Proposed financial overhaul puts Fed in charge of market stability

WASHINGTON -- It's a Herculean task: revamping a financial regulatory system dating back to the Civil War to deal with 21st century crises imperiling the country.

Under an ambitious Bush administration plan, the Federal Reserve would take on the unwieldy role of uber cop in charge of financial market stability. Other regulatory agencies could see their influence diminished.

The proposal won't fix the host of economic and financial problems that threatens to plunge the United States into a deep recession, but it might help guard against future troubles. It would take years and a lot of political wrangling to implement all the changes envisioned.

Yet, the initiative, formally announced Monday, casts a fresh spotlight on the best way to protect the country from financial catastrophes in an intricate web of complex, often-changing financial products and the wide array of financial players using them in the United States and beyond. That debate probably will take center stage in the next president's administration.

The plan would greatly expand the role of the Fed, created in 1913 after a series of bank panics, to oversee the stability of the entire financial system including commercial banks, investment banks, insurance companies, hedge funds, private-equity firms and others.

Rather than checking on the health of a particular organization, the Fed's focus would be on whether a firm's or industry's practices pose a danger to overall financial stability, said Treasury Secretary Henry Paulson, whom Bush put in charge of the plan.

"It will have broad powers and the necessary corrective authorities to deal with deficiencies," Paulson said.

Lyle Gramley, former Fed official and now senior economic adviser at the Stanford Washington Research Group, believes the plan isn't clear about the Fed's such corrective powers. "If you create a police force and don't give them any weapons, it is going to be useless," Gramley warned.

Others expressed concern about concentrating too much power at the Fed while also streamlining or consolidating the duties of other regulators. They feared that a safety net of checks and balances could be lost.

"The cataclysmic mistake is that if you eliminate so many 'eyes' that monitor the markets, and the single eye, no matter how super, misses something, then catastrophe," said Anthony Sabino, a professor of law and business at St. John's University.

For similar reasons, Howard Chernick, economics professor at Hunter College, said, "I would prefer not putting all my eggs in the Fed's regulatory basket."

The Consumer Federation of America accused the Fed of failing to heed warnings about risky mortgages that triggered the meltdown in credit markets in the first place and questioned expanding its scope. "Giving the Fed new responsibility to monitor market risks will do nothing if it is not accompanied by much broader authority for the Federal Reserve to act than this proposal provides, and even more important, by a willingness for the Federal Reserve to use the authority it has."

At the same time, the Fed would lose daily supervision of big banks, something the Fed probably would fight to keep intact, Gramley said. Taking away that supervision is a problem because the Fed is also the lender of last resort for commercial banks, he said.

In the biggest expansion of its credit authority since the 1930s, the Fed in mid-March temporarily granted that emergency lending privilege to big investment houses. It came after the crash of the once-mighty Bear Stearns, the nation's fifth-largest investment firm, stoked fears others could be in jeopardy.

Day-to-day banking supervision would be consolidated into one agency, compared with the current five. The Office of Thrift Supervision, which oversees savings and loans, and the Commodity Futures Trading Commission, which oversees the trading of gas, oil and other commodities, would be eliminated, with their functions merged into other agencies.

"I think it is a mistake to discard some federal agencies" because protective checks and balances could be lost, Chernick said. "A paper reorganization that is going to help must have the legal teeth and the staff behind it to regulate the industries," he said.

Walt Lukken, acting chairman of the CFTC, warned that his agency's expertise "may be jeopardized with the creation of a larger regulatory bureaucracy."

The Bush administration's creation of the Homeland Security Department, which merged 20 or so federal agencies into the new Cabinet level office, stirred turf battles, culture clashes and mission-identity crises. The new agency's effectiveness was hobbled, critics say.

While some regulators no doubt will be fearful of losing powers, those regulated had their own concerns.

"Dismantling the thrift charter and crippling state banking charters will weaken banking in America," said Edward Yingling, president of the American Bankers Association.

The plan, which would require congressional approval for its biggest changes, such as the Fed's expanded authority, would alter how the government regulates thousands of businesses from the nation's biggest banks and investment houses down to the local insurance agent and mortgage broker. It aims to overhaul a patchwork collection of sometimes overlapping regulatory jurisdictions and build a new structure that better suits the needs of the modern financial world.

Sen. Charles Schumer, D-N.Y., wanted even more regulatory consolidation, saying a "single regulator may be a better approach."

It would create one super agency in charge of business conduct and consumer protection, performing many of the functions of the current Securities and Exchange Commission.

The plan also would ask Congress to establish a federal Mortgage Origination Commission to set recommended minimum licensing standards for mortgage brokers, many of whom now operate outside of federal regulation. And, the plan would also take a first step toward federal regulation of the insurance industry by asking Congress to establish an Office of Insurance Oversight inside the Treasury Department.

Massachusetts Secretary of the Commonwealth William F. Galvin blasted Paulson's approach as "a disastrous backward step that would put the investor in jeopardy" because it would pre-empt state regulation of securities and insurance.

Paulson acknowledged that most of the changes will not occur until after a lengthy debate in Congress, leaving it to the next administration to deal with the biggest changes proposed by the report.

"Tearing down the existing regulatory structure and rebuilding it is an extraordinarily difficult task, involves a tremendous amount of turf battles in Washington and will be awfully difficult to solve," Gramley said. "Proceeding in this direction will happen very, very slowly."