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Kickoff to Financial Regulatory Reform

Austan GoolsbeeThe Obama Administration proposes to regulate Wall Street by focusing on consumers. It isn’t willing to take on the vested interests of the wizards of Wall Street.

Here’s a brief statement of principles. The Administration’s full proposal is here. Austan Goolsbee, a University of Chicago economics professor on leave, and currently serving on the Council of Economic Advisors, held a bloggers call to discuss the proposals.

There is much to be welcomed. Protections for investors are increased. I particularly like the idea of making stockbrokers fiduciaries for their customers, so that they would be required to act in the best interests of their customers. I’m not sure how this will be enforced, in light of the Private Securities Litigation Reform Act, a 1995 law designed to make it very difficult for private investors to protect themselves from stockbrokers. Floyd Norris of the NYT provides an entertaining description of the impact of this law on suits by investors screwed in the Auction Rate Securities debacle.

The administration proposes to create a new Consumer Financial Protection Agency (CFPA) to centralize the duty of protecting consumers from the unfair and deceptive trade practices of financial institutions. The new law will focus on unfair trade practices. Many on the right blame consumers for unreasonable borrowing, and for failing to comprehend their credit card contracts and the related disclosures. Sensible people think that disclosure isn’t enough. Some things are just unfair.

Goolsbee gave an example which involved a crafty (his word) way to interpret the overdraft and NSF rules to charge an unreasonable total fee for bouncing several checks at one time. No consumer could have realized that this was a possible interpretation of the rules of a checking account. Prohibiting unfair practices is every bit as important as preventing deceptive practices. An aggressive approach to this use of regulatory authority could be a real help to consumers.

Again, allowing consumers to protect themselves with a private right of action will be a big factor in whether the initiative has any teeth.

The CFPA “…would have the authority to require that mortgage brokers look out for the interests of families when they give advice about mortgages…”, instead of trying to make as much for themselves as they can, which is the current system. This is also a good idea.

The administration also proposes to create a systemic risk regulation council which will have the authority to monitor and deal with systemic risks to the stability of financial markets. Among other things, it would have the authority to dismantle institutions that are too big to fail. Here’s their explanation:

In the recent crisis, millions of American families saw their retirement savings or their children’s college funds fall dramatically. Unregulated markets for securitizations and derivatives and an over-reliance on the flawed judgments of credit rating agencies increased the instability of the financial system, which in turn exposed individual investors to tremendous risk. The Administration’s proposals help to make financial markets safer for investors by closing regulatory gaps, requiring registration of hedge funds, regulating securitization and derivatives, and strengthening standards for credit rating agencies.

The first two sentences are supposed to be cause and effect. This is hard to grasp, so here’s my translation. The wizards got in over their heads in securitized instruments and swaps, including credit default swaps. The stock market sank like a rock. Individual investors got hurt.

The missing steps are that the wizards panicked, and started selling parts of their vast holdings of securities, partly to meet their obligations under their innovative instruments and partly in fear. Their rich friends sold too. That scared everybody. The massive sales drove down the price of securities held for retirement by vast numbers of Americans.

It will take some serious regulation to fix that problem, and this isn’t it. The problem is that as long as the wizards are free to make up new ways to screw around, the average person is in danger of a similar wipe-out.

I asked Professor Goolsbee how the new plan would deal with innovative financial products that are only useful to speculators. I pointed out that the plan seems to give a pass to the “innovations” that wreaked havoc on the system, despite the lack of any evidence that they provided any benefit to the productive sector of the economy. He said that the new council will monitor innovations and do something if it thinks they pose a systemic risk.

This is the weakness in this proposal. The wizards get free rein to create new stuff and send regulators into the regulatory thicket. They sell and sell, and make a fortune, and it’s up to the regulators to fight their way through the minefield of regulation to stop or control them. The wizards pay people to come up with reasons why they should be allowed to do whatever they want to do. Regulators don’t really have a chance.

I’d say this is a lot like the administration’s health reform package. There is a lot to like, but neither takes on the big money interests. Neither tries to get at the roots of the problems the giant corporations have inflicted on the nation.

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