Corporate Governance

Henry Paulson and the Shift in Attitude about Regulation

By J. Robert Brown

It was almost exactly a year ago that Treasury Secretary Paulson questioned whether regulators had “struck the right balance between investor protection and market competitiveness.”  What did he mean?  Too many lawsuits, too many rules (not enough principles). 

Even before the bailout of Bear Stearns, he was already forced into a different position.  With the subprime crisis sweeping through the financial markets and the economy motoring towards a recession, principles based regulation and the power of the market wasn't working.  Certainly the approach didn't prevent the weakening of underwriting standards that provided much of the impetus for the current waive of problems.    

As a result, he is searching for a regulatory solution.  His latest committee, the President's Working Group on Financial Markets recently issued aPolicy Statement and it demonstrated the about face.  On the other hand, it contained a tepid set of recommendations that largely require state and federal coordination and encouragement of better practices.

What did the Committee recommend?  The Committee "believes that implementation of its comprehensive and complementary set of recommendations would constitute an effective response".  Reference to comprehensive reform almost make Secretary Paulson sound like Senator Sarbanes.  The actual recommendations?  A mix of federal and state regulation, the proposals tepid and often seem to place the blame on investors. 

Apparently unconcerned about the plethora of regulators, the proposal among other things called on states to "implement strong nationwide licensing standards for mortgage brokers."  In other words, a recommendation that reconfirms the role of 50 states in the regulatory process.. Substantial doubt has to exist over theeffectiveness of a state solution.  In addition to the difficulty in obtaining uniformity and rigor from 50 states, there is the problem of uneven enforcement, something impossible to avoid.  To the extent states are left with the task of regulating mortgage brokers on a "nationwide" basis, nationwide brokers will be able to cherry pick their jurisdiction.  Said another way, it will be another race to the bottom. 

In addition, the recommendations contained a mishmash of regulations from disparate regulators, ranging from stronger consumer protections rules from the Fed and increased disclosure by credit rating agencies.  The SEC and Banking regulators should "assess current guidance" on risk management weaknesses, take measures to promote better "capital cushions" and "provide strong incentives for effective risk management practices."

The vague proposals, therefore, mostly call for jaw boning, encouragement and increased state regulation, approaches almost destined to be unsuccessful.  Secretary Paulson has come late to the understanding that sometimes additional regulation is better, particularly when necessary for the integrity of the market, something those opposing SOX often ignored.  But he is only part of the way there.  As this proposal shows, he remains unwilling to recommend effective measures.  It will apparently take a worsening situation and perhaps more failures like Bear Stearns (other investment banking firms are on the watch list) for Secretary Paulson to make it the rest of the way there. 

Full post as published by The Race to the Bottom on March 27, 2008 (boomark / email).