A House Divided: Fractured Financial Regulation Threatens Reform

I agree with my colleague Daniel Harrison's take that forming a single global agency to supervise all financial institutions is, to put it technically, crazy talk. But it's equally important to recognize how fractured government oversight helped cause the banking crisis, along with the threat it now poses to financial reform.

Finance, as everyone knows, is today a global enterprise, with capital markets slotting together like Legos. Trouble is, regulation remains a fragmented, parochial affair. Despite efforts over the years by countries to "harmonize" their financial rules, most recently in the Basel II and G-20 negotiations, the supervisory infrastructure fits together poorly, and often not at all.

In the U.S., nearly a dozen federal regulatory agencies, numerous self-monitoring bodies and hundreds of state groups all share responsibility for keeping tabs on the financial industry. In banking alone, five federal agencies stand guard: The FDIC, Federal Reserve, Office of the Comptroller of the Currency, Office of Thrift Supervision and the National Credit Union Administration.

Then you have the states, which oversee state-chartered depository and other institutions. Even non-financial agencies are in on the fun. The FTC takes the lead in enforcing federal consumer protection laws for certain kinds of finance companies. Adding to the merriment, banks sashay from one regulator to another in search of Mr. Lenient.

A similar knot of regulators track the securities industry. That includes a separate agency keeping eye on futures contracts and various industry "watchdogs," usually to be found enjoying a good snooze. The insurance business mostly belongs to the states, resulting in a patchwork of industry rules. Rooting around in all these dumpsters is the IRS.

Most organizations target corporate conduct, a few look out for consumers, others do both. That's no picnic. Standards for judging the "safety and soundness" of financial companies are inconsistent, while understaffed agencies struggle to enforce compliance with industry regs. Accounting rules change faster than hemlines. Even the supposed bright line between federal and state jurisdiction is subject to a continuous shooting war over issues of preemption.

If all this sounds like a recipe for agita, it is. And keep in mind this is only within the U.S. So when someone like Morgan Stanley's John Mack comes along and proposes an "uber-regulator" to police all financial institutions everywhere, all one can do is try not to giggle (or suspect ulterior motives).

This regulatory muddle reflects how the financial industry grew up. The Fed, for example, dates to 1913. It emerged from the Panic of 1907, along with previous meltdowns (and from the desire of financiers to retain a measure of control over the central bank). Securities regulation, including the SEC, came along in the 1930s after the Great Depression. Government agencies born in different historical periods have different institutional customs, further discouraging unity.

But that's only the half of it. The nightmare begins when this spaghetti bowl of complexity gets snarled with the tentacles of finance. As we've learned, and partly by design, no one really has a handle on how the financial world works these days -- not Jamie Dimon, not Lloyd Blankfein, not Paul Krugman, not (by a mile) Alan Greenspan.

We are aware things move fast, interconnect. We know the capital markets are oceanic, and prone to sloshing around unpredictably. By now, people may even have learned to watch their backs when capital starts whooshing out of one asset bubble into another. Shadow banks share entrances with regulated banks, which themselves shun the light. Credit ratings race up and down the alphabet. Under the guise of innovation, structured finance geeks splice risk into ever weirder, and harder to price, exotica.

To echo the great screenwriter William Goldman, nobody knows anything. Take "systemic" risk, a favorite subject of regulators these days. Yet apart from a few basic metrics, merely identifying this sludge, let alone flushing it down the drain, is easier said than done (ask AIG).

Different countries seek to enforce order in different ways. The U.K. has a single agency, the Financial Services Authority, to oversee the industry. In Canada, one body supervises banks, insurers and pension plans, while another takes charge of protecting consumers from financial fraud. The Swedes assign one regulator to oversee banking, securities and insurance, while the country's central bank handles payments.

Here's the thing, though. Regardless of the regulatory set-up, no country with any skin in the game avoided getting burned. Some, like Australia, did better than others in responding to the crisis (Yes, that means you Tim Geithner.) But everyone bears the tell-tale scars.

As finance envelops the earth, the shifting economic, political and legal plates have left regulatory chasms. U.S. officials want to bridge them by simplifying things, perhaps by forming a noble Round Table of regulators and a separate consumer protection agency. That's a start. Yet they could do more.

Instead of merely combining the sieve-like OCC and OTS into a single banking and thrift supervisor, as has been proposed, it could consolidate all five agencies that oversee depository institutions. When everyone's accountable, no one is. That also might ease the turf fights that hobble regulation.

Another worthy cause would be to end the practice of financial institutions funding the very agencies charged with watching them, an invitation to "regulatory capture." Most important, our political class should banish the thoroughly debunked notion that markets can groom themselves.

Financial regulation can't be monolithic. But in an age when finance is all, it must cohere into something large enough to at least approximate the whole.