In yet another sign that the country can't rely solely on regulators to police the financial system, Treasury Secretary Timothy Geithner told Congress Tuesday that the system needs "clear rules" that impose "unambiguous limits" on financial firms.
But Geithner's desire is undercut by the bill under consideration in the Senate. The legislation, proposed by Senate Banking Committee Chairman Christopher Dodd, doesn't specify clear rules or unambiguous limits. Specifically, it doesn't set firm rules on how much cash firms are required to keep on hand; the amount of capital they need in order to back up their loans and other assets; or limits on leverage.
Rather, it leaves those issues up to regulators at the Federal Reserve.
"We cannot design a system that relies on the wisdom of regulators to act preemptively with perfect foresight," Geithner told the House Financial Services Committee. "To come in and preemptively diffuse pockets of risk and leverage in the system. You can't build a system that... requires that level of preemptive exercise of perfect foresight. It is not possible."
Later, Geithner told Rep. Ed Royce (R-Calif.): "The only way I'm aware of to design a more stable system is to use capital requirements... to set and enforce constraints in leverage on institutions that could pose catastrophic risks to the financial system."
The debate over setting firm rules versus giving regulators more authority and discretion is an important one: regulators and policymakers now argue that financial regulators didn't have the necessary authority to effectively police large, interconnected Wall Street firms like Goldman Sachs and Bear Stearns, for example, or to orderly wind down failing firms like Lehman Brothers and AIG. Had they been armed with those powers back then, things might have turned out different, say the Obama administration and its backers.
Others dismiss that argument by claiming that regulators had the authority back then -- they just chose not to use it. The U.S. Securities and Exchange Commission, for example, had full oversight over Lehman Brothers yet chose not to exercise it, according to Congressional testimony delivered Tuesday by the examiner in the Lehman Brothers bankruptcy, Anton R. Valukas. The Fed had full access to Lehman's books for months before it failed, yet steadfastly stood by while the firm descended into bankruptcy.
In AIG's case, the Office of Thrift Supervision had full regulatory authority over the firm's derivatives dealings. Yet that agency, too, chose not to exercise its full powers. The problem with the crisis and the regulatory failings that preceded it wasn't a lack of regulation or a lack of regulatory authority, critics say -- it was the refusal to use it.
Yet beginning on page 91 of the 1,408-page bill, the language in Dodd's bill is clear: The Fed's Board of Governors "shall" establish rules that "are more stringent" on systemically-important firms when it comes to capital requirements, leverage limits and liquidity requirements (the three things highlighted above).
But when it comes to specifics or how stringent those rules will be, that is entirely up to the Fed. Even the oversight council that's supposed to watch over the system doesn't have full authority to crack down on Wall Street. Rather, it "may" institute rules on capital, leverage and liquidity. It also "may" not.
To Geithner, that appears to be enough.
"In the bill that Senator Dodd has proposed in the Senate, he takes an approach which does impose actual limits and would require the Federal Reserve, if passed, to design regulations that would apply those limits," Geithner said. "So, it includes your broad grant of authority but accompanies that with an explicit requirement that clear limits be put in place," he told Rep. Paul Kanjorski (D-PA).
The bill doesn't specify the kind of limits that will be put in place. it just promises to be "more stringent."
In a January speech, Federal Reserve Chairman Ben Bernanke said that regulators -- including those at the Fed -- were to blame for the housing bubble and subsequent financial crisis.
"The crisis revealed not only weaknesses in regulators' oversight of financial institutions, but also, more fundamentally, important gaps in the architecture of financial regulation around the world," Bernanke said in January.
But regulators always run the risk of being shoddy, especially when it comes to policing financial firms.
"It is the habit of regulatory agencies to get captured by the industries that they are meant to be regulating," said Raj Date, chairman and executive director of the Cambridge Winter Center, a non-profit, non-partisan think tank focused on U.S. financial institutions. This happens most often with the bank regulators, Date said.
That's why, Date argues, the financial system needs "more bright lines" in legislation regarding what banks can and cannot do, and how much cash and capital they're required to have, for example.
In an interview with the Huffington Post, Federal Reserve Bank of Kansas City President Thomas M. Hoenig said he prefers for these rules to be set in law, rather than having it be left to regulators. So does former Fed chairman Paul Volcker, who told HuffPost that there's too much pressure on regulators and that they'd be too scared to act.
In an April 14 letter to Senate leadership, three dozen top economists, Wall Street veterans and former federal regulators called for specific minimum capital levels for banks to be enacted into law.
"The best strategy is to force the financial system to operate with more transparency, with clear rules that set unambiguous limits on leverage and risk, so that taxpayers never have to come in and protect the economy by saving firms from their mistakes," Geithner said Tuesday.
To Date, that's Geithner recognizing "that just hoping for the magical superhero to appear in regulators' clothing forevermore is neither a great nor realistic aspiration."
And while Date thinks the Dodd bill is "certainly better than where we are today," it still doesn't go far enough in calling for the kind of fundamental reform some say is needed in the wake of the worst financial crisis and economic downturn since the Great Depression.
Rather than the Senate enacting tougher rules, it's punting the issue to regulators, all of whom, at one point or another over the last two years, acknowledged mistakes, lapses in judgment, and laxity in regulating the financial industry.
"Three years after mortgage credit began to fall apart in the U.S., it ought to be that Congress should be in a position to draw a bright line" regarding rules governing the financial system, Date said. "I just don't see why one can't do that."
WATCH Geithner's responses below:
On "Clear Rules"
On "Actual Limits"
On the "Wisdom of Regulators"
READ Dodd's bill below:
Restoring American Financial Stability Act of 2010
READ the experts' letter to the Senate below:
Letter to Senate regarding Financial Reform