Dodd’s Single Banking Regulator Proposal Promising

Senator Chris Dodd (D-Conn.), chairman of the Senate Banking committee, is introducing a bill today with his vision for reform of financial services regulation. The bill is over 1,000 pages long and contains proposed reforms of many important aspects of the financial system. However, one area likely to generate the most comment—because it differs markedly from the Obama administration’s original proposals and from the House’s version of reform—is Dodd’s proposal to dramatically consolidate the federal bank regulatory agencies into a single new agency.

This is a big deal, even if it may seem arcane. Right now there are four federal agencies involved, including such powerful bodies as the Federal Reserve. This kind of consolidation is a very difficult thing to achieve in Washington, because it shifts power and jobs away from existing people and the interests with which they are allied. Financial regulation has a huge effect on the operations and profitability of banks and their competitors, and the banks are consequently not keen to see a shift in who regulates them. They do not always agree with their regulators, but they know how the existing ones think and operate and have found ways to work within those constraints. Some observers would go further and suggest at least an element of “regulatory capture” where existing agencies try too hard to please those they regulate.

In general, I strongly favor much more consolidation of financial regulation than the modest steps proposed by the administration and the House. Ideally there would be one regulator for “safety and soundness” and one for consumer protection, which is essentially Dodd’s proposal. I have not had the opportunity to read the full bill, so there may be devils in those details that would change my view, but the Dodd proposal appears very promising. My big fear is that if we don’t consolidate regulators, we will find that over the next decade financial business moves to institutions that are regulated by the laxest of the regulatory bodies. This so-called “regulatory arbitrage” has the potential to encourage the kind of lax risk management that was a major cause of the financial crisis that we are slowly emerging from now. The problems won’t appear all at once, but could build up over the years into something very threatening.