Take Time to Get It Right: Shape Financial System Rules for the Long Haul

Jason Furman
Jason Furman Aetna Professor of the Practice of Economic Policy - Harvard University, Nonresident Senior Fellow - Peterson Institute for International Economics, Former Brookings Expert

April 6, 2008

In the midst of the Civil War, Abraham Lincoln worked with Congress to establish the first regulatory structure for banks: the Office of the Comptroller of the Currency. Since then, an alphabet soup of federal and state agencies have joined that office to take responsibility for regulating aspects of banks and financial markets.

The recent financial turmoil has painfully revealed the limits of this system, which suffers from duplication in some areas and gaps in many others.

In the short term, the Federal Reserve has cut interest rates and taken extraordinary steps to supply liquidity, while Congress has enacted fiscal stimulus and is working on housing legislation. Further steps are needed to alleviate the credit crunch, ensuring that businesses have access to the funds they need to fuel continued growth.

As we fight the immediate battles, it is important for policymakers to focus on how to build a more stable and effective financial system. In recent weeks, House Financial Services Committee Chairman Barney Frank and Treasury Secretary Henry Paulson have started this conversation.

Senate Finance Chairman Max Baucus of Montana and Iowa Sen. Charles Grassley, the ranking member, have also made important contributions with their vigorous oversight of the federal government’s role in the Bear Stearns-JPMorgan Chase deal.

One priority is to empower a single entity, either the Federal Reserve or a new super-regulator, to monitor systemic risk throughout the financial system. This regulator should have access to information from a wide range of institutions and take needed steps, from disclosure to more vigorous measures, to prevent major risks to the entire financial system.

A second priority is to better protect consumers. The Federal Reserve and other regulators had the tools to prevent some of the most abusive subprime lending. However, despite urging by people such as the late Ned Gramlich, then a Fed governor, and Iowa’s own Attorney General Tom Miller, these regulators chose not to use their full arsenal in the fight against predatory lending. Now we understand that the consequences of the failure of consumer protection have ramifications for the entire financial system and economy.

A third priority is to regulate financial institutions based on their function, not their form. More institutions are acting like traditional banks and getting such taxpayer-financed privileges as access to loans at the discount window. These institutions should be regulated more like banks, with greater transparency and the consideration of whether it is possible to develop capital or liquidity requirements to prevent them from taking bets that could ultimately jeopardize the taxpayer.

Although the financial turmoil we face today is not comparable to the Civil War, the task of developing a new regulatory structure for our complex financial system is considerably more difficult than it was in the early 1860s. Policymakers should take their time to study their options and get it right. The system they build will likely be with us for decades to come.