Five Questions We Should Ask About Financial Oversight

On June 17, the Obama administration will make public its long-awaited
white paper on financial reform, quite possibly with a speech by the
president himself. Leaks from various players within the administration
over the past few weeks have focused on whether there should be a major
consolidation of the different agencies that supervise banks,
investment companies, and financial exchanges.

But where regulatory oversight is located, which got headline treatment in recent leaks to the Wall Street Journal,
is really a minor detail. The more important issue is how tough
regulation will be. When I spoke with senior administration economic
officials late last week, it was clear that they are still working in
the particulars.

Among the most contentious issues will be these:

How should the shadow banking system, namely hedge funds and private equity firms, be regulated?

President Barack Obama has long argued that any financial firm with the
capacity to create credit and risk should be subject to regulation;
hedge funds and private-equity companies currently are not. But should
this include detailed disclosures of trading positions and capital
reserve requirements, of the kind required of other financial
companies? And who should regulate them? The advocates of tough reform
want to have the Securities and Exchange Commission to do the job;
allies of the industry want to give general authority to the Federal
Reserve, in a new capacity as "systemic risk regulator" but without
explicit standards.

Should the Fed get more power -- or less?
Treasury Secretary Timothy Geithner is passionate about the idea that
the system needs a super-regulator to oversee systemic risk and that
this body should be the Federal Reserve. The premise is that since the
responsibility of intervening in a crisis falls to the Fed, the Fed
should be charged with heading off financial meltdowns before they
occur. However, many in the administration and in Congress think this
would give the Fed too much power and that the Fed is the wrong agency
for the job. Federal Deposit Insurance Corporation Chair Sheila Bair
wants a new panel made up of chairs of agencies, with its own
professional staff, to be the watchdog for systemic risk; both Rep.
Barney Frank and Sen. Christopher Dodd have indicated that they prefer
this approach, which has the support of some consumer and industry
groups. (See my recent Prospectpiece on the Fed and its critics.)

Should there be a Financial Product Safety Commission?
Elizabeth Warren, the Harvard law professor who also chairs the
congressional oversight panel on the banking bailout program, has long
advocated for a commission that would review and restrict potentially
hazardous financial products such as sub-prime mortgages, deceptively
priced payday loans, and other consumer rip-offs. The argument is that
the banking agencies have paid too little attention to consumer welfare
and that consumers need an agency that is their champion. The
counterargument is that a new Financial Product Safety Commission would
scramble lines of authority and that it's better to strengthen bank
regulators' ability to safeguard consumer interests just as they assure
bank soundness. Support for an FPSC is gaining strength in Congress. My
sources say that President Obama was very pleased with the positive
reception when he signed the credit-card bill last month and that he is
inclined to support more high-profile, pro-consumer measures such as
the FPSC but that his senior economic advisers are lukewarm on such
steps.

What kind of Resolution Authority for Failed Banks?
Since the financial crisis began, the Treasury and the Fed have helped
zombie banks like Citigroup with low interest rates, credit advances,
and direct infusions of government capital. The idea of a temporary
government takeover has been disparaged as "nationalization." Now, in
the new administration proposal, Geithner wants government to have the
authority to take over failed banks. The FDIC already has that
authority for small and medium-sized banks but not for large
bank-holding companies. There are two key issues here. Would the new
authority go to an expanded FDIC, whose independent-minded chair,
Sheila Bair, is sometimes depicted as disloyal to the administration?
And would the administration actually use the new authority -- or just
keep doling out money to keep sinking banks afloat?

How to Regulate Derivatives?
Along with sub-prime mortgages, complex and highly speculative
derivative securities, such as credit-default swaps, were at the heart
of the financial collapse. Several key Democratic senators were
appalled when President Obama named Gary Gensler to chair the Commodity
Futures Trading Commission (CFTC), since Gensler, as a Treasury
official under President Bill Clinton, was one of the key players in
the effort to prohibit CFTC from regulating customized derivatives,
such as the ones abused by Enron and American International Group.

Sen. Maria Cantwell of Washington state, one of the Senate's experts
on derivatives, put a hold on the Gensler nomination until she got a
written commitment from the administration to require much greater
disclosure to the CFTC of derivative trading positions as well as
capital reserve requirements, but there are potential loopholes. The
administration does not yet support the reformers' goal of requiring
that all derivatives, including customized ones, be traded on regulated
exchanges.

The president's release of a plan next week is only the opening gun.
The key House and Senate committees will hold hearings this month, and
floor action will not begin until after Labor Day. Senate Majority
Leader Harry Reid has said that given all of the other legislative
business, he can't imagine the Senate actually passing legislation
until early 2010. That's probably a good thing, since it will give
consumer groups pushing for tough financial regulation more time to
organize, while the continuing weakness of the banking sector provides
the exclamation point. Until now, the main players in this insiders'
debate have been the government and the financial industry. A new
consumer-labor reform coalition made up of several dozen groups is set
to be unveiled on June 16, just before the release of the
administration's plan.