Streetwise Professor

Treasury Secretary Paulson made a big splash with his announcement of a “plan” to reform US financial markets. In fact, it is much sound and fury signifying nothing, with virtually no chance of being implemented. Moreover, it is completely non-responsive to the current travails in the credit markets.

The biggest headline was that the recommendation for the merger of the SEC and the CFTC. This puts in me in mind of two quotes. The first is by Churchill: “A fanatic is one who can’t change his mind and won’t change the subject.” Whenever anything happens in the financial markets, the cry immediately goes up to merge the SEC and the CFTC. Many people are apparently fanatical, because they never change about their minds about the desirability of the merger, and the subject always seems to return to it.

The second quote is by somebody slightly–well, a lot actually–less famous; that would be me. In a 2001 Regulation Magazine piece on the Clinton regulatory legacy, I wrote that the SEC-CFTC combination was a solution in search of a problem.

I am always somewhat mystified by the substance of the arguments for the merger. The most commonly mentioned benefit is a harmonization of margins between stocks and stock index futures. What, it’s not possible to harmonize without going merging the two bodies? Moreover, given the myriad other more important issues facing the two agencies, this seems like a very thin reed on which to rest a major reshaping of the regulatory structure.

In reality, there is very little overlap between the regulatory responsibilities of the two agencies. What’s more, there are huge swathes of the trading landscape that fall outside the jurisdiction of either agency. So merger will hardly reduce that much duplicative or contradictory regulation, and will not fill any regulatory gaps. So what’s the point?

Indeed, there are many sources of potential danger in a merger. One, very underappreciated in my view, is that it sacrifices the advantages of specialization. There are issues unique to securities markets and derivatives markets. Specialized agencies can develop the expertise needed for each market space. Of course the staff at a merged agency could specialize, but major policy, rulemaking, and interpretive decisions are made at the commissioner level. Right now SEC commissioners, for example, need to deal with arcane issues of accounting, disclosure, securities intermediation, and securities trading practices in stock, option, and fixed income markets. This is an already daunting task. Adding new areas of responsibility involving different markets and different instruments with different issues will further tax the already limited expertise of the commissioners of the merged agency.

The inevitable outcome of this dilution of expertise and specialization will be to enhance the power of staff, and degrade the quality of commission decision making. Neither outcome is desirable.

Indeed, I would argue that the SEC is already underspecialized. The agency operates subject to three statutes, the Securities Act of 1933, the Exchange Act of 1934, which focus on primary and secondary markets for securities, respectively; and the Investment Company Act of 1940, which focuses on mutual funds and the like. The agency has responsibility over the issuers of securities, and the markets and intermediaries that trade securities. There is little overlap between these areas. Issues of disclosure and accounting can be conceptually and operationally distinguished from issues of market structure and organization.

A second area of concern is that a unified agency will provide a mechanism to reduce and distort competition between different sectors of the financial markets. There are many on Wall Street that would love to throttle the futures exchanges in order to reduce competition for the securities business. (The margin issue is a perfect example of this. The securities firms would love to force an increase in margins on futures to drive some business from the futures exchanges to the stock market.) The regulatory autonomy of the CFTC has largely precluded such an outcome. The SEC has indeed tried in the past to impede the development and introduction of futures products that compete closely with securities markets but has largely failed in these endeavors because it does not have the necessary authority or jurisdiction.

Now, of course, a merger would change agency politics. Under the current framework, the SEC is largely responsive to securities firms and exchanges, and the CFTC is responsive to the futures exchanges and the FCMs. A merged entity would be responsive to the interests of all of these parties. But that is not necessarily a good thing, as one very likely outcome is that the merged entity would implement regulations that would reduce competition between the varying constituencies.

A more sensible, but still problematic, regulatory reorganization would involve (1) stripping out the primary market, accounting, and disclosure responsibilities from the SEC and putting them in a separate agency focusing on these corporate finance issues, and (2) creating a separate agency responsible for trading and market structure issues in securities and derivatives markets. This second agency, call it the “Commission for Financial Trading and Markets” (“CFTM”) would focus on issues relating to manipulation; fraud; the financial adequacy of intermediaries (securities and derivatives brokerages); and facilitating competitive market structures in financial markets. Arguably the manipulation, fraud and competition responsibilities should give the CFTM some authority in the OTC markets.

This approach would be far preferable to mashing together two disparate agencies with very different histories and cultures in the hope that something beneficial will come out of the unnatural coupling. It would permit the development of some specialization, and many issues of fraud, manipulation, and market structure are common across securities and derivatives markets, so the specialization could be applied to a variety of related markets. This alternative is still problematic, however, because the CFTM could easily become a mechanism for stifling competition between different methods of allocating risks and discovering prices.

All that said, there is little likelihood that the merger (or the creation of a CFTM) will come to pass in any event. The idea has been around for decades, and has never even come close to implementation. This is no surprise. There are powerful political forces in the way. Most notably, the futures exchanges, their members, and the FCMs have fought the SEC’s loving embrace vociferously, and found vocal support in Congress. Moreover, whereas the SEC falls under the congressional banking committees (e.g., the Senate Banking Committee and the Securities, Insurance and Investment Subcomittee), the CFTC is under the ag committees. Neither is about to readily cede jurisdiction over a large, well-heeled, and generous industry.

There is another strange aspect of the Paulson initiative. The ostensible reason for the urgency of financial reform is to address systemic risks. The most recent event stoking this urgency is the near failure of an investment bank and the resulting bailout (call it what you will, but by any other name it would still stink.) But what financial institutions are almost wholly absent from Paulson’s “blueprint”?–well, investment banks. Now, presumably, they would be subject to the Fed’s “supercop” authority if they posed a threat to financial stability, but what is striking is that the specificity of the proposals for commercial banks, insurance companies, the SEC, the CFTC, and mortgage intermediaries is not matched by specific proposals for changes in the regulation of investment banks.

Don’t get me wrong, I am not advocating expansive new regulations of IBs. I just find the contrast somewhat jarring.

I also think that the blueprint shockingly fails to mention, let alone address, a major source of the current ongoing tumult in the credit markets, and what could be the source of worse problems in the future: the lack of transparency in the valuation of many products in bank and investment bank portfolios.

One reason for Bear-Stearn’s liquidity crisis was that potential lenders and counterparties had no way of ascertaining the value of the complex products in its portfolio. Even if Bear had opened the kimono (as the phrase goes) and told everybody what was in its portfolio, nobody would have been able to put a value on it. The complexity of many of the products, and the lack of pricing data make the task of valuation impossible.

I wish I could say I had a canned answer to this last problem. I don’t. Neither does anybody else. However, Treasury and the SEC have already made tentative moves to engage the NYSE in launching a pricing service. There are some existing precedents, albeit dealing with simpler tasks–the Municipal Securities Rulemaking Board and NASD have created price reporting services for municipal and corporate bonds, respectively, for example. Getting accurate valuations of much more complex structured products will be far more daunting, but before this difficult problem can be tackled, it must be raised. Paulson did not do so.

In my view, all of the things that Paulson actually addressed are small beer compared to the thing he left out–improving price discovery, valuation accuracy, and transparency in the vast markets for structured credit and mortgage products. These products are the source of the current problems in the credit markets, and are the most likely source of future problems. The lack of good information about the valuation of these products is what makes the credit markets most vulnerable to seizing up; who will finance intermediaries when nobody knows what they are really worth?

As I said, this is a hard problem. But it is a problem of first order importance–something which cannot be said of other things in the Paulson initiative, the SEC-CFTC merger most notably. it would be far better had the Treasury secretary identified this problem as a priority, and at least outlined a proposal to tackle it.