Corporate Governance

Henry Paulson and Fed Regulation of Investment Banks

By J. Robert Brown

The regualtory structure for investment banks has been back in the news, with allegations in the WSJ that the SEC is asleep at the switch and Henry Paulson, a lame duck secretary of the treasury, giving a speech calling again for an overhaul of the regulatory system for financial institutions, including investment banks.  He specifically called for increased authority for the Federal Reserve Board.  As he noted:

• Much of the Fed's current authority as lender of last resort was granted during the Great Depression. In light of the changes and developments in today's financial markets, we should take a hard look at whether the Congress has given the Fed the appropriate authority and direction to execute this lender of last resort responsibility when the system is threatened.
• We have now learned that a wider range of institutions can potentially threaten the stability of the financial system. It seems clear that in the future the central bank might need to make liquidity available to a broader range of financial institutions under certain extraordinary circumstances. However, at the same time, the circumstances under which that liquidity is provided must be limited and focused on systemic risk that can impact the overall economy. We must examine this authority and the processes and procedures to implement it and calibrate them appropriately. It is imperative that market participants not have the expectations that lending from the Fed is readily available.

In taking these positions, Paulson, someone who cut his regulatory eye teeth on criticizing regulation (also recall that it was Treasury that favored the government's position in Stoneridge cutting back the scope of Rule 10b-5) now finds himself calling for more.  He also ignores the fact that the very problem confronted by the Fed arises out of misguided deregulation. 

It was in the 1990s that Congress pulled down the barriers separating investment and commercial banking.  As I noted then in my piece, The Great Fall:  The Consequences of Repealing the Glass Steagall-Act, the removal of the barriers would result in the large commercial banks muscling into the investment banking area and gradually eliminating the independent investment banks.  This was a process well underway in the US capital markets in the 1930s before Glass Steagall put a stop to it.

While Paulson can call for additional Fed regulation, extending the central bank's authority to investment banks, he need not obtain any legislative changes to achieve the result.  It will happen through market forces.  With only a small handful of investment banking firms left, it is only a matter of time before they collapse or are purchased by commercial banks (or both).  In other words, sooner or later the Fed will have oversight of all investment banking functions because all of those functions will be executed by commercial banks.

Full post as published by The Race to the Bottom on June 25, 2008 (boomark / email).