"Not modest repairs at the margin, but new rules of the game."
That's Treasury Secretary Tim Geithner today on sweeping changes being proposed for the financial sector.
The administration’s regulatory framework would make it mandatory for large hedge funds, private-equity firms and venture-capital funds to register with the Securities and Exchange Commission. The SEC would be able to refer those firms to the systemic regulator, which could order them to raise capital or curtail borrowing.
The strategy also would require derivatives to be traded through central clearinghouses. And it would add new oversight for money-market mutual funds to reduce the risk of a run on those funds after a shock like last year’s failure of Lehman Brothers Holdings Inc.
The Treasury chief also said regulators should consider new rules requiring banks to set aside extra reserves during boom times to build up a cushion for economic slumps.
“We need to examine our accounting rules to see whether, consistent with investor protection, we can require firms to build up loan loss reserves that look forward and account for losses in downturns,” Geithner said.
It's a seedling of a good idea: A single regulator with expanded access to financial information and understanding of realtime risk in the banking sector could help stop this sort of crisis from happening again. We simply don't have that now.
As for the argument against oversight, namely that it will kill innovation, well, innovation got us into this mess and regulation is coming one way or the other. That's where the Geithner Plan gets smart. In the long run, oversight by a systemic regulator could actually foster more innovation compared to allowing the more draconian elements of the government step in and punish banks using traditional tools like punitive capital requirements or blanket rules for leverage (though Geithner's comments hint there could easily be a bit of that as well). As with all first drafts of the Obama Administration's plans, Geithner's latest is thin on specifics, so it's tough to know what it'll look like in the end.
What the plan really offers is an opportunity for wider debate on how regulators should adjust to the enormous complexity of the modern financial system. That debate needs to center on transparency and information. The very same technological advances that made possible the huge explosion in securitization that eventually spawned the mortgage and credit mess also contain the very tools regulators can use to track where the money is flowing in the future. For example, hedge funds may operate in the shade, but their trades bottleneck at the few prime brokers left in the market. An agreed-upon set of metrics to analyze and measure market risk are more a question of agreeing on what existing tools are best, rather than building them from scratch. The technology is already largely in place.
Not that it will be easy. Some of the plan's ideas are obvious. Transparent derivatives markets, for example, should be a given. But putting together a "systemic risk regulator" is a little tougher. There will be real challenges in organizing and supervising banks that are located (and regulated) around the globe, not to mention insurers and hedge funds, who are already howling at registering with the SEC, let alone falling in line with an organization who will define their risk-taking horizons. It's not much easier on the government's side. The regulator (it could be the Federal Reserve) would be charged with standing in the river of money flowing through the global financial system, trying to dam up bits and pieces. Again, that's why the focus needs to be on analyzing and understanding systemic risk rather than shutting down risk takers. A global component, involving regulators from the globe's major financial centers (China, Britain, etc.) would also probably be required to make such a system work, which opens up a huge can of multilingual worms in terms of sovereignty issues.
That doesn't mean it's a bad plan. The debate will continue over what role the government should have in forcing banks, insurers, hedge funds or anyone else to control their risk taking in the future. But one basic premise of the Geithner plan -- that there can and should be some organization capable of taking the measure of global financial risk -- is sound. We have the capability. We just need the will.
The WSJ has the text of Geithner's remarks here.
For more on how bank regulation should evolve, see Andrew Lo On Fixing Finance.