Financial Regulation: How We Got Here

Posted by: Theo Francis on September 21

Could it have been different?

This week promises to be an action-packed one on the financial-regulation front — it’s on the agenda at the G-20 in Pittsburgh at week’s end, Tim Geithner is likely speaking on it before the House Financial Services Committee on Wednesday morning and regulators are holding forth Wednesday afternoon. Meanwhile, the Fed wants to rein in bankers’ pay, and Sen. Chris Dodd is making noises about scrapping big chunks of the Administration’s proposals and combining the banking regulators.

But for all the talk, there’s plenty of disagreement about whether the various proposals amount to significant enough change. The criticism boils down to calling reform efforts thus far too meek, too slow or too burdensome. And certainly, as colleague Peter Coy and I argued in a recent BusinessWeek article on the topic, the proposals on the table here and globally generally pale in comparison to some of the dramatic proposals that seemed possible only a few months ago.

Still, was there really an alternative?

One school of thought says yes: Strike when the banks were at their weakest, dismantling those that threatened the economy, ousting the executives, wiping out shareholders and giving bondholders a haircut. Use government funds to recapitalize the healthy remains as smaller, more staid banks that would then rapidly be able to raise new private-sector capital from investors previously wary of the toxic assets that burdened their big predecessors. Much the same could be attempted with non-bank financial firms, some argued.

Critics say that scenario was never very realistic, thanks to practical and political reality. For one thing, Congress and much of the public had little appetite for nationalizing banks -- indeed, the mere possibility of it sparked fevered headlines last winter. Similarly, dramatic change in the structure of U.S. regulatory bodies would have sparked such intense turf wars among lawmakers and regulators that it was quickly dismissed as a possibility.

Plus, remaking a financial system on the fly is a tall order. The Obama Administration crafted its regulatory-reform plan even as it sought to prevent the financial system from collapsing altogether.

"Had the world economy collapsed, and there was a reason to believe it could have, the leaders of this country and others may have been forced to take hugely dramatic steps," says Douglas Rediker, a former investment banker now running the New America Foundation's Global Strategic Finance Initiative. "There was a calculation made that it was better to save the current system than to watch it be destroyed and then create something new from the ashes. ... Drama in global finance is never a good thing."

Then, as the financial system stabilized and the sector began recovering from its excesses, a new problem presented itself: Taking the time to reshape the regulatory system from the ground up would have meant extensive study and bruising political fights that could have stretched on for years -- leaving the financial system vulnerable to the same abuses in the meantime.

"If we had to do it all over again, would we do it this way? We don't have that option," says Steven Adamske, a spokesman for House Financial Services Committee Chairman Barney Frank. The alternative, he says, was to "take what we have now, create some additional layers, eliminate one agency, and put this back together in a little better way."

Deeper reform could still happen over time, of course, as more scholarly analysis of the 2008 panic emerges. Or it could come more quickly, particularly if the economy falters again.

"I don’t think this regulatory debate is going to occur amongst all these beautiful green shoots blooming into flowers," says Daniel Alpert, managing director of investment bank Westwood Capital LLC.

Indeed, the dramatic regulatory changes of the Great Depression came not immediately after the depths of the stock-market crash of 1929, or immediately following those lows, when the economy appeared to be recovering. The reforms came from 1932 to 1934, after the economy soured again – and after the Pecora Commission issued a scathing report on the causes of the crisis.

Until then, as now, "all you heard was discussions of returning to speculation and green shoots -– except they didn’t call them green shoots,” Alpert notes. “It was all about business as usual.”