Personal Finance Advice

Earlier today, Treasury Secretary Henry Paulson released his Blueprint for a Modernized Financial Regulatory Structure, a study that was commissioned back in March of 2007.  The 212 page proposal would overhaul the nation’s banking system and give the Federal Reserve broader regulatory powers.

The report acknowledges the diminished role of the Fed’s discount window lending as a “market stability” tool.  The Fed’s normal purview are commercial banks but in today’s financial markets, regular banks have a much smaller role as credit intermediaries than they used to.

In the current financial crisis, the Fed has had to step in to lend credit to financial institutions that are normally under the regulatory control of the Securities and Exchange Commission.  The proposal would legitimize the actions that the Fed has already taken and broaden it’s lending powers to non Federally Insured Depository Institutions.

The proposal also calls for a modern streamlining of regulatory powers that would eliminate the inefficient overlapping of regulatory control that we currently have.

“Due to it’s sheer dominance in the global capital markets, the U.S. financial services industry for decades has been able to manage the inefficiencies in it’s regulatory structure and still maintain it’s leadership position.”

“The United States can no longer rely on the strength of it’s historical position to retain it’s preeminence in the global markets.”

The Fed would basically become the head of this new regulatory structure and would broaden it’s market stability function in order to better cope with systemic risk.

Many of these regulatory changes will require legislative approval and because this is an election year it is unlikely that any these changes will take place under the current administration.

The Fed looks like it’s willing to pull out all the stops during the current financial crisis but despite all that, a tight credit market will continue for some time.  Financial institutions will remain cautious with their capital until the final costs of the sub prime mortgage collapse is fully realized.

The lesson of Bear Stern’s near collapse fresh in their minds, financial institutions are hoarding their cash waiting for the next round of write downs.  Banks are reluctant to enter into long term loans when they might need those funds in the near future to meet margin calls or otherwise suffer Bear’s fate. 

Securitization allowed banks to transform a bundle of illiquid loans into a series of liquid securities tradable on secondary markets.  Demand for any sort of collaterized debt has pretty much dried up, making it difficult for banks to roll over their loans.

Credit can be quite difficult to obtain these days for both individuals and corporations.  Mergers and acquisitions have slowed to a crawl due to lack of financing.  This also has an effect on business spending as many companies are having to delay work on capital projects.

The Fed may have slashed interest rates but mortgage rates still remain relatively high.  Even those with good credit ratings are finding it tough right now.  It’s hurting demand in an already weak housing market and will delay any sort of recovery.

Many analysts are predicting that the tight credit market will most likely continue past the end of this year and into the next.  Even if the economy doesn’t go into a recession, it will slow to a crawl for some time.

Starting in the 1970’s, the banking system has undergone a long cycle of deregulation.  The culmination of all this was the repeal of the Glass-Steagall Act in 1999 which has since muddied the distinctions between banks, securities firms and the insurance industry when they began a period of consolidation.

The arguments for deregulation was to foster a climate of competition, innovation and lower prices by lessening government oversight and allowing  market forces to dictate the flow of credit.  Since then financial sector has experienced a rapid expansion by offering many new products and services.

After this current financial crisis is over, I think we can expect things turn back the other way.  While the collapse of the housing bubble was the main cause of our current economic troubles, no one can deny that the financial sector has it’s fair share of the blame for all this.  Lax lending standards and excessive risk taking through the explosive growth of securitization and derivatives has created a highly leveraged financial machine that is at it’s breaking point.

Unfortunately because the financial system is so intertwined now, market forces can’t be allowed to reach their ultimate conclusion, the collapse of a large number of financial institutions, no matter how much they deserve to go out of business.  The Federal Reserve has had to step in and use powers it hasn’t needed since the Great Depression in order to keep the banking system from collapsing.

One thing is for certain though, the larger the final cost to taxpayers, the more lawmakers will call for an increase of regulatory oversight of the financial services industry and that might not necessarily be a bad thing.