In his speech on the future of the global financial system before the Bretton Woods Committee, Paul Volcker discussed the need to redesign the financial regulatory framework.  The case for why a redesign is necessary is simple: it failed.  As he observed,

The historically fractured regulatory framework is riddled with gaping holes and overlaps. The inconsistencies in approaches among the half-dozen or more regulatory agencies stand as an enormous obstacle to achieving consistent and effective oversight of the financial system. It was this disjointed regulatory structure, among other public and private sector failings, that lulled regulators into a false sense of security before the crisis. And it deprived them of the understanding and tools necessary to address threats to systemic stability.

 

He then went on to explain why the Financial Stability Oversight Council added under Dodd-Frank to improve inter-agency cooperation and coordination was inadequate.

But we need to recognize the FSOC is insufficient as a vehicle to overcome the serious flaws in the regulatory architecture. It cannot force competing agencies to take coordinated action. It cannot itself be the focus for cooperation with our international counterparts on systemic issues. It is simply not adequately equipped for the challenge of fairly and effectively supervising financial markets of the complexity, sophistication, and size characteristic of the 21st century.

So the question is “What should be done?”.

The starting point for answering this question is to look at how our financial system was redesigned in response to the Great Depression.  As I discussed in Transparency Games, the financial system was redesigned so it was based on the combination of transparency and caveat emptor.

As FDR said, government had two roles in the redesigned system.

First, it was the government’s responsibility to ensure all the information necessary for making a fully informed investment was disclosed (a task given to the newly created SEC).  This is the critical role in preserving financial stability and preventing financial crises.

Why?

Under the redesigned financial system, investors are held responsible for all losses on their investment exposures.  This gives investors the necessary incentive to use the disclosed information to assess the risk of an investment and use this assessment to limit their exposure to what they can afford to lose.  Financial stability and market discipline are the direct result of investors limiting their exposures.

Let me give you an example of how this works.  Banks are investors.  They have an incentive to assess the risk of an investment in another bank and to limit their exposure to what they can afford to lose if the other bank is closed.  By limiting their exposures to other banks to what they can afford to lose, banks naturally end contagion risk.  One bank can fail without bringing the other banks down.  Hence, there is financial stability.

Second, it was the government’s responsibility to never be seen as recommending an investment in a security.  If the government was seen as doing this, it created a moral obligation to bailout the investors should the investment lose money.

FDR and his administration also introduced bank deposit insurance.  The FDIC was created to protect bank depositors and it was given one special regulatory tool.  It was given the right to close any bank where there was a risk of loss to the deposit insurance fund the FDIC oversaw.  This right exerts further discipline on investors in bank stock and uninsured securities to assess the risk of the bank and limit their exposure to what they can afford to lose.

It was clearly understood the government was recommending “investment” in bank deposits covered by insurance.  To satisfy the moral obligation this entails, the FDIC can borrow money from the Treasury to cover any needs for repaying depositors.

So why did this redesigned financial system fail after over 70 years beginning on August 9, 2007?

The SEC wasn’t up to the task of ensuring disclosure of all the information needed to make a fully informed investment decision.  The opaque, too big to fail banks were the result of the Federal Reserve engaging in a regulatory turf war.  The opaque, toxic subprime mortgage-backed securities were the result of Wall Street’s capturing the process by which the SEC sets disclosure requirements.  When doubts about the value of securities and banks began to be raised, the absence of disclosure meant there was no logical stopping point in valuing the securities or banks other than zero.  As the value of the securities and banks plunged, the markets for these securities and bank related securities froze and the financial crisis began.

The Transparency Label Initiative was created to fill the void left by the SEC’s failure to ensure disclosure.  Call this the buy-side’s contribution to financial stability.

As for redesigning the alphabet soup of financial regulators and eliminating the worthless financial regulations, they need to be looked at for compliance with the roles spelled out by FDR for the government’s involvement in the financial system.

If it doesn’t comply it should be eliminated.  For example, public announcement of the results of the bank stress tests should be eliminated.  It is nothing more than the government recommending an investment and create a massive ongoing obligation to bailout the banks.