The Task of Taming Highs and Lows
By JON HILSENRATH
WASHINGTON -- The proposed regulatory revamp is setting out to do what history suggests can't be done easily -- tame the financial system's tendency to drive itself off a cliff.
The objective of "stability" is all over President Obama's plans. The word shows up 53 times in his 88-page blueprint. His proposal, if approved by Congress, would make banks hold more capital in reserve for a rainy day, reducing funds available for making risky bets. It would require mortgage originators to hold a piece of the loans they sell, and the plan would steer compensation for a wide range of players away from risky practices.
Financial booms and busts have become especially familiar in the past quarter century. But until the credit squeeze that started in 2007, they seemed to have become more benign. The 1987 stock-market crash, the savings-and-loan debacle of the late 1980s, emerging-market crises of the 1990s and the tech bust early this decade came and went leaving only two modest U.S. recessions in their wake.
The current recession has emphasized to Mr. Obama and his economic team the threat that unstable financial markets pose to the broader economy. Lawrence Summers, Mr. Obama's chief economic adviser, speaks often about creating a new foundation for a less-bubble-driven economy.
"Over the past two decades, we have seen, time and again, cycles of precipitous booms and busts," Mr. Obama said Wednesday. "In each case, millions of people have had their lives profoundly disrupted by developments in the financial system, most severely in our recent crisis."
The Federal Reserve would stand at the center of the effort, with new power to regulate financial institutions that threaten broader stability. The Fed will have the power to cast a watchful eye beyond banks, to insurance companies or other too-big-to-fail firms, and will be expected to be alert to how their exposures might ripple through the system.
Derivatives markets that had been left to police themselves, on the premise that they help make the financial system more resilient, would no longer be left to do so. The Fed also is examining whether it can do more to deflate financial bubbles before they get too big. For many years officials felt it was sufficient to clean up after a bubble burst -- the idea has now been discredited.
"The thrust of this reform proposal is to insulate the system when and if the next bubble happens and then bursts," said Robert Litan, a scholar at the Brookings Institution. "The hope is that the next time around there will be some warnings."
One important cause of the credit bubble hasn't been addressed by Mr. Obama -- the large trade imbalance between the U.S. and China. It produced a flood of dollars pouring into US markets from abroad during the credit boom, propping up debt markets. But that can't be regulated away.
The challenge with a regulator revamp is doing it without stifling Wall Street innovation or the economy's growth. Some Obama administration officials call it the "elusive frontier."
"We must recognize that the singular pursuit of stability, however well-intentioned, may end up making our economy less productive, less adaptive, and less self-correcting -- and in so doing, less able to deliver on its alluring promise," Kevin Warsh, a Federal Reserve governor and former administration official under George W. Bush, said in a speech this week.
Another problem is that of unintended consequences. Regulators toughened capital requirements on banks after the S&L crisis, which encouraged the growth of a "shadow" banking system populated by unregulated financial institutions and markets. A Great Depression restriction on the ability of banks to pay interest on deposits, called Regulation Q, sometimes left them squeezed for funds and forced them to tighten credit.
This time, tougher restrictions on banks or insurance companies could push money further into less-regulated markets, such as private equity, hedge funds or institutions offshore.
Administration officials are conscious of the risk. One pillar of their plan is improving international cooperation on financial regulation. They also want to force hedge funds and other private money players to register with the Securities and Exchange Commission. But the White House isn't talking about imposing the same kinds of capital and liquidity requirements on many of them that it would for banks, meaning hedge funds could remain a path of least resistance for investors looking to avoid heavy regulation.
There also is a risk that officials, in responding to the last crisis, will miss the next one. Congress responded to the tech bust and accounting scandals of earlier this decade by passing Sarbanes-Oxley accounting regulations. But the current crisis was already brewing in housing, not stocks.
"The next problem is not going to be mortgage-backed securities," says Raghuram Rajan, a finance professor at the University of Chicago Booth School of Business. "It is going to be something else."
Mr. Rajan holds up Citigroup Inc. and its predecessor companies as an example of the pitfalls of regulating financial institutions. Citi "found three ways of getting itself into trouble in the last three decades," he notes. In the 1980s, it became burdened by emerging-market debt that had gone bad. In the 1990s, it was overexposed to commercial real estate. And in the last crisis, it suffered huge losses in residential mortgages.
"You can sharpen enforcement in one area, increase regulation, but if the underlying incentive to take excessive risk is not mitigated in some way, it is going to move somewhere else," Mr. Rajan says.
For that reason, White House officials want the Fed to be able to oversee the compensation policies of top executives at big financial institutions, to make sure they don't create perverse incentives. Clamping down on compensation could send Wall Street's best and brightest to some new area of finance nobody has yet thought of.
Write to Jon Hilsenrath at firstname.lastname@example.org
Printed in The Wall Street Journal, page A12