The Paulson proposals (http://www.treas.gov/press/releases/reports/Blueprint.pdf) are like many previous financial reform road maps forward during times of crisis.  Despite the claim that they are not in response to the current problems, this set is like the other in that they are largely recommendations that either have been on the back shelf and/or are kneejerk responses to perceived immediate problems.  Despite the wide ranging attention they will get – witness the coverage in today’s Wall Street Journal (March 31, 2008), there is nothing in them relevant to investors.  So unless you are simply interested in policy, there is no need to read further. 

The rest of this commentary is directed towards those who would be interested in a quick summary and evaluation of the report.  The proposals are as complex and far reaching and involve short term, intermediate term and longer term recommendations.  Therefore it seems logical to divide the discussion of the proposals into parts. 

Short Term Proposals

The report has three short term proposals, which include: a) expanding of the President’s Working Group (PWG) to coordinate regulatory policy, b) increasing regulation and oversight of mortgage originations, and c) institutionalizing and regulating the expansion of the Federal Reserve’s Discount Window access to non-depository institutions. 

 Expansion of PWG

Expanding membership in the PWG beyond the current Secretary of the Treasury, the Chairman of the Federal Reserve, the Chairman of the SEC and the Chairman of the FTC to include the Comptroller of the Currency, the Chairman of the FDIC and the head of the Office of Thrift Supervision under the chairmanship of the Secretary of the Treasury seems to be a bad idea for three reasons.  First, it isn’t clear what policies the group would coordinate.  Second, the claim that the group has worked well since its inception in 1987 is at best self serving since it isn’t clear what impact the group ever had on policies, given that it has been in existence some 20 years.  Third, Treasury should not be involved in coordination of regulatory and prudential policy, which should be left to independent agencies.  Otherwise, Treasury may be tempted to introduce political considerations into implementation of regulation and supervision.  Fourth, creating new agencies, which tend to perpetuate themselves, when the long run objective (at least as articulated in the report) is to streamline and simplify regulatory structure introduces an unnecessary complication and potential barrier to further reform.  Once created, it is nearly impossible to eliminate an agency or commission if it has permanent funding.  Fifth, diverting the time and attention of agency heads from their main mission is likely to be costly to that mission and may not pass a cost benefit analysis.  Finally, there already exists a body to coordinate financial institution supervisory policies (the Federal Financial Institutions Examination Council) whose record is at best mixed, but might be a better place to locate coordination responsibilities envisioned in the Treasury report.

 Regulate Mortgage Originations

Given the alleged problems in the origination of sub prime mortgages, the Treasury proposes creating a new regulatory commission, in addition to the 50 states and three federal agencies (the Federal Reserve, the FCC and OTS) already involved in mortgage origination oversight.  This new commission, the Mortgage Origination Commission, would be comprised of a Chairman and representatives of the Federal Reserve, the OCC, the OTS, FDIC, NCUA and Conference of State Bank Supervisors.  This group would develop uniform licensing and standards for state mortgage participants including personal conduct and educational and other qualifications and it would be charged with monitoring the adequacy of each state’s systems.  This group would not, however, be responsible for drafting regulations which would remain with the Federal Reserve.  Finally, the Treasury suggests that enforcement authority of federal laws be clarified.  Clarifying responsibility seems to be easy and shouldn’t necessitate a commission.  And as far as setting uniform licensing and other standards, Congress could simply draft a model statute, similar to the Uniform Securities Act, governing investment advisors and securities issuance.  This might be a more direct, less costly and less burdensome way of addressing the problems in one segment of the financial services industry than creating a whole new regulatory apparatus.  Note too, however, that the Treasury proposal would do little to address the problems that have arisen because borrowers simply didn’t understand the terms or risks of some of the contracts into which they were entering. 

 Liquidity Provisioning by the Federal Reserve

The last short term recommendation concerns the need to revisit and enhance the expansion of the Federal Reserve’s provision of emergency access to the discount window to non-depository institutions and to ensure that the terms under which that access is granted is transparent.  Treasury also suggests that the PWG should consider a broad array of regulatory issues associated with providing that access to non-depository institutions.  This recommendation seems to be suggesting that the emergency provisions under existing law are inadequate and that the Federal Reserve lacked access to information that may or may not have existed.  As of yet, we don’t know whether this is fact or not.  Beyond this, it should be the Federal Reserve’s responsibility to identify and raise any issues that it has encountered, based upon a post mortem of its experience, and go to Congress with suggestions for any needed change in law.  It is not clear what the PWG might bring to the table on this issue or why it should have the responsibility to conduct the review. 

 Conclusions -  Short Term Recommendations

After examining the short term recommendations, one might be tempted to ask, why all the fuss?  Clearly, aside from an attempt to layer an additional regulatory structure on the origination of mortgage loans, the two other recommendations appear to be ho hum.  Despite the Treasury’s claim, two of the three recommendations are clearly in response to the present crisis. What problems that the recent turmoil have exposed are the proposals designed to remedy?  Where were the major breakdowns in either coordination or in the Fed’s operation of the discount window?  What were the real problems in the mortgage origination process?  Were they in the structure of the regulations?  Were they in the implementation of oversight by either state or federal authorities?    Was there inadequate demarcation of responsibilities?  Most important, why is it necessary to create a new regulatory agency to oversee one particular loan market?  Will this be done every time there is a problem in a politically important loan market?  All of these are elemental questions that need to be addressed after a full forensic investigation of the current problems has been performed. 

 Intermediate Term Recommendations

The intermediate-term recommendations in the Paulson report are substantially more ambitions and potentially much more controversial than its short term recommendations.  These include: a) elimination of both the Office of Thrift Supervision and thrift charter by converting federally chartered thrifts to national banks;  b) simplification of the federal supervision of state chartered banks by giving sole authority to either the Federal Reserve or the FDIC; c) creation of  a federal charter for all systemically important payments and settlement systems and placing oversight responsibilities with the Federal Reserve; d) rationalization of the regulation of the insurance industry by creating a federal charter option for insurance companies to be administered by a new agency – the Office of National Insurance within the Treasury (paralleling the Office of the Comptroller of the Currency) and e) merging the CFTC and SEC so as to rationalize the regulation and oversight of both the futures and securities markets and also establish a self-regulatory regime for investment advisors similar to that for broker-dealers. 

Clearly, as the Treasury has recognized in its report, elimination of the thrift charter, changing the supervisory structure for state chartered banks, modifying the McCarran-Ferguson Act treatment of insurance, and merging the futures and securities regulators are all controversial.  None of these are new recommendations.  They have been proposed before and have experienced significant industry resistance, so they don’t warrant further comment here.  

 Payment and Settlement System Oversight

The newest, most interesting and far reaching proposal is the one that would expand the Federal Reserve’s responsibilities for major clearing and settlement systems for payments as well as securities and other financial instruments.  At present the Federal Reserve is only responsible for its portion of the check clearing and settlement system, the large dollar payments system as part of Fed Wire and the related securities transfer system.  But the proposal might be construed as covering the major clearing houses, foreign exchange settlement systems, the clearing and settlement systems for futures and options as well as equities, debt securities, credit cards and ATM networks.  The list is long and deep, and probably everyone has another that could be added to the list. 

From the Federal Reserve’s perspective being handed such responsibilities just as its check business is disappearing and it is facing operating only four (and soon to be only two) check clearing sites for the whole nation would represent manna from heaven in terms of jobs and responsibility.  Given this potential broad scope of responsibilities when payments and settlement systems in the rest of the world are largely operated by the private sector, this change in responsibilities would represent a major departure from how payments systems are evolving.  Clearly, more forensics are needed to determine what the risks are, whether systems structured like the futures exchanges, which extend no daylight credit are sufficiently safe to warrant remaining private, and what systems should be covered should be the subject of careful study before the Treasury recommendations are taken seriously. 

 Longer Term Issues

The long-term recommendations of the Paulson report purports to be based upon a model of “optimal regulatory framework.”  But since there is no accepted model for an optimal regulatory framework in the finance or economics literature, or elsewhere, what is considered optional is most likely in the “eye of the proposer.” The assertion of optimality is how one legitimizes a set of recommendations. 

The framework envisions a three part regulatory regime for financial institutions in which there is a separate regulator focusing on financial stability (the Federal Reserve), a prudential supervisory for institutions with government guarantees, and a business conduct regulator.  In addition, there would be two other regulators focusing on the deposit guarantee function and a corporate finance regulator.  While a lot of time in the summary is spent on describing the scope and potential issues that might be the prevue of each of these entities and how they might relate to the industries they are involved with, the report is short on discussion of why this structure is optimal and of more concern is the unsupported assertion that this structure would be more responsive to change or to either industry needs or consumer concerns than the current structure.  In scope, for example, much of what is recommended tends to mirror the division of responsibility in the United Kingdom, which has not distinguished itself in the current crisis.  So, even the most current evidence leads one to be skeptical that the proposals are serious or merit much attention.  In fact, there has been much in the way of analysis and study of what the key regulatory reform issues are, and none of this seems to be reflected in the discussion in the Executive Summary.

 Conclusions. 

A summary reaction to the set of proposals is one of general disappointment.  They focus mainly on reshuffling of responsibilities without any consideration of efficiency or incentives.  In short, the proposals are generally naive and suggest a lack a full understanding of the importance of some critical issues.   For example, many of the problems that have arisen surrounding the resolution of Bear Stearns arose because BS wasn’t a bank and therefore was not subject to either Prompt Correction Action provisions and procedures of the Federal Deposit Insurance Corporation Improvement Act of 1991 or the expedited closure rules incorporated in the special bankruptcy procedures that apply to banks.  Not dealing with this fundamental problem for financial intermediaries that are to be brought under the scope of federal regulation, insurance and related rules and regulations is a critical failing.  Resolving this issue is more important than even who exercises the authority.  Similarly, the discussion of changes in the structure of deposit insurance fails to consider the fact that the current system is now a mutual deposit insurance system that has an ex post first claim on the resources of surviving covered institutions as a backstop should the fund become depleted. Being sure that the incentives of the insurer are aligned with the interests of those for whom they are acting as agents is an important reform issue.  Additionally, many of the problems that the recent turmoil have exposed suggest difficulties in governance and in the accounting conventions that dictate what, when and how information is disclosed and presented to investors and other creditors.  Again, this issue is not addressed in the report as reflected in the Executive Summary.

Finally, the report glosses over the practical political issues of how one gets from here to there.  Most reform proposals fail because they don’t address the issue of how to overcome the self interests of both the regulated and regulatory agencies to move to a better and “more optimal regime.”  This report is no exception and will suffer the same fate.