Regulating Banks and Non-Banks: One Year Later

A year ago today I wrote about financial regulation . As the G20 meeting on April 2 approaches, the topic is more relevant than ever.

I argued last year that when the Glass-Steagall wall between banking and non-bank financial institutions was torn down in 1999, the law should have extended U.S. regulatory authority beyond banking to all the other institutions.

My views were shaped by research I did at the FDIC. I developed a state credit-quality indicator, based on bank examiners' classification of loan quality at insured banks. The indicator deducted 20 percent of the loan value classified as substandard, 50 percent of loans classified as doubtful, and 100 percent of loans classified as loss. The results were included in an article I wrote with Professor George Benston published in the Journal of Money, Credit and Banking, "Bank Examiners' Evaluation of Credit".

Whatever use a state credit-quality indicator might have had as an early warning system (e.g., of mortgage-quality problems in Arizona, California, Florida and Nevada) disappeared when mortgage loans were wrapped up into securitized packages that were beyond easy classification by bank examiners and were camouflaged by AAA ratings by rating agencies and insurance companies.

The Chairman of the UK Financial Service Authority (FSA), Lord Turner, on March 18 has highlighted for the G20 socially undesirable financial innovation as a key source of the global crisis. He recommends regulation of near-bank activities such as hedge funds and credit-rating agencies, with a Europe-wide financial body to set standards and supervise. The UK seems to have joined the hawkish German and French authorities.

While the United States has been considered a dove on financial regulatory issues, the Obama administration may surprise the G20. Stephen Labaton in the NY Times on Saturday says a plan is being prepared that would

regulate the shadow banking system, with heightened standards put in place after the economy began to rebound. A broad consensus has emerged that hedge funds must be registered and more closely monitored, probably by the Securities and Exchange Commission.

The U.S. plan will probably give the government greater authority over large troubled companies not now regulated by Washington. The Treasury secretary would have authority to seize a struggling institution after consulting with the president and upon the recommendation of two-thirds of the Federal Reserve board. The government now can seize only the banking unit that controls federally insured deposits of large troubled institutions.