The Paulson plan: Goodbye OTS, CFTC, and FDIC, hello FIGC, PFRA, and CBRA - By Justin Fox

Posted by ProjectC 
By Justin Fox
March 29, 2008

Hank Paulson is going to make a speech Monday about what our financial regulatory system ought to look like. But the WSJ, NYT, WaPo, and LAT already have all the details. (Not a word yet in the FT, interestingly enough.)

This latest of several "Paulson plans" (the full "executive summary" is here) is not directly a response to the craziness of the past few weeks; it's part of a longer-term Treasury project aimed at making U.S. capital markets more competitive. And it proposes to do so by modeling our regulatory structure after those of fearsome capital markets juggernauts Australia and the Netherlands.

Actually, Australia and the Netherlands do probably qualify as capital markets juggernauts, given their size. And the sight of the Bush administration actually looking overseas to learn stuff is kinda mind-boggling, in a good way. Like Hank Paulson or not, he's certainly cut from a different and far-higher-quality cloth than your average Bush cabinet appointee.

The plan initially calls for things like merging the Office of Thrift Supervision into the Office of the Comptroller of the Currency and the Commodity Futures Trading Commission into the Securities and Exchange Commission, and creating a federal insurance charter (insurance companies are currently all regulated by the states). But the longer-term idea is to meld almost all financial regulatory activities into two new agencies: the Prudential Financial Regulatory Agency, which would regulate all the depository institutions (let's just call them banks from now on) and insurance companies that get government insurance, and the Conduct of Business Regulatory Agency, which "would be responsible for business conduct regulation, including consumer protection issues" for banks, insurance companies, and all other financial services providers. Then there would be the market stability regulator, the Federal Reserve, which would have the power to snoop around any kind of financial institution it wants in search of risks to the financial system.

Now, I remain extremely dubious that we can rely on Fed staffers to be wise and strong-willed enough to identify looming problem areas and shut them down. Paulson apparently agrees: "I am not suggesting that more regulation is the answer, or even that more effective regulation can prevent the periods of financial market stress that seem to occur every 5 to 10 years," he says in a draft of his speech obtained by the NYT. But if the Fed is going to be backstopping financial firms of all sorts in times of troubles, it does seem to make sense to give it some regulatory authority over all of them.

The most crucial element here might turn out to be the CBRA, the conduct-of-business agency, especially its consumer protection arm. What went wrong with mortgages was that sophisticated and ruthless financial markets interacted with unsophisticated consumers with no intermediation but that of mortgage brokers (whose incentive structure was all wrong) and minimal regulation.

Financial products, in particular loans, are useful but potentially dangerous things. Sort of like drugs. Or toasters. If the CBRA had an aggressive consumer arm--maybe something along the lines of Elizabeth Warren's Financial Products Safety Commission--the collateral damage of financial markets' inevitable episodes of insanity could be limited.

That's could, not would. It will always be really hard to get the balance of vigilance and flexibility right. But an agency like CBRA would certainly have a better shot at it than the current mish-mash of federal and state regulators, whose incentive structures mean they are often far more interested in maximizing the number and profitability of the companies under their charge than in protecting consumers.

One final note: The lobbying campaign to prevent Paulson's proposed reforms from happening, or tweaking them to favor particular sectors of the financial business, will be one of the most aggressive and expensive Washington has ever seen. So while the plans sure look like a step in the right direction, the final result may not be.