Last week we derided David Corn's argument that deregulation of derivatives championed by McCain adviser Phil Gramm had led to all the problems of the current financial system. One of the many problematic passages was this:
But the Enron loophole was small potatoes compared to the devastation that unregulated swaps would unleash. Credit default swaps are essentially insurance policies covering the losses on securities in the event of a default. Financial institutions buy them to protect themselves if an investment they hold goes south. It's like bookies trading bets, with banks and hedge funds gambling on whether an investment (say, a pile of subprime mortgages bundled into a security) will succeed or fail. Because of the swap-related provisions of Gramm's bill—which were supported by Fed chairman Alan Greenspan and Treasury secretary Larry Summers—a $62 trillion market (nearly four times the size of the entire US stock market) remained utterly unregulated, meaning no one made sure the banks and hedge funds had the assets to cover the losses they guaranteed.
No. The Federal Reserve regulates the money-center banks; if those banks are entering into credit derivative swaps, then the Fed will oversee their activities in that area. However, it is fair to say that no one was empowered to watch hedge funds, and it was the SEC that regulated investment banks.
Geithner, echoing an elaborate proposal by Treasury Secretary Henry M. Paulson Jr., said the nation's fragmented system for regulating banks and other financial institutions needs to be consolidated -- and in Geithner's vision, the Fed would take on new power. Currently the Fed can order commercial banks to adjust their exposures to a given type of asset or to improve their systems for measuring risk -- but has no such formal power for investment banks and a range of other financial institutions.
"At present the Federal Reserve has broad responsibility for financial stability not matched by direct authority," Geithner said, "and the consequences of the actions we have taken in this crisis make it more important that we close that gap."
He stopped short of proposing new regulation of hedge funds or private-equity firms.
The WSJ has more and better coverage:
"The conventional risk-management framework today focuses too much on the threat to a firm from its own mistakes and too little on the potential for mistakes to be correlated across firms," Mr. Geithner said in prepared remarks to the Economic Club of New York.
Mr. Geithner called the existing regulatory structure "an enormously complex web of rules that create perverse incentives and leave huge opportunities for arbitrage and evasion, and creates the risk of large gaps in our knowledge and authority."
A recent Treasury Department blueprint for regulatory overhaul, designed to address those problems, shifts some of the Fed's power to other agencies while giving the central bank overall responsibility for the financial system. Mr. Geithner appeared to take issues with that design, saying that major "globally active" banks and investment banks need to operate under a single framework with stronger consolidated supervision.
Geithner spoke about hedge funds and derivatives two years ago.
MORE: Megan McArdle notes the absence of omniscient, prescient regulators and wonders what Barack has in mind on the regulatory front.