Financial System Reform in the U.S.: What Happens Next

Columbia University's Committee on Global Thought yesterday hosted a lecture with two movers-and-shakers, past and present, in the world of financial regulation in the United States: former Securities and Exchange Commission Chairman Arthur Levitt, and current Commodity Futures Trading Commission chief Gary Gensler. The topic: how to reform a regulatory system that fell asleep at the wheel and failed to detect a crisis.

The panel discussion - chaired by Nobel laureate Joseph Stiglitz - came to two key conclusions: financial markets need more transparency, and the United States needs to take the lead in developing smart regulations if the rest of the world is to sign on.

Gensler's proposal is to bring more futures/derivatives trading into a central clearinghouse, allowing regulators to more easily monitor and assess risk in a market that is fragmented. Centralizing derivatives transactions into a more open, central clearinghouse will cut into the premiums earned by derivatives dealers but will also make the market less risky and more transparent, he contends.

Levitt, a veteran of the Clinton Administration, was decidedly pessimistic on the financial reforms proposed both in the U.S. House and Senate, saying they would do little to prevent moral hazard and a "too big to fail" mentality among major financial institutions. He also said Europe, the United Kingdom and other major financial centers will fail to tighten their regulations until the United States takes the lead. Gensler agreed, but admitted that after 18 years on Wall Street, he knows bankers will, in such a case, take advantage of the inevitable opportunity for regulatory arbitrage - that is, investors will put their money in jurisdictions where capital is less tightly regulated at the expense of American financial markets. These points illustrate that any kind of real policy coordination between the United States and the European Economic Community is an idealistic, rather than realistic, endeavor in such tight political and economic conditions.

What the panel failed to accomplish was finding a way to navigate through the alphabet soup of agencies that are already charged with regulating various segments of the American financial system. Very little was said about the Federal Reserve System, which despite being charged with regulating the banking system from a macroeconomic view, is widely criticized for failing to regulate and for creating the conditions that enabled the crisis through its loose monetary policy. And yet, the Fed remains a key player in any regulatory structure going forward and needs to be a keystone of any reform.

In the end, the discussion itself and the very presence of two speakers representing regulators that, in the grand scheme, have a small purview over the American financial system, revealed how broad a reform is needed. As such, is any discussion that contains only the SEC and CFTC even relevant?

The SEC, staffed with just 3,700 regulators, for example, has very little authority over financial instruments that fall outside the more traditional definition. And, how does an agency such as the SEC both target run-of-the-mill insider trading and securities fraud while also tracking systemic risk in a complex financial system? The failure to bring down Bernard Madoff before it was too late shows how overextended the agency already is.

In the meantime, as Gensler aptly pointed out, the CFTC only regulates futures markets, missing the important and growing piece that is over-the-counter derivatives, among which are the many mortgage-backed securities that were at the heart of the sub-prime crisis. The two in combination have little effect on monitoring a financial system that is increasingly global and increasingly spread over a variety of financial instruments.