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Wall Street's Coming Reforms

Author: Lee Hudson Teslik
September 17, 2008

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The turmoil that rocked the global financial sector this week, bringing storied institutions to their knees and prompting harrowing declines for major stock indices, left more than a measure of uncertainty in its wake. Analysts generally declined to hazard near-term economic predictions, focusing instead on what might halt the contagion. Just when the government appeared to have said "enough," refusing to save the investment bank Lehman Brothers, the potential collapse of America's largest insurer, AIG, forced Washington back into the bailout pool (WSJ). One of the few consistent refrains was that reform of the financial system—on a much larger scale than many had previously considered—now seems increasingly likely (WSJ). Yet with a new U.S. president and Congress set to assume power, analysts say 2009 could bring dramatic regulatory changes for U.S. banks, potentially spelling major changes for the future structure of the global financial network.

The likely starting point, reports Dow Jones, is that the sweeping proposals put forth earlier this year by U.S. Treasury Secretary Henry M. Paulson could gain traction. Paulson's plan calls for a broad expansion of the Federal Reserve's powers and, over the longer-term, a reorganization of several government regulatory agencies to eliminate overlapping areas of responsibility and the loopholes created between them. Among other changes, the plan advocates merging the Securities and Exchange Commission (SEC) with the Commodities Futures Trading Commission (CFTC), and calls for shutting down the U.S. Office of Thrift Supervision, which currently monitors savings and loans operations. The plan also calls for a federal charter for all banks—at present, some are managed by states, and others by the federal government. In an interview discussing the proposals, CFR's Benn Steil says the plan rightly attempts to eliminate gaps and overlaps in the current system, but also notes that practical tensions could arise—particularly when merging the SEC and CFTC—given differences in how they operate. He adds, however, that if the plan succeeds in making the system more cohesive, it could bolster the competitiveness of the U.S. financial services sector internationally.

Beyond Paulson's plan, lawmakers have floated other ideas for making the financial system work more smoothly. Rep. Barney Frank (D-MA), the chair of the House Financial Services Committee, endorses the idea of a new federal institution (WashPost) to manage the assets of insolvent institutions. House minority leader Rep. John Boehner (R-OH) has "flatly dismissed" the idea, but the minority's views may hold considerably less sway after January. In any case, both sides agree that policy change on Capitol Hill is unlikely until next year.

As Wall Street works to put out existing fires, some changes are taking place on their own accord. Slate notes that Bank of America's buyout of Merrill Lynch shattered a long-standing policy separating governance of commercial and investment banks. The result, the article says, is more power for the Fed, which will now have oversight of Merrill's investment banking operations. The Financial Times' John Plender, in a video analysis, called it "the death knell of the independent investment bank."

Beyond technical market governance, some analysts say markets face a bigger problem. "The Street's fundamental problem isn't lack of capital," writes Robert Reich, the former U.S. Labor Secretary. "It's lack of trust. And without trust, Wall Street might as well fold up its fancy tents." Reich says the trust problem goes even deeper than the subprime mortgage mess. The recent market blowups, he says, have exposed a complicated game involving subjective ratings agencies, off-balance sheet liabilities, complex derivatives, and seemingly endless leverage. Here, however, the regulatory picture gets more murky—particularly given the global nature of financial markets. Once a new president takes office, Washington may well act to limit how much risk U.S. investment banks can assume. But analysts say that won't necessarily solve the problem. If Washington imposes very strict regulations on investment banks, Plender says, "a lot of those very clever, ambitious people, the investment bankers, will jump ship." The effort to regulate could thus backfire, he says, prompting an expansion of the "shadow banking system" of hedge funds and financial institutions in countries with looser laws, and leaving Washington's regulators with even less power than they have now.

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