Geithner Regulates: After the Carrot, A Stick for Banks

"Not modest repairs at the margin, but new rules of the game."

That's Treasury Secretary Tim Geithner today on sweeping changes being proposed for the financial sector.

From Bloomberg:

The administration’s regulatory framework would make it mandatory for large hedge funds, private-equity firms and venture-capital funds to register with the Securities and Exchange Commission. The SEC would be able to refer those firms to the systemic regulator, which could order them to raise capital or curtail borrowing.

The strategy also would require derivatives to be traded through central clearinghouses. And it would add new oversight for money-market mutual funds to reduce the risk of a run on those funds after a shock like last year’s failure of Lehman Brothers Holdings Inc.

The Treasury chief also said regulators should consider new rules requiring banks to set aside extra reserves during boom times to build up a cushion for economic slumps.

“We need to examine our accounting rules to see whether, consistent with investor protection, we can require firms to build up loan loss reserves that look forward and account for losses in downturns,” Geithner said.

It's a seedling of a good idea: A single regulator with expanded access to financial information and understanding of realtime risk in the banking sector could help stop this sort of crisis from happening again. We simply don't have that now.

As for the argument against oversight, namely that it will kill innovation, well, innovation got us into this mess and regulation is coming one way or the other. That's where the Geithner Plan gets smart. In the long run, oversight by a systemic regulator could actually foster more innovation compared to allowing the more draconian elements of the government to step in and punish banks using traditional tools like punitive capital requirements or blanket rules for leverage (though Geithner's comments hint there could easily be a bit of that as well). As with all first drafts of the Obama Administration's plans, Geithner's latest is thin on specifics, so it's tough to know what it'll look like in the end.

What the plan really offers is an opportunity for wider debate on how regulators should adjust to the enormous complexity of the modern financial system. That debate needs to center on transparency and information. The very same technological advances that made possible the huge explosion in securitization that eventually spawned the mortgage and credit mess also contain the very tools regulators can use to track where the money is flowing in the future. For example, hedge funds may operate in the shade, but their trades bottleneck at the few prime brokers left in the market. An agreed-upon set of metrics to analyze and measure market risk are more a question of agreeing on what existing tools are best, rather than building them from scratch. The technology is already largely in place.

Not that it will be easy. Some of the plan's ideas are obvious. Transparent derivatives markets, for example, should be a given. But putting together a "systemic risk regulator" is a little tougher. There will be real challenges in organizing and supervising banks that are located (and regulated) around the globe, not to mention insurers and hedge funds, who are already howling at registering with the SEC, let alone falling in line with an organization who will define their risk-taking horizons.

It's not much easier on the government's side. The regulator (it could be the Federal Reserve) would be charged with standing in the river of money flowing through the global financial system, trying to dam up bits and pieces. Again, that's why the focus needs to be on analyzing and understanding systemic risk rather than shutting down risk takers. A global component, involving regulators from the globe's major financial centers (China, Britain, etc.) would also probably be required to make such a system work, which opens up a huge can of multilingual worms in terms of sovereignty issues.

That doesn't mean it's a bad plan. The debate will continue over what role the government should have in forcing banks, insurers, hedge funds or anyone else to control their risk taking in the future. But one basic premise of the Geithner plan -- that there can and should be some organization capable of taking the measure of global financial risk -- is sound. We have the capability. We just need the will.

The WSJ has the text of Geithner's remarks here.

For more on how bank regulation should evolve, see Andrew Lo On Fixing Finance.

Comments

[MattZN:]

I'm a bit confused about the title. I listened to Geitner's remarks and most of them were directed at NON-bank financial entities (i.e. like AIG). "A Stick for the banks" doesn't really capture the intent of his remarks.

-Matt

Mar 26 05:51 PM

[Dante311:]

I think that a broader coverage of the financial institutions whether it be banks, hedge funds, or private equity firms is a necessary step as those who wished to avoid regulation simply side stepped it by change the legal identity. I don't see why you would avoid monitoring unless you were concerned about the safety of the risks you were taking.

I also agree that fostering a environment of long-term planning in corporations and government is the right mentality to have and that those who provide for the long-term growth of the their company should be rewarded instead of those who only try to insure short term profits at the expense of future ones.

I do worry though about the costs of overseeing the entire finance industry and if it will be able to be achieved. Pay is much higher at private institutions and the ability to hire the best will stack the odds in favor of private firms. Those who know what's going on best may be more interested in staying in the private sector.

Mar 26 06:04 PM

[James Wilson:]

The British setup a clearing house last month !!!!!!!
What is the problem it is working in England, Spain and France.

Mar 26 06:36 PM

[Amit Kumar:]

Regulators having been bouncing the idea of system regulator for TBTF entities since LTCM collapse. Today, Jim Chanos said on bloomberg that hedge funds and non-banking financial institutions have been bracing for such a regulation since the current credit crisis began. Most large hedge funds and private equity firms over $2b are already registered with SEC. The question is not as much about capability as about political will and execution. For multinational institutions, winding down an entity global could pose serious cross-border political hurdles.

Mar 26 09:17 PM

[Moon Kil Woong:]

This is a sot at unadulterated power and has nothing to do with banks or too big to fail institutions even though he has been hammering on these issues in speeches for a week. It's a clever ploy.

Furthermore, if the treasury can't regulate the top 36 banks what hopes do they have regulating VCs and hedge funds. Sad to say the Fed and the Treasury fail at any attempts to regulate anything. For one thing it's because they brown nose politicians and for another they are bankers trying to give their friends ways to make more money.

I am hopeful, at least something will be done to regulate derivatives going forward, although we need a clean up of past derivatives, not just managing ones being written going forward. It would be better if Geithner has the political power to propose something retroactive on this front. It's like proposing a healthy diet to a guy who is having a heart attack. You have to solve the immediate problem first.

Mar 27 03:47 AM

[aarc:]

Regulators and their constituents want regulations. Punish the wrong-doers. That's what they want. Give it to them.

Simple logic - close the barn door when the horses are gone? Close it anyway, does'nt matter. Just close the darn door! And chase back those horses, we have a reconing to make!

To my logic; Strick regulations must be implemented during, and not after, the markets are in irrational bull run in order to prevent commission of crimes and other excesses of capitalistic greed.

During extremely stressful recessions such as these days; regulatory forebearance should be a better solution in order to prevent even viable companies from going bankcrupt thus further agravating mounting unemployment rates.

Some regulations must be implemented right now in order to plug the gapping loopholes that can threaten economic survival such as the CDS giant loophole that is wide open for further abuse.

But for forcing financial institutions right now to provide adequate reserve capital while the economy is in dire straights and obviously needs lots of fresh capital in order to prevent further erosion and be able to stage a recovery is counter-productive.

Give them some breathing room to recover, tightening the noose right now will only suffocate them.

Mar 27 03:56 AM