Principles that must guide new financial regulation

Published: June 16 2009 03:00 | Last updated: June 16 2009 03:00

When the Obama administration releases a framework for reform of US financial regulation tomorrow - accompanied by announcements in the European Union and other financial centres - it will be the first step in the most significant regulatory overhaul since the Great Depression. As proposals give way to the rough-and-tumble of the legislative process, lawmakers should be mindful of certain core principles that are integral to the fair and efficient functioning of financial markets.

Now is the time to overhaul the financial regulatory structure. Simply put, the current system failed to identify systemic risks, much less manage them. It proved incapable of protecting investors or even recognising the magnitude of the threat they faced. It is a system characterised by confusing overlaps in some areas and perilous gaps in others.

Today's regulatory structure evolved in piecemeal fashion over the past eight decades, with short-term responses to successive financial crises heaped one atop another. Getting our regulatory house in order requires constructing a new foundation, rather than taping broken windows and patching cracked walls.

What principles should frame a truly modern and proactive regulatory architecture of the 21st century?

First, financial regulatory reform must protect investors and restore investor confidence. That demands a new approach to regulation. Innovative financial instruments blend elements of equity, debt and insurance - but regulators today only focus on their own specific area of responsibility. We must close the gaps, ensuring all market functions are supervised by an appropriate regulator. This is crucial if we are to ensure that no single institution is large enough to threaten the entire system.

Second, financial oversight must be rationalised and harmonised. Seven federal regulators with overlapping missions and fragmented supervision oversee US markets and financial institutions. Increasingly, government officials and experts in banking law recognise that the US needs a single, strong prudential regulator to ensure the safety and soundness of our banking system, reduce the problem of "too big to fail" and provide true accountability. Both Tim Geithner, Treasury secretary, and his predecessor have proposed consolidation of bank regulation. It is time to act.

Today's financial markets are increasingly borderless and US regulators must work in harmony with their counterparts around the world. This could be accomplished by establishing a strengthened Financial Stability Board, which the Obama administration and the Group of 20 have recommended.

Third, a new system must bring complex financial instruments out of the shadows. What cannot be seen cannot be regulated properly. The solution: trade standardised deriv-atives on regulated exchanges rather than opaque over-the-counter markets, as Mr Geithner has proposed.

Lack of transparency contributed mightily to the seizure of credit markets, as investors struggled to properly price and analyse risk. Many financial institutions still do not fully understand the exact composition and value of the financial products that have wrecked their balance sheets. Regulated exchanges have a track record of transparency and reliability that served investors well through many periods of market disruption.

Fourth, a new regulatory system must stress smarter regulation, not over-regulation. Quality, not quantity, is the test. With 39,000 employees of financial regulatory agencies, the US already has more than 12 times as many regulatory personnel as the UK's 3,100, although its gross domestic product is only seven times bigger. Simply adding regulators to this existing army would not have prevented the meltdown.

Regulatory overreaction would limit access to capital markets, dampening the entrepreneurial energy that is critical to any sustained economic recovery. It would also drive companies and jobs to overseas markets. Investors, businesses small and large, and our financial markets cannot afford regulatory overkill.

The administration's enthusiasm for reform is a hopeful sign that a modernised regulatory structure is achievable, but it will take bold leadership to ensure that the principles necessary for this reform survive the coming legislative battle.