Washington Revisits Big-Bank Regulation

Treasury Secretary Henry M. Paulson Jr. and Rep. Barney Frank (D-Mass.) (WDCpix)

Last week, as Wall Street was flailing over the collapse of one of its largest investment banks, Rep. Barney Frank (D-Mass.) took a podium and told members of Boston’s U.S. Chamber of Commerce precisely what they didn’t want to hear. Congress, Frank suggested, should move to subject investment firms and hedge funds to the same regulations and oversights that currently target commercial banks.

A year ago, the prospect of empowering a federal super-regulator to intervene across financial markets — regardless of the corporate model — might have been unthinkable. After all, the freedom of investment companies, hedge funds and other non-bank institutions to dabble in highly unregulated speculative transactions has generated enormous profits for Wall Street firms and shareholders alike.

Illustration by: Matt Mahurin

But with the economy teetering somewhere near the edge of recession — and with some of those same Wall Street deals propelling the decline — Washington’s policy-makers have begun a panicked reexamination of the nation’s banking laws not seen in decades. What began with the sub-prime mortgage crisis has swept across the tangled web that constitutes America’s financial system, threatening thousands of foreclosures and pushing the country’s central bank to its first bailout of a non-depository lender since the 1930s. The quick succession of events has forced the White House to reassess its faith in a self-regulating market; it has sent congressional leaders scrambling for solutions in a high-stakes election year; and it has shaken the memories of historians old enough to recall the similarity of events leading to the Great Depression.

“When speculation gets out of hand, it becomes a force all its own,” said John Morton Blum, history professor emeritus at Yale University, a Roosevelt scholar who is the author of “V Was for Victory: Politics and American Culture During World War II.” “It’s extraordinary that we’re seeing this happening all over again.”

In the eight decades since that nation-changing crash, most of the banking laws created to prevent its recurrence have been repealed, ignored or made irrelevant by the imagination of an ever-hungry financial sector. Frank’s proposal, some historians observe, would simply return some of the oversight mechanisms that have been lost to time.

“What Barney Frank is trying to do is reinvent the wheel,” said Nelson Lichtenstein, a history professor at the University of California, Santa Barbara, and the author of “American Capitalism.”

Under Frank’s proposal — which he floated conceptually, without details — Congress would either create a new federal entity or empower the Federal Reserve to assess the risk of deals being cut by the nation’s big investment banks. In return, those banks would gain access to the Fed’s “discount window,” a bailout mechanism historically reserved for commercial banks. Frank, who heads the House Financial Services Committee, has found some unlikely allies in his push.

Thomas A. Firey, policy analyst at the Cato Institute, a Libertarian think-tank, is one such unexpected Frank supporter. “If we’re going to let these investment banks access Fed money,” Firey said, “I can appreciate the argument that they should also be subject to the regulations.”

“Frank really has a very good point,” said Robert E. Rubin, former Treasury secretary and now director of Citigroup Inc. If the federal government will be called in to bail out the big financial institutions, he said, “[then] whatever regulatory structure exists for the banks, probably should exist for the others.”

Proposals to install new banking restrictions have been anathema to Wall Street and the Bush administration. Both are wary that the changes will discourage market innovations and investment activity.

Proposals to install new banking restrictions have been anathema to Wall Street and the Bush administration. Both are wary that the changes will discourage market innovations and investment activity.

But on Wednesday, Treasury Secretary Henry M. Paulson Jr. also threw his weight behind the push for more big-bank oversight — with two key asterisks. First, he said, the Fed’s expanded regulatory role should be done without congressional intervention. (Most congressional proposals floated thus far, he said, “would cause more harm than good.”) And second, he ventured, it’s too early to know if the big banks will require anything but short-term access to the Fed’s emergency reserves — and therefore short-term oversight.

“Certainly, any regular access to the discount window should involve the same type of regulation and supervision [as that applied to commercial banks],” the former Goldman Sachs CEO told members of the U.S. Chamber of Commerce in Washington. “[But] it would be premature to jump to the conclusion that all broker-dealers or other potentially important financial firms in our system today should have permanent access to the Fed’s liquidity facility.”

Paulson said the White House will unveil its own banking reform blueprint “sometime soon.”

The comments arrive during a volatile time on Wall Street. Earlier in the month, the Fed intervened to prevent the near collapse of Bear Stearns, supplying JPMorgan Chase with $30 billion in taxpayer funds to help finance the takeover of the floundering investment bank. The Fed also opened the discount window to other big investment institutions facing liquidity troubles. That move has raised the eyebrows of consumer groups and academics, who wonder what the banks will offer in return.

“Something important like mortgages almost has to be supported by the government,” said Lichtenstein of UCSB. “The question is: What’s the give-back?”

Some scrutiny has come from Capitol Hill as well. On Wednesday, Sens. Max Baucus (D-Mont.) and Charles Grassley (R-Iowa), leaders of the powerful Finance Committee, announced plans to review the terms of the bail-out for evidence of its public benefit. “Separate from the question of what was needed, or not, to avoid a market panic in the Bear Stearns case are the implications of the deal for the taxpayers,” Grassley said in a statement.

The bail-out marks a sea change in the way Washington has approached banking regulations in recent decades. Stretching back to the 1970s, Democratic and Republican administrations alike were perfectly willing to scale back big-bank restrictions — many dating back to the New Deal — under the optimistic theory that market discipline alone would prevent lenders from taking on unreasonable debt. Instead, the market’s freedom led to reckless lending.

“The assumption was that lenders — out of self preservation — would do more vigorous underwriting,” said Josh Nassar, vice president of federal affairs at the Center for Responsible Lending. “That turned out to be completely false.”

All sides agree that Wall Street’s imagination has evolved far more quickly than the consumer protection regulations targeting the industry. What is left to decide is what mold the reforms will take. “What’s happened is the definition of ‘bank’ has gotten away from us,” Lichtenstein said.

Meanwhile, Frank is finalizing legislation to refinance mortgages for at-risk borrowers through the Federal Housing Administration. The plan would create a system under which lenders could volunteer to refinance troubled mortgages at a reduced interest rate in return for a cash fee. Sen. Christopher J. Dodd (D-Conn.), chairman of the Banking Committee, is drafting similar legislation in the upper chamber.

White House opposition, combined with the financial clout of Wall Street, could mean these proposals have little chance of moving this year. At least one historian suggested that such major reforms might prove unlikely under the current administration, regardless what happens in Congress.

“The people the Bush administration has put in the regulatory positions are wolves guarding the hens,” said Yale’s Blum. “So you’ve had a personnel problem as much as a legislative one.”