Paulson Plan Endorses Fed's Enhanced Market Authority (Update1)

By Jesse Westbrook and Alison Vekshin

March 31 (Bloomberg) -- Treasury Secretary Henry Paulson's plan to overhaul U.S. market regulation would officially endow the Federal Reserve with the broader authority that it has already accrued in the past two weeks.

The Fed, which engineered JPMorgan Chase & Co.'s purchase of Bear Stearns Cos. and became lender of last resort to the biggest bond dealers, will oversee ``market stability,'' under proposals that Paulson will unveil today. The Securities and Exchange Commission, traditionally the main regulator of Wall Street firms, will be merged with the Commodity Futures Trading Commission, according to a draft of the report.

``It would be Congress and the president essentially giving a blank check to a regulator over which they have very little power,'' said Michael Greenberger, a professor at the University of Maryland in Baltimore and a former CFTC official. Paulson's proposal will ``allow Wall Street to do whatever they want until a crisis occurs, at which point the Fed would intervene.''

The central bank's response to the credit freeze and the near bankruptcy of Bear Stearns shows how the role of regulators is being redefined by events, regardless of Paulson's review, which began nine months ago. SEC Chairman Christopher Cox isn't protesting the proposed merger of his agency -- formed during the Great Depression -- with the CFTC, saying that regulation would be better served by fewer organizations.

`Regulatory Divides'

``Just as systemic risk cannot be neatly parceled along outdated regulatory lines, the overarching objective of investor protection can't be fully achieved if it fails to encompass derivatives, insurance, and new instruments that straddle today's regulatory divides,'' Cox said in a statement on March 29.

Paulson, 62, is scheduled to speak at 10 a.m. at the Treasury Department in Washington. Fed Chairman Ben S. Bernanke testifies to Congress two days later.

The Treasury will recommend that the Fed share authority over banks, securities firms and insurers in monitoring corporate disclosures, writing rules and stepping in to prevent economic crisis, according to the draft, which was distributed to officials last week and obtained by Bloomberg News.

The plan also suggests a distinction be made between the Fed's ``normal'' lender-of-last resort discount window to help banks meet short-term funding needs and ``market stability'' lending to help stave off funding shortages and panics. In that function, loans could be extended to federally chartered insurers and financial institutions.

Historical Precedent

President George W. Bush and U.K. Prime Minister Gordon Brown have also agreed to establish a joint body to develop plans to regulate the international banking system, the Financial Times reported today. The working group will examine issues such as the role of credit-rating companies and ways of increasing cooperation between financial regulators in both countries, the paper said.

Changes to the U.S. regulatory system, parts of which date back to the Civil War, have been proposed in the past, only to be thwarted in Congress and frustrated by industry opposition. The Presidential election also makes it hard for the Bush administration to push through changes in its final year, said Bill Isaac, who was chairman of the Federal Deposit Insurance Corp. between 1981 and 1985.

``It's a lame duck administration, so it automatically means they have less credibility than they would have if they were in their first year,'' said Isaac, who now heads The Secura Group, a financial consulting firm in Vienna, Virginia. ``And the known devil is better than the unknown devil in the minds of those who are regulated.''

Reich Bets on Survival

John Reich, director of the Office of Thrift Supervision, said he's skeptical that the combination of his agency with the Office of Comptroller of the Currency, as proposed by Paulson, will be easily achieved.

``Expect to see news stories and renewed questions about what the future will hold,'' Reich wrote in letter to employees on March 28. ``The 20th anniversary of the OTS is next year. We can all expect -- despite predictions over the years to the contrary - - to be celebrating it.''

The OTS, a Treasury division created in 1989 after the savings-and-loan crisis, oversees lenders including Calabasas, California-based Countrywide Financial Corp., the biggest U.S. mortgage lender, and Seattle-based Washington Mutual Inc., the largest U.S. savings and loan.

In his letter, Reich outlined obstacles to Paulson's plan, saying congressional debate and hearings could stretch into next year, when a new Congress and a new president ``may well have their own priorities and agendas.''

Lack of Support

A dozen similar efforts by presidents, legislators and others over the last 60 years never ``became reality,'' Reich wrote. His office distributed the letter to reporters on the weekend.

He also said there was a lack of industry support for restructuring the regulatory system, including opposition from the American Bankers Association to merging the OTS with another agency.

Treasury's proposal would ``create a more coherent supervisory scheme'' by ending ``some of the inconsistencies arising from today's patchwork system,'' Lou Crandall, chief economist at Wrightson ICAP LLC, a Jersey City, New Jersey-based research firm, said in a report.

Still, expanding the Fed's role to stabilize markets would exacerbate the ``moral hazard problems'' stemming from the central bank's decision to lend money to investment banks after the near collapse of Bear Stearns, said Crandall, who used to work at the New York Fed.

So-called moral hazard is the notion that bailouts encourage financial companies to take risk because they assume the government will always come to the rescue.

To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net .

Last Updated: March 31, 2008 03:09 EDT

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