Holding Back the Flood

By Justin Fox

Financial regulation is usually born of financial disaster. The Panic of 1907--during which several big New York City banks actually did fail--led to the creation of the Federal Reserve. The Great Depression, unleashed by a market crash and countless bank runs, gave us the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, and the Glass-Steagall Act separating banks from Wall Street. Now we're up to our elbows in another mess, albeit one that has yet to acquire a name for the ages. (Credit crunch? Subprime meltdown? Give me a break!) And so, as foreclosure follows reset subprime loan, talk has turned to the need for sweeping changes in how we regulate financial markets and institutions.

The Fed's arranged sale of about-to-fail Bear Stearns in mid-March and its subsequent decision to extend credit to other investment banks over which it has no regulatory say have been major prods to discussion. Both House Financial Services Committee chairman Barney Frank and Treasury Secretary Hank Paulson have since suggested that the Fed be given power to snoop around such institutions in search of market-endangering risks. Frank and presidential candidate Barack Obama have also talked of replacing the hodgepodge of federal and state regulatory agencies with a simpler and less loophole-ridden structure--and on March 31, Paulson issued a long-term plan to do just that.

These aren't bad ideas. But neither are they likely to prevent financial crises.

The regulatory structure built after the Great Depression was all about containing risk by sharply restricting what banks, thrifts, brokerage firms and other financial institutions were allowed to do. That worked well for several decades but proved incapable of withstanding the rise of inflation and global competition--not to mention deregulation proponents--in the 1970s. Since then, the priority among regulators and politicians has been to try to manage risk but to by all means avoid thwarting innovation. "I do not believe that government should stand in the way of innovation or turn back the clock to an older era of regulation" is how Obama put it in his big speech on the subject.

But the simple truth is that innovation leads to financial crises. That's because the risks of new financial products are so easily glossed over--until that fateful day when they can't be anymore and markets respond by freezing up with distrust and fear. That's what happened with subprime mortgages and the securities built out of them.

To really prevent crises, then, we would need to prevent or at least seriously slow the pace of innovation. This sounds terribly un-American (although, of course, it was U.S. government policy from the 1930s through the 1970s), and when it comes to professional financiers making deals with other pros, perhaps we're better off leaving them be.

Consumers are different, though, which is why we already have laws and regs meant to protect small borrowers and investors. But compared with the rules designed to shield us from dangerous drugs or even faulty toasters, they're pretty toothless. Plus, most are administered by agencies whose main responsibility is keeping whole the firms they regulate, not looking out for customers.

Paulson's suggested regulatory revamp addresses this issue, sort of, by calling for the creation of a Conduct of Business Regulatory Agency with the sole responsibility of making financial businesses behave decorously. Far more catchy and to the point, though, is Harvard law professor Elizabeth Warren's year-old proposal--which Hillary Clinton has recently begun talking up on the campaign trail--for a Financial Product Safety Commission. It would be modeled on the Consumer Product Safety Commission, which keeps exploding toasters off the market. Such a body might stand in the way of financial innovation. But for consumers, that wouldn't necessarily be such a bad thing.

More Money To read Justin Fox's daily take on business and the economy, go to time.com/curiouscapitalist