President Obama unveiled a stem-to-stern overhaul of financial industry regulation Wednesday, promising dramatic changes for banks, consumers, hedge funds and even the inner workings of the Federal Reserve. The ambitious proposal is designed to strengthen a ramshackle system of government oversight that failed to either prevent or mitigate the current financial crisis.
The administration rolled out its 88-page plan amid a full-scale public relations offensive culminating in a 13-minute presidential statement in the East Room of the White House. Addressing an audience that included Fed Chairman Ben Bernanke, members of Congress, and representatives of the financial industry and consumer groups, Obama called for "a sweeping overhaul of the financial regulatory system, a transformation on a scale not seen since the reforms that followed the Great Depression."
Under the Obama plan, the Federal Reserve would get new authority to police all financial institutions — not just banks — whose failure could threaten the financial system. And the government would have new powers to wind up the affairs of financial institutions other than banks, such as insurance companies. Hedge funds would be compelled to register with the Securities and Exchange Commission and a new agency would be created to safeguard consumers against overly complex or fraudulent financial products. The new regulatory blueprint would "protect America's consumers and our economy from the devastating breakdown that we've witnessed in recent years," Obama said.
The sweeping proposal marks an emphatic end to an era during which top policymakers, notably including then-Fed chairman Alan Greenspan, celebrated the ability of market participants to largely police themselves. Now, smarting from the collapse of major institutions such as Bear Stearns and Lehman Bros., the costly government bailouts of insurer AIG and the worst U.S. recession since the 1930s, the pendulum has swung back toward an ethos of robust government oversight.
"Millions of Americans who have worked hard and behaved responsibly have seen their life dreams eroded by the irresponsibility of others and by the failure of their government to provide adequate oversight," the president said. "Our entire economy has been undermined by that failure."
The Obama plan also breaks with the pre-crisis period by attempting to head off financial bubbles before they form. Greenspan maintained that central banks could not "definitively identify" bubbles until after they had burst. Rather than attempt to prick bubbles before they grew dangerous, it was better, he said, to clean up after they popped.
"The president does not accept the judgment that it's best to let the market forces rip and then when there's an accident, to clean up after. He believes the last two expansions have, to an extent, been bubble driven, and it's important the next expansion rest ... on a new foundation and a much stronger foundation," Larry Summers, director of the National Economic Council, told reporters Wednesday afternoon.
Still, the far-reaching initiative fell short of what some sought. The administration backed away from merging the SEC and the Commodity Futures Trading Commission, fearing a turf battle between affected congressional panels. Obama also opted to eliminate just one agency — the Office of Thrift Supervision — from a sprawling regulatory network widely regarded as excessively fragmented. The OTS had hardly distinguished itself during the financial crisis; last year's two biggest banking failures occurred in institutions it regulated: IndyMac and Washington Mutual.
Administration officials, convinced of the need to act while memories of the crisis are fresh, will begin their sales pitch Thursday when Treasury Secretary Timothy Geithner testifies on Capitol Hill. Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, which will take the lead in considering the regulatory revamp, wants to pass legislation this year. But Rep. Spencer Bachus of Alabama, the panel's ranking Republican, wasted no time Wednesday in criticizing the president's road map.
"The administration's plan continues the cycle of bailouts for 'too-big-to-fail' financial institutions, furthers the government's role in picking winners and losers, complicates rather than streamlines the current regulatory structure, and keeps taxpayers on the hook for losses caused by imprudent risk-taking on Wall Street," he said in a statement.
Increased powers for Fed
Among the most controversial elements are expanded powers granted the Fed. The central bank, which controls the nation's money supply and supervises the banks, would become the financial system's uber-regulator. The Fed missed the housing and credit bubbles while they were inflating, badly underestimated their costs when they did pop and already has a full plate, critics say. With the Fed already engaged in numerous unconventional interventions in financial markets, some worry that adding a new role could backfire.
"I'd rather that the Fed stick to its knitting of conducting monetary policy and be the lender of last resort, as opposed to take on the role of supervision of individual institutions. ... In this role, the Fed will be thrust into the center of controversy," said Hal Scott, a professor at Harvard Law School and director of the influential Committee on Capital Markets Regulation, a private-sector body.
But administration officials say they carefully considered alternatives before opting to task the Fed. Countries that place key supervision authority outside the central bank don't operate well in crisis situations, Geithner said.
"I do not believe there's a plausible alternative that would create the necessary degree of confidence, accountability, responsibility and authority for protecting us against some of the risks we faced in this crisis," he said.
A key target of the plan: financial institutions so large and interconnected, their failure could ricochet around the economy with catastrophic results. These "systemically important' companies would be subject to more scrutiny and would need to hold more capital in reserve than under current standards. The government also would win new authority to handle "the orderly resolution" of them if they suffer fatal wounds.
"After this crisis, it's clear that there are a number of financial institutions that are capable of being the domino that causes the rest of the financial system to fall over," said Douglas Elliott, a former JPMorgan investment banker.
But some worry that investors will view any financial institution the government labels "systemically important" as effectively government-backed.
That could enable such firms to borrow at lower interest rates, since they would seem better credit risks than smaller rivals not vital to the financial system, says the Brookings Institution's Martin Baily, who chaired President Clinton's Council of Economic Advisers.
At the heart of the current crisis were sophisticated financial products known as derivatives, securities whose values depend upon the performance of another asset. In the years leading to the credit crisis, unregulated derivatives markets mushroomed. Banks relied on them in an ill-conceived effort to control risk. But when the derivatives' values plunged amid unusually turbulent markets, the banks suffered huge, unexpected losses.
The administration now wants to impose for the first time record-keeping and reporting requirements on all over-the-counter derivatives trades.
After repeated financial crises and investment bubbles, the proposed regulatory overhaul seeks to make the financial system more stable. But that objective might be attained only at some cost. By requiring banks to maintain higher capital reserves, for example, the amount of credit flowing through the economy could be pinched. Likewise, new limits on the ability of banks to package their loans into securities that are sold to investors could crimp an important channel of credit formation.
Small businesses, in particular, might feel the efforts, Fed Governor Kevin Warsh suggested Tuesday in a speech to a bankers' association. "Then we might find ourselves with lower growth and diminished economic potential," he said.
But after the turmoil of the past 18 months, the political tide is running against such sentiments. U.S. households have seen $12 trillion in wealth disappear amid deflating housing and credit bubbles. Unemployment has soared to 9.4% with more than 6 million Americans added to the jobless rolls since the crisis began.
John Taylor, president of the National Community Reinvestment Coalition, backed the president's proposal. "There are a lot of powerful interests in Washington that have an allergic reaction to any type of regulation. ... They've had their shot at having loose or no regulation," he said. "Let's try having some regulation."
Contributing: Pallavi Gogoi in New York and Paul Davidson in Washington