The long-awaited Administration plan to reform financial regulation has arrived. The good news is that the specific proposals are virtually all sensible and constructive. The bad news is that there were some missed opportunities. On the whole, the good news significantly outweighs the bad -- we'll be better off if the proposals pass. The good will probably be watered down and some bad ideas may creep in as entrenched interests fight for changes as this goes through Congress, but the signs are good that we'll still get an improvement compared to the present set-up by the time we're done.
There are a lot of specifics, which you can read about in a longer paper of mine, (PDF) but the big points are threefold. First, the regulatory structure is being rejiggered to look more carefully at big risks to the system, both widespread problems and specific trouble at institutions large enough to be the domino that knocks the system over. A council of regulators is charged with coordinating on the systemwide issues, such as looking at the dangers caused by potential bubbles. More importantly, the Fed is being given considerably more authority over all of the financial institutions big enough to be that dreaded domino. The powers include the ability to step in earlier and more flexibly than they've legally been allowed to do. This will help a lot with situations like the one that developed at AIG, where their weak regulatory powers more or less forced the bailout in the form we saw.
Second, there will be a new Consumer Financial Protection Agency responsible for ensuring that mortgages, credit cards, and similar products are easier to understand and have fewer unfair or unsafe terms. Everyone agrees that this needs to be done better. Having a new agency with very substantial powers, as proposed, will put greater focus on this issue and will probably be more effective than trying to ramp up the effort on consumer protection at the existing regulators. However, the devil is in the details, which will change as the bill goes through Congress and as the new regulator finds its sea-legs.
Third, all financial institutions will face tougher capital requirements. Capital represents the assets of a financial institution that are not promised to creditors, depositors, or anyone but the owners. So, capital is the margin for error to cover mistakes and bad luck, which we have seen can be a real problem in this industry. More capital means safer banks and other financial institutions. It also means somewhat higher costs for loans and lower rates for deposits, but the cost is relatively modest compared to the additional protection we clearly need.
The biggest piece of bad news may sound technical, but it does matter. We have an insane regulatory structure with six different regulators of banks, and this is counting the state regulators as one body. No one would design a system this way, we just stumbled into it. The original Administration inclination was to consolidate down to one or two bank regulators. Instead, we're going to be stuck with five instead of six. They could have done better. This matters because the more regulators there are the easier it is for something to slip between the cracks and the easier it is for banks to shop around for the most lenient regulations.
Still, the plan as a whole is sensible and should help. Hopefully it will stay largely intact as it goes through Congress.