hires and pays a rating agency to rate its issues. This conflict could have been removed simply by having an independent party (e.g. the stock exchange) select the rating agency. If the hiring decision was taken away from the company, then the rating agency would have no incentive not to present an honest assessment of the issues it rates.

However, the biggest problem with the Obama administration's regulatory proposals is that they support the view that we had an economic meltdown primarily because we had an inadequate regulatory structure rather than failed regulators. The basic story of this crisis was not that the regulatory authorities lacked the ability to rein in this disaster before it was too late. Rather, the regulators - most importantly the Fed - opted not to use their power to rein in the housing bubble.

The discussion of financial issues has largely worked to hide the centrality of the housing bubble to the crisis. If there had been no credit default swaps, collateralized debt obligations, or subprime and Alt-A mortgages, but the housing bubble had still grown to $8 trillion, we would be in pretty much the same economic situation that we are in today.

Residential construction would have collapsed due to a huge glut in the housing market and consumption would have plunged as a result of the loss of $8 trillion in household wealth. The financial problems created by failed regulation do complicate the picture, but the fundamental picture is a very simple one of a collapsed bubble causing demand to plummet.

Politicians and regulators have a direct interest in portraying the crisis as being the result of an inadequate regulatory apparatus rather than failed regulators, because failed regulators should get fired. However, by not holding failed regulators accountable, this reform proposal is setting the grounds for the next crisis.

Even a perfect regulatory structure will not work if the regulators do not do their job. They will not have an incentive to do their job if there are no consequences for failure

In this case, we have seen the most disastrous possible regulatory failure. This is like the drunken school bus driver who gets all his passengers killed driving into oncoming traffic and no one is held accountable. The message to future regulators is, therefore, to simply go along with the powers that be (i.e. the financial industry) and you will never suffer any negative consequences.