Weighing the Regulatory Reform Plan

• The Obama administration's proposed financial regulation reforms appear as wide-ranging as any since those enacted in the 1930s.

• The proposal does not appear heavy-handed, and if implemented, will ensure a more steadfast, albeit slower-paced financial system.

• The reforms themselves will not prevent future financial crises; wise and deft decisions by regulators will remain critical.

The Obama administration's proposed reform of financial system regulation is much needed and reasonably well designed. The financial system has stabilized in recent weeks, but it remains in significant disrepair. Credit remains severely impaired; the growth in household and nonfinancial corporate debt weakened to its slowest pace on record in the first quarter of this year.

The economy will not regain its footing until credit flows more freely. Reform is necessary to re-establish confidence in the financial system, particularly among global investors. The reform proposal is well thought out, at least in theory; it attempts to fill most of the cracks in the regulatory framework, cracks that contributed significantly to the current financial crisis.

The proposal's most significant reforms would:

• Establish the Federal Reserve as a systemic risk regulator. The Fed would have authority to adjust capital and liquidity levels and risk management practices of any financial institution deemed a possible threat to the financial system's stability.

• Give regulators authority to address a potential failure of any financial institution that puts the stability of the system at risk. This would help avoid cases such as AIG and Lehman Brothers.

• Establish a new Consumer Financial Protection Agency (CFPA) with authority over providers of financial products including credit, savings and payment services. Many households have little understanding of their obligations and responsibilities as borrowers or the risks they take as investors.

• Require originators of securitized assets to retain a material economic interest in the securities they issue. Without skin in the game, issuers of such assets in the past lacked incentive to ensure the underlying loans in their securities were appropriately underwritten.

• Regulate over-the-counter markets for derivatives, including credit default swaps, to increase these markets' transparency and efficiency. Their opacity as the bubble burst contributed to the panic that pervaded the financial system in the crisis.

• Broaden the definition of a bank holding company to include thrifts, industrial loan corporations, credit card banks, trusts, and other grandfathered "nonbank banks." This will allow for more consistent regulation across the universe of financial institutions.

• Provide increased oversight of hedge funds, money-market mutual funds and insurance companies. The proposed oversight appears very modest, including registration of hedge funds, studying the structure of money funds, and collecting more information on insurance companies. Since all these institutions played some role in the current financial crisis, it is important for regulators to know more about them.

The reform proposal isn't perfect. Some significant criticisms:

• The current alphabet-soup of federal and state regulators remains largely in place. The one substantive change here is eliminating the thrift charter, and combining the Office of Thrift Supervision with the agency regulating commercial banks. Regulatory arbitrage will be more difficult under the proposed structure but will remain a significant problem.

• The reform proposal does not adequately identify lines of authority among regulators and mechanisms for resolving differences. A new Financial Services Oversight Council will bring the key regulators together, but this doesn't appear much different than the interagency meetings that take place currently. Regulators' inability to forge consensus on guidance for financial institutions contributed significantly to the crisis.

• The Federal Reserve's political independence would be at greater risk under the reform, given the Fed's expanded role in regulating the financial system. Such independence is vital to the central bank's ability to appropriately conduct monetary policy. There are no new mechanisms provided in the reform to ensure the Fed's independence. In fact, the Fed would require agreement of the Treasury Department to take action on the "exigent circumstances" clause of its charter.

Overall, an assessment of the reform proposal finds that:

• The proposed regulatory regime would not have prevented the current financial crisis, but would likely have made it less severe.

• Even the best regulatory structure and oversight would have been unable to stop the flood of global cash that fueled trillions of dollars in poorly underwritten lending that led to the crisis. Booming emerging economies such as China and Russia had accumulated surplus dollars from trade with the U.S. These investors initially bought risk-free U.S. Treasury securities, but in a quest for greater returns, they gradually moved into riskier mortgages and other financial products, doing little due diligence of their own. Nothing in the regulatory reform proposal addresses this broad global macroeconomic imbalance.

• Had the proposed reforms been in place, the securitization process might not have grown dysfunctional, since issuers of asset-backed securities would have retained some of their inherent credit risk. The bad lending that led to the crisis was due in part to the fact that no one in the securitization process had sufficient incentive to see that the underlying loans were sound.

• Risks in the credit-default swap market would likely also have been less substantial under the proposed regulatory regime. AIG's failure was due in large part to the giant insurer's egregious risk-taking in the CDS market. With the greater disclosure required under the administration's reform plan, it would have been more difficult for AIG to become such a large player in that market.

• Households might not have borrowed as aggressively during the housing boom if they had fully understood the loans they were taking on. Fed surveys show that a sizable proportion of subprime mortgage borrowers did not know or understand that their mortgage payments were likely to balloon two years or less after they obtained the loan.

• With authority to act as a systemic risk regulator, the Federal Reserve might have also worked to reduce leverage throughout the financial system. This is most likely with respect to Fannie Mae and Freddie Mac: the Fed had publicly expressed skepticism about risk-taking at these institutions. Yet it is not likely the Fed would have been willing to require broker-dealers to raise more capital and reduce leverage; regulators were actually allowing many of these institutions to take on more leverage, assuming they had the acumen to manage their risks. The Fed also displayed little appetite to require more disclosure or curb risk-taking by hedge funds.

• Perhaps most importantly, the proposed regulatory regime would allow a more orderly resolution of troubled institutions. Important financial players such as Fannie and Freddie, Bear Stearns, Lehman Brothers and AIG were not under the purview of the Fed or other banking regulators when they fell; they would be under the proposed system. Resolution of these institutions was botched in part because regulators lacked clear authority; this in turn caused the financial crisis to become a financial panic last September.

Many of the proposed reforms will likely survive the legislative process. Early opposition appears centered around the new consumer protection agency. Financial institutions are fearful that that the CFPA will stifle their ability to create new financial products and raise the cost of existing ones. The Federal Reserve Board also seems reluctant to let go of its authority to set policy in the consumer-protection area. Yet a CFPA-like institution is a good idea. Like the Food and Drug Administration, the new agency will not get it right all the time, but like the FDA, it will help ensure that consumers get what they pay for. The Fed has historically given consumer financial products only cursory oversight with its other, weightier responsibilities—which will grow weightier still under the proposed reform.

In theory, the Obama administration's proposed reforms are as wide-ranging as any since those pushed through during the 1930s. The current plan does not appear heavy-handed; if implemented, it will ensure a more steadfast, albeit slower-paced financial system. However, the reforms will not preclude future financial crisis, because they are unlikely to work as well in practice as they do in theory. The plan provides only a structure; it does not address a number of important questions, from capital standards to fair-value accounting to loan-loss provisions, to the role of the rating agencies. It is appropriate that these questions be answered by the regulators themselves after careful deliberation, but how they are answered will ultimately make all the difference.