Newswise — The regulation of banks and other financial institutions in the United States is a "crazy quilt" of decentralized federal agencies that need to be reorganized to make future market meltdowns less likely, according to a University of Iowa law professor.
Hillary Sale, a securities law expert in the University of Iowa College of Law, believes federal agencies should be realigned so that some oversee consumer protection and others oversee the institutions' financial health.
Currently, she said, too many agencies must perform both tasks, which means they can do neither task well and creates conflicts of interest.
In a recent paper, "Redesigning the SEC: Does the Treasury Have a Better Idea?", Sale and her co-author, Columbia University law professor John Coffee, point out that one of the reasons for the current economic meltdown was the lack of a cohesive regulatory approach that allowed financial institutions to inflate the real estate and mortgage bubble.
Investment banks, commercial banks, mortgage lenders, stock brokers and other financial institutions are regulated by a patchwork of federal agencies with different missions and different resources. It doesn't help, either, she said, that the agencies frequently engage in political turf wars and suffer other management dysfunctions.
For instance, Sale said banks and savings and loans can be regulated by the Federal Reserve, the Office of the Comptroller of the Currency, the FDIC or the Office of Thrift Supervision. Securities are regulated by either the SEC or the Commodities Futures Trading Commission, while insurance isn't regulated by any agency at the federal level.
At the same, the approach toward federal regulation in recent years has generally been the less, the better, causing regulatory agencies to loosen rules and regulations for banks and other financial institutions. Sale said cuts in the SEC also left the agency "outgunned" in its efforts to regulate organizations that could afford to fight off regulation with armies of economists and attorneys.
As a result, she said the SEC was not nearly robust enough to contend with the mortgage and real estate bubble, just as it wasn't robust enough to properly regulate the dot com-fueled run-up in the stock market in the 1990s. Or the accounting irregularities scandal that brought down companies like Enron that followed, or stock options backdating, or Bernard Madoff operating a hedge fund that was actually a $50 billion Ponzi scheme, or any number of other corporate scandals in the past decade.
"It becomes plausible that failures in regulatory oversight, including by the SEC, may have played a greater cause in the economic debacle than has been generally emphasized, by softening requirements for disclosure and due diligence standards," Sale said.
Now, in the wake of the economic collapse, Sale said the government needs to create a new regulation framework, if for no other reason than to restore investor confidence in the markets and to maintain the global competitiveness of the U.S. economy.
The Department of the Treasury undertook such a task in 2006, when it released its own paper suggesting a number of changes in the regulatory framework. Among those was the so-called "twin peaks" framework that gives some agencies the mission to protect consumers and others the mission of ensuring an institution's business soundness.
Sale and Coffee support aspects of that recommendation and suggest the SEC take over the function of consumer protection, while the Federal Reserve and OCC are merged into an agency that monitors financial institutions for soundness.
They also suggest that the new, merged agency have regulatory authority over insurance companies, hedge funds and other institutions that are currently unregulated by any federal agency.
Sale and Coffee argue that the government must restore a robust regulatory emphasis to rebuild confidence in the market by making sure lenders do not take undue risks in trying to keep up with competitors who are taking unnecessary risks. That's what happened in recent years, when competitive pressures encouraged banks to make billions of dollars in questionable loans that, in the end, were not paid back.
"Once the market becomes hot, the threat of civil liability-either to the SEC or to private plaintiffs in securities class actions-seems only weakly to constrain this momentum," Sale said. "Explosive growth and a decline in professional standards often go hand in hand."
But Sale and Coffee are critical of the Treasury Department's recommendations to allow more self-regulation by financial institutions instead of the government, and to force state regulators to take a back seat to federal agencies when investigating fraud.
Sale said that state regulators, particularly in New York, have uncovered some of the most dramatic fraud cases in recent years and provided competition that forces the SEC to take action. That competition, she said, increases enforcement and fills in the gaps between the various federal agencies.
"Redesigning the SEC: Does Treasury Have a Better Idea?" will appear in a forthcoming issue of the Virginia Law Review, which is published by the University of Virginia College of Law.
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