The Financial Fix Just Got Political

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Paulson proposed a major consolidation of the various agencies that oversee the financial system. The Securities and Exchange Commission and the Commodity Futures Trading Commission, for instance, would be merged into one body. Over time, the plan—which has been in the works since March, 2007—foresees three primary regulators taking over that function from a patchwork of agencies that exist today.

Most important, Paulson is also proposing that the Federal Reserve be given stronger oversight powers over investment banks, hedge funds, and others, significantly expanding its ability to examine the books of such institutions when they borrow from the central bank. But the proposal also places a heavy emphasis on streamlining regulatory function and making it more efficient. Consumer advocates and others say that on first glance some of those proposals appear likely to weaken rather than strenghten regulation.

By setting the terms of the debate, however, the Administration hopes to head off more extensive measures being cooked up in Congress. Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, is currently working on proposals that would appear to give regulators more ability to force investment banks or others to raise their capital levels or reduce leverage than do the Treasury proposals. Both Frank and Senator Chris Dodd (D-Conn.) have proposed bills that would provide up to $400 billion in government guarantees for reworked mortgages if lenders agree to bring the principal value down to the currently appraised value of houses that are under water.

Mixed Reaction

Analysts say that growing momentum for those plans—and the difficulty of continuing to fend off increased government aid for struggling homeowners when the government has invested tens of billions in rescuing the banking system—have clearly put pressure on the Administration. Much of that pressure is coming from congressional Republicans, says Clifton. With the approach of elections, the Republicans in Congress "know they must keep the ball rolling," he says. "This is really hurting all Republicans now because of the perceived inaction on the part of the Administration. They know they need to have proposals of their own; they can't just keep voting against Democratic bills."

Initial reaction to the Treasury's regulatory proposal was mixed. Some Democrats, especially those representing the corridors of financial power in New York, saw it as a positive starting point. "In broad outlines, we agree with large parts of Secretary Paulson's proposal," said Senator Charles Schumer (D-N.Y.) in a prepared statement.

But Democratic Presidential candidate Barack Obama told reporters the plan was "inadequate." The Illinois senator—who outlined his own proposals for regulatory reform in a speech a week earlier—said that while investment banks are now able to tap into the Federal Reserve's discount window for funds if they run into trouble, the Paulson plan would not require them to meet the stiffer requirements for capital reserves and liquidity levels required of commercial banks under Fed supervision.

"If they can have access to the Fed's discount window when in a crisis, that is a sacred insurance policy underwritten by the American people," says Austan Goolsbee, Obama's lead economic advisor. "If they can access that, then we must have government oversight and rules over what kind of behavior they can engage in" as the commercial banks have.

Paulson argues that the Fed has that oversight now, while the investment banks temporarily have access to the discount window; he adds that it is not a foregone conclusion that they will continue to benefit from such access. The Treasury proposal calls for further study of whether such access to the Fed backing should be made permanent for investment banks or other institutions that might now be granted it on a temporary basis; if it is made permanent, then heightened capital requirements and other standards that now apply to commercial banks would also be put in place.

But Goolsbee argues that the Fed has already opened the door to future emergency use of its lending window by investment banks, so greater oversight is needed before they get to a crisis point. He agrees that many parts of the Treasury proposal are a worthy starting point. Overall, though, he sees it as inadequate, part of a continuum in which the Administration has taken a minimalist approach to addressing the problems thrown up by the meltdown in the mortgage and credit markets. "They wait for the crisis to happen, then they react; they are doing something, but it's not enough," he says. The current proposals "would have done little to prevent the current crisis never mind to anticipate or prevent the next one."

A sure sign, if one was needed, that even as the Administration is stepping up its game, the political fight over how best to deal with the situation will continue.

Sasseen is Washington bureau chief for BusinessWeek.