At the Heart of the Problem is the Task of Fixing the Financial Architecture

Hank Paulson has an article in the Financial Times where he emphasises that a key part of fixing financial regulation in the US is the task of changing the architecture of financial regulation. This is essential for avoiding problems like AIG being regulated by the State of New York. As he says:

Creating a fundamentally different regulatory system is complex and will take months, if not years. But policymakers can achieve significant near-term regulatory reforms that represent progress towards the ideal. These include giving the Fed expanded powers to regulate market stability, combining the Office of Thrift Supervision and the Office of the Comptroller of the Currency to strengthen regulation by reducing duplication, centralising the scrutiny of mortgage origination, creating an optional federal insurance charter, beginning the process of integrating the Securities and Exchange Commission and Commodity Futures Trading Commission and continuing to improve arrangements for clearing and settling over-the-counter derivatives, including development of well regulated and prudently managed central clearing counterparties for OTC trades.

For some of the background, see this speech, and see here.

Like many democracies, the US is very bad at solving such problems under normal times. The SEC vs. CFTC separation was a silly thing to have, but for decades, it has lingered on. Now, in the aftermath of this crisis, there’s a good chance that it will get fixed. I hope the merged agency draws its organisational culture more from the CFTC than from the SEC.

In the UK, the architecture was fixed in the late 1990s: regulation of all financial firms was placed at the FSA; investment banking for the government was placed at the DMO; the Bank of England was given independence in return for (a) transparency (b) accountability and (c) a narrow mandate to only do monetary policy. The gap in that framework was the lack of a deposit insurance mechanism akin to the US FDIC; this is now being fixed. In the new framework, FSA regulates banks; when FSA makes a decision that a bank is in a bad way, the bank gets handed to the Bank of England which chooses whether to give liquidity support or to shut it down. For the rest, the basic structure of agencies and laws is fine, unlike what’s seen in the US.

In India also, the deeper problems of Indian finance are critically about the accidents of history, which have given us a warped financial architecture. The RBI Act, the FC(R) Act, SC(R) Act, etc., were all done decades ago when knowledge of finance in India was absent. That task before us is that of now replacing all these badly drafted laws by sensible ones.

In the UPA period, we have understood these problems and done a lot of the technical work that lays the groundwork for what comes next. The task for the next goverment is to implement this technical work. The regulation and supervision of all organised financial trading needs to be placed at SEBI (thus merging functions that are presently at FMC and RBI); banking needs to come out into a BRDA; the regulation of all pension activities (and not just the NPS) needs to be placed in PFRDA; the investment banking for the government that’s presently done at RBI needs to go out into a professional and independent Debt Management Office (which is termed NTMA). At the end of this, we would be holding four regulators (SEBI, BRDA, IRDA, PFRDA), one investment banker (NTMA) and one independent central bank.

1 comment to At the Heart of the Problem is the Task of Fixing the Financial Architecture

  • Sure, let’s let the big investent bankers, Paulson, Geithner, et al “regulate” those big, bad investment bankers and rework the architecture to reign them in. All of the key positions in the administration are big bankers. But of course, we all know that they are no longer in it for their buddies in banking. They are really, really on our side now. As Dr. Evil would say, Right! Wink, Wink.

    The problem with the United States is that it is trying to emulate the failures of central planning in it’s older brothers and sisters. Neither Paulson nor any other central planner can solve the problems in good times or bad. They can only distort the economy with every action they take.

    The banking industry in the United States was never deregulated, it was only reregulated. The regulations were juggled but still serve the big bank interests at the expense of everyone else.

    The deeper problems in Indian finance have to do with the accident of history that brought socialism there. It has ignored the idea of free markets, just as the United States has for decades.

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