The Best Regulatory Fix

U.S. Treasury Secretary Timothy Geithner told a Senate Appropriations committee that he wants to overhaul the nation's financial regulatory architecture, some parts of which date back to the '30s, in order to prevent any future economic collapse. The revamp includes a package of new, systemic risk regulations.

However, Geithner's comments before a subcommittee of the Senate Appropriations committee come closely on the news that the Obama administration has backed off plans to slash the number of regulators for banks and financial companies.

The moves raise fears among Wall Street watchdogs that the same regulatory loopholes that let banks make risky bets that led to the collapse of the financial system will remain.

The choice to do little in the way of consolidating regulatory agencies has broad implications for Wall Street and investors.

The government has been down this road before, and laws already exist on the books to stop much of the financial mess. The problem is, "we have plenty of regulation, just a shortage of enforcement," a top Wall Street analyst tells me.

Since laws already exist on the books  to crack down on the financial industry, is the real issue this: that government regulators need to grow a backbone, but don't, because they are beholden to Congressional committees who are lobbied fiercely and plied with political donations from financial industry groups?

The financial sector is far and away the biggest source of campaign contributions to federal candidates and parties, with insurance companies, securities and investment firms, real estate companies and commercial banks leading the way, Fox News analyst James Farrell notes.

In the 2008 election cycle, the financial services industry contributed $472.8 mn to federal candidates and parties, with 51%, $240.6 mn, going to Democrats versus $231 mn that went to Republicans--the first time since 1990 that the industry gave more to Dems than Republicans.

The Plan

"In the next few weeks we will outline a comprehensive plan of reform that will include systemic risk regulations to ensure that no large and interconnected firm or market can take on so much risk that its failure could destabilize the entire financial system," Geithner told Congress, adding "it will streamline our out-of-date regulatory structure so that our regulatory system matches the size, shape and speed of our modern financial system."

Besides new rules, the plan is to let the Federal Reserve, the Office of the Comptroller of the Currency, the FDIC, the Securities and Exchange Commission, the Commodity Futures Trading Commission, and other agencies to continue to run their regulatory fiefdoms.

Regulatory Breakdown

The last time the government streamlined securities regulation, the regulatory arm of the New York Stock Exchange that dealt with investors was folded into the new Financial Industry Regulatory Authority, an industry-run regulatory body warehoused in a sleepy suburb of DC, a group that essentially missed not only the systemic risk that caused Wall Street and banks to collapse, but potentially detectable scam trading done by fraudsters including Bernie Madoff.

Moreover, statutes overseeing systemic risk and capital reserve requirements, the cushions that protect financial companies against a downturn, have long sat on the books of regulators.

For example, in its 1991 reform legislation to clean up the S&L mess, Congress included a "systemic risk" exception, which gave regulators, with the approval of the president and the Treasury secretary, the power to protect depositors, both domestic and foreign, and all other creditors from the implosion of a large failing bank.

Specifically it said regulators could do so if they had determined that a big bank's failure would impose losses on uninsured depositors and other creditors and "would have serious adverse effects on economic conditions or financial stability," the dusty statute reads.

The problem is, when some regulators try to step in, they get big footed. For instance, when states like Georgia and North Carolina tried to pass tighter laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local units of nationally chartered banks.

Government and Industry Officials Want Change

Federal and bank officials have called for streamlined oversight and consolidation of agencies and regulations in the past in some form or another, to reduce the alphabet soup of regulatory agencies.

The group includes former Treasury Secretary Henry Paulson, Office Comptroller of Currency John Dugan, JPMorgan Chase chief executive Jamie Dimon, and Bank of New York Mellon Corp. chief executive Robert Kelly.

What Won't Happen

While the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC are expected to get broader powers, it appears for now that the government will not merge the Commodity Futures Trading Commission and the Securities and Exchange Commission.

The idea here is that the CFTC regulates and oversees commodities-based derivatives trading, or contracts closely related to the financial securities that the SEC regulates.

The CFTC trades involved here include commodity futures and options, as well as options on others futures and some derivatives.

The SEC holds regulatory authority over a broad range of derivatives, much of which underlie or are connected to other derivatives under the CFTC's jurisdiction. For instance, the SEC oversees credit-default swaps.

Still waiting to see whether the government will eliminate the Office of Thrift Supervision, the S&L regulatory body that has its roots in the S&L crisis of the late '80s and early '90s.

The OTS has been hotly criticized for not doing more in its oversight of the American International Group, the collapsed insurer which received a $185 bn taxpayer bailout.

The fear remains that important problems may still fall through the regulatory cracks. Analysts on Wall Street are still watching for tighter regulator oversight of:

Mortgage brokers - typically overseen by state regulatory bodies, and are less regulated than dry cleaners or nail salons.

Mortgage securitizations - JPMorgan's Dimon has noted there is little oversight of underwriting here. The SEC has oversight of securitizations and the credit rating agencies who grade them, but has been lost in the deluge, some $4 tn worth. Also, the SEC and the Federal Reserve has oversight of the banks who hold these derivatives on their balance sheet, but has done little to crack down on insufficient capital cushions backing up these assets, and in fact have allowed those reserves to be weakened, allowing all sorts of madness to creep into the system.

Hedge funds - both the SEC and CFTC oversees hedge funds, with half of hedge funds pools of money that place bets on commodities.

Insurance industry - overseen by a patchwork of state regulatory bodies.

Government Turf Wars

Because each agency receives its funding from fees paid by the banks or thrifts they regulate, critics have long argued that companies often treat the institutions they regulate as constituents to be protected, analysts note

Also, political donations from financial industry fuel Congressional Turf War concerns, as watchdogs at places like the Center for Responsive Politics fear the donations help stop tougher oversight.

A case in point is the Commodity Futures Trading Commission.

Both the Senate Agricultural, Nutrition and Forestry Committee and the House Agriculture Committee oversee the CFTC.

The biggest donors to these Congressional committee members? The financial, insurance and real-estate industry, far outpacing agribusiness donations, with about $29 million in 2008 to the Senate committee, and $8 million to the House overseers.

Remember This Little Known Fact

In ice hockey, the first testicular cup was used in 1874. The first ice hockey helmet was used in 1974. It took 100 years for men to realize how important the brain is.

And so is the backbone.