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On Not Fixing the Alphabet Soup of Financial Regulators: The DHS Analogy

The executive summary of the Blueprint for Financial Regulatory Reform, a report from the Treasury Department on ways to improve oversight of the financial services sector, includes the following:

The intermediate recommendations focus on eliminating some of the duplication of the U.S. regulatory system, but more importantly try to modernize the regulatory structure applicable to certain sectors in the financial services industry (banking, insurance, securities, and futures) within the current framework.

Treasury also presents a conceptual model for an “optimal” regulatory framework. This structure, an objectives-based regulatory approach, with a distinct regulator focused on one of three objectives— market stability regulation, safety and soundness regulation associated with government guarantees, and business conduct regulation—can better react to the pace of market developments and encourage innovation and entrepreneurialism within a context of enhanced regulation. This model is intended to begin a discussion about rethinking the current regulatory structure and its goals. It is not intended to be viewed as altering regulatory authorities within the current regulatory framework. Treasury views the presentation of a tangible model for an optimal structure as essential to its mission to promote economic growth and stability and fully recognizes that this is a first step on a long path to reforming financial services regulation.

The current regulatory framework for financial institutions is based on a structure that developed many years ago. The regulatory basis for depository institutions evolved gradually in response to a series of financial crises and other important social, economic, and political events: Congress established the national bank charter in 1863 during the Civil War, the Federal Reserve System in 1913 in response to various episodes of financial instability, and the federal deposit insurance system and specialized insured depository charters (e.g., thrifts and credit unions) during the Great Depression. Changes were made to the regulatory system for insured depository institutions in the intervening years in response to other financial crises (e.g., the thrift crises of the 1980s) or as enhancements (e.g., the Gramm-Leach-Bliley Act of 1999 ("GLB Act")); but, for the most part the underlying structure resembles what existed in the 1930s. Similarly, the bifurcation between securities and futures regulation, was largely established over 70 years ago when the two industries were clearly distinct. ...

Among the specific recommendations are:

1. Product and market participant convergence, market linkages, and globalization have rendered regulatory bifurcation of the futures and securities markets untenable, potentially harmful, and inefficient. To address this issue, the CFTC and the SEC should be merged to provide unified oversight and regulation of the futures and securities industries.
2. In the optimal structure three distinct regulators would focus exclusively on financial institutions: a market stability regulator, a prudential financial regulator, and a business conduct regulator.
3. The corporate finance regulator should have responsibility for general issues related to corporate oversight in public securities markets.

I’ll have more to say on each of these, especially the last. At the moment, I simply want to raise a cautionary note about the utility of any proposal that relies on “fixing” the current alphabet soup of regulators. John Carney comes at the problem from one angle:

Treasury Secretary Hank Paulson ... would eliminate thed SEC, FDIC, CFTC, OTS and OCC. And after dumping out this bowl of alphabet soup, he would fill it right back up again with the Prudential Financial Regulatory Agency , the Conduct of Business Regulatory Agency, the Federal Insurance Guarantee Corporation and the Corporate Finance Regulator. ... Barney Frank worries that the plan may take too much power away from states, particularly (from what we’ve been lead to understand) in the area of regulating insurance. Larry Ribstein worries that the new, more concentrated structure of regulation could result in losing significant flexibility in financial innovation.

“On this latter point, consider that the CFTC’s replacement, CBRA is likely to be less accommodating,” Ribstein writes. He adds that “with one regulatory agency we’re likely to get fewer new financial products.”

Larry Ribstein also cautions that:

A big problem here is that this overhaul is being proposed in the midst of a financial crisis—the sort of thing that’s given us the whole misguided patchwork the new system wants to replace (think SOX). Glenn Hubbard comments for the WSJ along these lines.  But another way to look at this is that putting all this in a huge hard-to-digest package may have the salutary effect of deferring any regulation until after the crisis has passed.

My cautionary comment comes at the problem by way of analogy. Remember 9/11? remember how we were going to create a Department of Homeland Security to solve the problem of having too many cooks supervising domestic security? How’s that worked out? The latest issue of the Economist opines:

Since September 11th America has made Herculean efforts to improve domestic security. It has undertaken the biggest departmental reorganisation since the second world war by creating the Department of Homeland Security (DHS), and has increased spending on homeland security by more than 300%, to over $40 billion a year. Most air travellers’ luggage is now screened. Cockpit doors on aircraft have been strengthened. Thousands of armed air marshals fly the friendly skies. Millions of doses of antibiotics and smallpox vaccine have been stockpiled to guard against biological weapons.

The absence of further terrorist attacks in America since September 11th suggests that all this may be having some effect. Mr Bush claims that America has prevented several planned al-Qaeda attacks. Unlike many European countries, America is also fortunate in not having a large alienated Muslim population. But none of this means that the country is safe. The jihadists regard America and Israel—the big Satan and the little Satan—as their prime targets. They are determined to follow September 11th with something spectacular, and they believe that America will not be able to tolerate large-scale casualties.

The DHS’s abysmal response to Hurricane Katrina revealed its lack of preparedness for a future attack. The department is a bureaucratic mess. In May 2007 a quarter of the department’s executive jobs and a third of the jobs in its intelligence department remained unfilled. In a survey of 36 government departments the DHS ranked last in job satisfaction, second to last in leadership and 33rd in talent management.

America’s defences have also been undermined by a tendency to treat homeland security as another form of political pork. Huge amounts of money have been spent on out-of-the-way places that face little risk of attack. Security is often tighter in small city airports than in the big hubs. America’s list of potential terrorist targets includes a petting zoo, a popcorn factory and an annual parade of mules.

The next president has to do better than this. America needs to concentrate on strategic targets such as power stations rather than spraying money around. It also needs to staff vital jobs on the basis of merit rather than political connections. ...

America has nevertheless erred badly in refusing to do what all other rich countries do: create a dedicated domestic intelligence agency rather than expect the FBI to do both police and intelligence work.

September 11th revealed the foolishness of this arrangement. The FBI’s intelligence division put up an appalling performance, failing to act on information about foreign terrorists operating on American soil and to share that information with the CIA. But instead of going back to the drawing board, the government responded by injecting more resources into the FBI’s intelligence arm. Since 2001 the bureau has increased the number of its joint terrorism task forces from 35 to over 100 and doubled the number of its intelligence analysts and its linguists.

Yet these increased resources are trapped within a police culture that is incompatible with the bureau’s task. Richard Posner, one of America’s great public intellectuals, points out that police and intelligence work require very different skills. “Criminal investigation is case-oriented, backward-looking, information-hugging and fastidious (for fear of wrecking a prosecution). Intelligence, in contrast, is forward-looking, threat- rather than case-oriented and free-wheeling.” The FBI and the CIA also have a long history of mutual rivalry and suspicion.

So the FBI’s mistakes have continued.

If we can’t get the domestic security alphabet soup right 6+ years after 9/11, how credible is a proposal like Paulson’s?