NYU Stern

The Value in Paulson's Proposals

By Thomas Cooley

The New York Sun
Copyright 2008 The New York Sun, One SL, LLC. All rights reserved.

For some time now, Treasury Secretary Paulson and others have been concerned that the chaotic, costly patchwork quilt of regulations that govern American financial markets and corporations is undermining American competitiveness and shifting the financial center toward London.

That concern is well placed — the system has evolved over many decades as the result of the whack-a-mole response to crises and scandals. Like Dutchmen at the dike we rush in with regulations, legal opinions, exchange regulations, and legislation in response to new failures in financial markets, corporate scandals, and so on. Some have argued that a simplified, principles-based regulatory structure like that in place in Great Britain would do much to restore American competitiveness in the business and financial areas. Next came the major liquidity crisis in the markets and the concomitant need for action, the reasons for which have been well-rehearsed in the financial press and elsewhere. Mr. Paulson's changes already are facing lots of pushback, but the treasury secretary has it mostly right in the larger sense of creating a more rational regulatory structure. It consolidates a number of regulatory functions of the security and exchange commission, adds a separate oversight over institutions that carry implicit government guarantees, and gives the Federal Reserve Bank broad new supervisory and regulatory powers over financial institutions that require access to the Fed's lending facility.

It's clear that Mr. Paulson intends, at least in part, to forestall a regulatory reaction to the specifics of the current liquidity crisis. His proposals would not necessarily have prevented liquidity problems, but they put in place a structure that is better equipped to handle such shocks to the credit market.

The first good thing about the reform is that J.P. Morgan, following the panic of 1907 that lead to the founding of the Fed, saw the need for a central bank that would keep financial markets functioning and liquid and that could be lender of last resort. There is no more clear regulatory mandate than that.

Mr. Paulson's proposals speak exactly to this need by extending powers over the very firms that could threaten the orderly functioning of financial markets. The markets are now infinitely more complex and interwoven than they were in J.P. Morgan's day. So it is essential that the Fed be able to supervise and regulate and, if necessary, lend to a wider range of institutions. The complexity of financial markets makes this an extremely tall order for the Fed as the recent credit market crisis illustrates well.

Critics have already jumped on the fact that Mr. Paulson's proposal shifts responsibility from the SEC to the Fed. But that is the logical choice. First, the SEC has neither the regulatory capacity to oversee the liquidity and solvency of the institutions in question nor the ability to be lender of last resort. Only the Fed can do both. Secondly, the SEC is conceptually and historically positioned to represent the interests of individual investors - not the broader collateral interests of the markets.

Lending without regulatory power can lead to trouble. Just look at the Northern Rock debacle to see what happens when the two are separated. There, the Bank of England was lender of last resort but not the regulatory agency. In the end, it cost British taxpayers a lot of money.

Regulation is in many ways a nasty business - because the law of unintended consequences is always there to show us how we got it wrong. Mr. Paulson is taking considerable risks in trying to address the current situation in the present economy. He has almost no chance of getting it exactly right. But at least he is responding in a thoughtful way at a time when there is a real crisis of confidence. It would be infinitely worse to rush in with short-term regulatory responses to the credit crisis that have no principles behind them.

Mr. Cooley, dean of New York University's Stern School of Business, is the Paganelli Bull Professor of Economics.