July 22, 2010

'Wise Men' to Rule U.S. Capital Markets
By Robert Robb

The financial-market legislation enacted by Congress last week ushers in a new era in the relationship between capital markets and the government.

If the country decides it was a mistake, unwinding it will be very difficult.

Until now, regulation of capital markets has been primarily disclosure-based. Investment firms were largely free to offer whatever products they wanted. The role of government was principally to ensure that there was adequate disclosure so that potential investors could make informed decisions and not be hoodwinked. Who made or lost money wasn't the government's concern, except at tax time.

The primary exception was banks whose deposits were insured by the federal government. Since the government was ultimately on the hook, it oversaw the prudence with which these banks did their business.

The conventional wisdom is that this system failed in the financial-market turmoil of 2008. Financial institutions subject to lighter prudential regulation took on too much bad risk with too much leverage. These firms had become big and interconnected enough that their failure threatened the collapse of the entire U.S. financial system.

Now, I happen to believe that this narrative overstates the threat that existed in 2008. But I am part of a very small and uninfluential minority on the matter. So, for purposes of discussion, let's assume that the narrative is correct and the goal of reform should be to prevent a reoccurrence.

There are several things that Congress could have done to address the perceived threat directly. If financial institutions over a certain size represent a systemic threat, Congress could have prohibited companies from becoming that large. In the past, the U.S. got by with smaller banks, and it could again.

If excessive leverage is a systemic threat, Congress could have limited it directly.

Instead, Congress decided to vastly expand the federal government's discretionary, prudential regulation of capital markets.

A new Financial Stability Oversight Council and the Fed are authorized to prescribe individualized requirements for any company they deem to pose a potential systemic risk. The new council of wise men can tell a company not only what capital it needs to maintain but what products or services it can offer. It can order a company to divest some of its holdings or lines of business. The federal government can even take over a company with the intent of completely liquidating it.

In many cases, the company has no ability to contest these decisions in court. Where there is judicial review, it is limited to whether the regulatory decision was arbitrary and capricious.

So, there is no real rules-based regulation of capital markets anymore. The council of wise men will make it up as it goes along. Companies of the same size in the same lines of business may have entirely different rules they must follow.

There will no longer be a capital market regulated by an arm's-length federal regulator, setting the same rules of the game for all competitors. Instead, there will be symbiosis between government and financial institutions, interacting continuously with one another to determine what any particular financial institution can and cannot do at any particular point in time.

This approach is doomed to failure. No group of regulators has the wisdom required to do what this new legislation requires.

Once the symbiosis is established, however, unwinding it will be very difficult. The politicization of the allocation of capital tends to be addictive.

This bill is also probably the beginning of the end of an independent Fed. The Fed cannot play this large of a role in the conduct of every major financial institution in the country without politicians seeking to get into its knickers. The role of primary systemic-risk regulator is simply incompatible with that of an independent monetary policymaker.

President Barack Obama and Democrats regard this legislation as monumental. I don't think they even partially understand how right they are.

http://www.realclearpolitics.com/articl ... 06426.html