Enforcement is key to US reform proposals' success
An article by Timothy Geithner, US treasury secretary, and Lawrence Summers, director of the National Economic Council, published in the Washington Post on Monday, provides an outline of the Obama administration’s financial reform agenda. It comprises five broad themes, each drawing on specific inferences about the causes of (and lessons from) the recent financial crisis. The first theme relates to the perception that inter-connectedness among financial institutions tends to magnify the risks faced by each one. This implies that risk mitigation measures based on individual exposures are inadequate. The levels of these measures need to be raised to account for the magnification. Further, large institutions with multiple linkages, when they become fragile, pose a threat to the whole system; hence their behaviour needs to be more closely monitored and controlled. The second covers the huge increase in asset classes and markets, and emphasises ways to bring them into a harmonised and integrated risk and disclosue regulatory framework.
The third theme emphasises the inadequate safeguards that consumers have when it comes to dealing with financial products. Sub-prime mortgages are a perfect example; large numbers of borrowers were simply unaware of the stringent conditions attached to the loans. Greater mandatory disclosure and better protection are proposed as the solution to this. The fourth theme refers to the inadequacy of policy instruments to deal non-disruptively with a financial meltdown. The US government didn’t seem to be able to find a middle ground between “bail-out” and “bankruptcy”. The reform agenda proposes a more organised resolution process that will help achieve a more orderly adjustment. Finally, the proposal recognises the extent of global integration in the financial sector and the need to persuade other countries to pursue similar regulatory reforms.
One way to view this agenda is that it essentially perpetuates the status quo. A little bit of tinkering on disclosure, prudential norms and consumer protection is hardly commensurate with the intensity and magnitude of the crisis that originated in the US financial system and spread rapidly through much of the rest of the world. Critics of the proposals would call for far more stringent measures, including explicit constraints on the kinds of exposures that different kinds of financial institutions can take on. But there is a legitimate counter-view. Too many constraints will stifle the flow of resources to activities that, while risky, also significantly enhance production and consumption capacity. There is a fine line between the two, but nobody knows or even can know where it lies. The effectiveness of regulatory reform will certainly depend on the formal changes in the regime, but is far more sensitive to the quality of enforcement. This is the real challenge, particularly in the US because of its inherent reluctance to put curbs on markets and risk-taking. To that extent, the proposals represent a realistic assessment of the country’s appetite for stiffer regulations, notwithstanding the public outcry. Now, if only the new rules were firmly and uniformly enforced.
