U.S. Treasury Secretary Henry M. Paulson put forth a series of proposals on March 31 aimed at overhauling regulation of the U.S. financial system. The plan calls for major structural reforms, including the possible merging of the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC). It was also widely interpreted as giving additional powers to the U.S. Federal Reserve. Benn Steil, CFR senior fellow and director of international economics, says many of the proposals should be understood as part of a long-term push for financial market reform that began before the current credit market turmoil. He cites gaps and overlap among current financial regulators, but also notes that merging commissions like the SEC and CFTC won’t be easy given their different regulatory philosophies. In the long term, Steil says, some of Paulson’s proposals could help to make the U.S. financial services sector more competitive globally.
This week Hank Paulson announced a sweeping plan to amend the financial regulatory system. What were your initial reactions?
Well, the first thing to emphasize is that most of the components of what he proposed have been in the works for quite some time now, so most of the ideas were not triggered by the current market turmoil. Nonetheless, he’s clearly using the current market turmoil as an opportunity to promote debate on these issues, because of the fact that it’s always been very difficult in Washington to make significant institutional reform. Most of the proposals do not relate to the current market turmoil—for example, the proposal to merge the SEC and the CFTC. Other aspects of the proposal are more geared towards the problems we’re seeing in the market right now—for example, giving the Federal Reserve more formal authority for what’s being called systemic stability.
Do you find the current system problematic?
It’s always been problematic in the sense that there are numerous overlapping agencies. Sometimes these agencies are multiple federal agencies. Other times they are federal and state agencies. And there are often gaps between them. And because of the overlap there’s often a competition between them as well. For example, since banks can choose whether to be state chartered or federally chartered, there’s a form of regulatory arbitrage going on. Most observers, myself included, feel that that type of regulatory arbitrage is not positive for the financial system as a whole.
Given the current crisis, is a focus on the structure of financial regulation the appropriate focus? Or should there be more direct concern about what the rules actually say, as opposed to who enforces them?
There is cause for taking a close look at the regulatory structure. There is always a risk in the middle of a crisis of writing too many specific rules without adequate reflection on precisely what went wrong, and where it went wrong. So I do think this proposal has merits. Hank Paulson is right to emphasize that the proposal needs to be evaluated separately from the market turmoil we’re experiencing now. In other words, there are aspects of it that are geared toward much larger questions, and I think that’s appropriate.
I wanted to ask about some of the specific measures. We can start with the SEC and the CFTC, which you’ve already mentioned. What’s the impulse there?
In the abstract, it makes absolutely no sense to have an SEC that regulates things related to what are technically called securities, and a CFTC whose oversight is primarily aimed at futures markets. The different types of instruments have converged in the marketplace. There are an increasing number of border disputes between the institutions. And from the perspective of the users of financial products, there’s no meaningful distinction to be drawn between them, so having different agencies for these different types of products doesn’t make a whole lot of sense. Having said that, the devil is in the details. The two institutions, even though they have very similar functions in certain areas, have very different regulatory philosophies. So if this, for example, is going to be largely an SEC takeover of the CFTC, broadly speaking that could be construed as bad news for the U.S. futures exchanges, because it will mean a more heavy-handed regulation of their activities.
What would that mean in practice?
For example, the options industry is regulated by the SEC, and market structure in the options industry is very different from that in the futures industry, which is regulated by the CFTC. There’s one common clearing utility [an organization associated with an exchange that regulates trades and the delivery of goods traded] used among options exchanges in the U.S., called the Options Clearing Corporation, and the existence of that industry utility was instituted by the SEC. In the futures market, the individual futures exchanges own their own clearing firms. These are very, very different business models. Broadly speaking, it makes competition among options exchanges a lot fiercer than competition among futures exchanges, but it also means that options exchanges have fewer incentives to innovate because they can’t necessarily capture all the benefits of innovation.
One of the short-term proposals is to allow the Fed the ability to conduct on-site examinations of investment banks that receive emergency federal funding. Then, once the borrowing institution is no longer receiving that funding, the Fed’s oversight would evaporate. Do you think that’s reasonable? Some people have argued this would lead to market instability.
Broadly speaking, the proposal about reforming the Federal Reserve’s regulatory role is problematic. It gives the Fed considerably more responsibility, particularly in the area of systemic stability, and particularly when we have a crisis, like we do now. On the other hand, overall, it gives them less supervisory capacity, because on a day-to-day basis their supervisory responsibilities are going to be given to other agencies. And it doesn’t make their authority any more explicit. In other words, if they find problems, do they have the clear, explicit authority to engage in certain interventions? During the current market turmoil, the Fed has basically been writing the rules as it goes along. So although it’s a positive thing to have the Fed better informed during a crisis, it’s an open question as to whether they actually will be better informed if, on a day-to-day basis, when markets are normal and quiet, they will have less of a formal supervisory role.
Zooming out, how does this all fit in the effort to make U.S. financial services more competitive globally? Do you think these reforms would have a major effect one way or the other?
They could. As you know, there’s a very significant debate going on in the country—it’s been going on for quite some time now—as to whether the U.S. should move toward a more principles-based regime [as opposed to the rules-based accounting standards in place in the United States, a principles-based standard provides a more conceptual framework for accountants to follow, rather than a list of concrete rules, and is considered more flexible by many accounting firms]. Broadly speaking, the UK regime can be seen as principles based, whereas the U.S. regime is much more focused on the implementation and enforcement of very specific rules. There are merits to each and there are costs to each. But broadly speaking, I think most observers have reasonably concluded that the UK system is more flexible. That is, the financial markets are exceptionally dynamic, and a principles-based regime is better able to adapt with the market than one that’s much more rules based. So the reforms that Secretary Paulson is proposing would bring the U.S. more toward a principles-based regime, like we see in the UK. It would also produce more consolidation of regulation, which is the course that the UK has followed over the past fifteen years.
You mentioned already that some of the timing of this is due to the fact that the current credit crisis gives some leverage in terms of pushing things through. First, do you think any of this is likely to make it through Congress? And second, what would be your biggest concerns about how it might get botched up going through that process?
I think very little if any of it is likely to go through during the life of the current administration. This is basically a plan that will be parsed in considerable detail under the next administration. What actually happens to it will depend very much on the outcome of the election in November. There are clearly aspects of Secretary Paulson’s proposal that can be seen as being deregulatory in thrust, and that’s not a very popular position at the moment. For example, under his proposal, U.S. stock exchanges would have the right to make rule changes in their trading structure without prior approval by the SEC. It’s unlikely that Democratic legislators are going to put a reform like that at the top of their agenda. So in the midst of considerable market turmoil, it’s highly unlikely that issues like that will be resolved.