Fixing financial regulation in the US

Financial Express, 20 June 2009

The US has long had one of the more awkward systems for financial regulation in the world. A gigantic insurance company like AIG was regulated by the state government of New York. Every advanced economy has a unified regulator dealing with all organised financial trading, other than the US where this is split between two agencies -- the SEC dealing with the spot market and the CFTC dealing with the derivatives market. Banking regulation in the US is balkanised between multiple agencies and included a considerable role for state governments. Housing finance is distorted by having large PSUs performing social functions. The credit rating business is riven with conflicts of interest. It is perhaps not surprising that the financial crisis of 2008 erupted, given these mistakes in the functioning of the regulatory regime.

In monetary policy, the world has moved towards enshrining the independence of central banks in law, at the same time narrowing their role to monetary policy, requiring transparency and setting up the accountability mechanism of inflation targeting. In the US, the law governing the Federal Reserve was written before these issues were understood. This has implied weaker independence provisions and greater confusion about the goals of the agency. The Fed has done well in moving towards inflation targeting de facto, but has only a weak legal foundation for doing so.

The broad contours of US financial regulation fell into place in the 1940s. With a once-in-a-century financial crisis winding down, this should have been an ideal time to comprehensively think about the nature of financial regulation that is required for the 21st century. After all, a crisis is a terrible thing to waste.

Unfortunately, the mechanisms of governance in the US are not very good at grappling with problems and coming out with new legislation. The lawmaking process is cumbersome, and littered with roadblocks thrown up by special political interests. When Barack Obama won the presidency, there was hope that his immense political capital would be put to the purpose of reforming US financial regulation. However, the power of the president has been significantly attenuated in the last seven months.

The administration has now unveiled a proposal for reforms. Some elements of this make eminent sense. The US FDIC has done a good job of closing down weak banks. Its domain of work would be extended to non-banks. In addition, other legal changes required for government involvement in closing down financial firms are proposed. One of the many banking regulators in the US - the Office of Thrift Supervision (OTS) - is sought to be closed down. A new agency focused on consumer protection would be created. The Federal Reserve would monitor "systemic risk" in the economy, together with a council led by Treasury.

These changes are being talked up by the administration. Obama used the phrase "a transformation on a scale not seen since the reforms that followed the Great Depression". This statement is true, but that is only a comment on the lack of institutional reform in the US after the Great Depression.

At a deeper level, these changes are disappointing. There are numerous well known flaws which have not been addressed. The authors of the proposal seem to have greatly watered down the changes needed so as to improve the chances of getting the legislation passed. However, the proposals are only the starting point of a negotiating process through which the text of the legislation will crystallise. Further watering down might happen (or, lawmakers could improve upon these proposals).

By the standards of advanced countries, monetary policy in the US is on a relatively shaky legal foundation. This is a particularly important concern given present fears about massive government debt and the temptation to inflate it away. The direction that needed to be taken was to shore up these legal foundations, by enshrining independence and setting up the accountability mechanism of inflation targeting. Instead, the administration aims to place more functions in the US Fed. When the Fed exercises these discretion-intensive functions that create winners and losers, politicians will inevitably want a say in how those decisions are made. In the process, the US runs the risk of corroding the institutional foundation of monetary policy. The best way to achieve a technocratic, apolitical and independent central bank is to narrow its functions down to a small core, where politicians are willing to accept a suspension of their control in return for strong transparency and accountability mechanisms.

Curiosity about lessons for the Indian financial debates is inevitable. However, the two countries have very different initial conditions. The US has a complete financial system, while India does not. In India, the biggest achievement of financial reforms in 2009 was giving banks the ability to setup ATMs without requiring permission from the RBI. In India, RBI continues to ban trading in plain vanilla products such as futures on the 90 day treasury bill. Further, the US is often not a very good role model for how to do financial and monetary policy, given the burden of history and the weaknesses of the lawmaking process.

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