Soap Opera of Financial Regulatory Reform–Pyrotechnics or Performance

The suspense is killing me, and right now we've got both pyrotechnics and performance.  Financial regulatory reform is like a soap opera.  It pauses at what seems to be a near climax, inviting the viewer to tune in tomorrow.  When the viewer returns, the show unveils an array of new plot twists instead of an ending.

So far Republican foot dragging has been parried, methinks, with a strong Democratic message that saying x while doing negative x won't cut it when populist anti-Wall Street fervor is at fever pitch.  That probably means something will pass both houses, but what?

Banks are fighting to the death over the right to trade derivatives.  While the banks could survive  an  "exchange traded only" approach, a more complex compromise might work even better for the banks and the performance of the  economy.  Give a regulator (probably CFTC) authority to assign derivatives contracts to one of three categories, based on analysis of the risks posed by the contract to the financial system: 1) exchange only with clearing, daily margin, etc. 2) off-exchange trading permitted, but only with position disclosure (this would require some greater standardization and a prior approval process compared with current practice, but for the banks it's better than losing the business); 3) no special limitation on trading, provided both parties to the contract are big boys – essentially the current regime under Part 35 of CFTC Rules.  Part of the problem in dealing with AIG, Lehman, etc.  was that trading counterparts did not assess their creditworthiness accurately because they didn't have enough information on one-sided trading positions.  Pushing derivatives onto an exchange solves this, but so does position disclosure as long as its complete and reasonably prompt.  If the CFTC can do this job properly, regulatory limits on derivative trading (there are “good” derivatives with real benefits to the economy) can be crafted to match the least intrusive regime while still changing the regulatory role to include systemic preservation and performance, not just the protection of the individual parties.  If the Banks are limited to categories 1 and 2, possibly with some provision for very limited activity in category 3, then the market's credit discipline and the Comptroller of the Currency would be in a position to keep risk, systemic or bank specific, from getting out of hand.

Thursday's mysterious flash crash, likely caused by an NYSE shift to slow trading on selected stocks, the routing of sell orders to other exchanges and the shut down of some computerized trading programs, might throw a monkey wrench into the works.  Should Congress include a quick fix on this in the current financial reform bill before diagnosis is complete, slow everything down, or ignore it and  move forward anyway, leaving the glitch for regulators, or, if needed, different legislation next year.  House Committee holds hearing on this today.  It is an urgent issue, preventive performance of regulator's was underwhelming, but with a disaster to focus them, this one might be fixed without legislation.

Thanks, in part, to the Financial Times Alphaville blog, the world is getting a better understanding of what went astray inside Moody's.  The SEC is seriously considering action against Moody's, but what about the reform bill?  Anyone want to go for a non-contingent, no opinion shopping approach to fees for the rating's agencies now that we know more?

Then we have Fannie Mae and Freddie Mac – If AIG was the Exxon Valdez then these twins are the slow oil leak in Brooklyn that produced a total spill dwarfing the Alaskan disaster.  Are we really stuck with a never ending bailout?  Can we at least figure out some way to pull the plug incrementally on these atrocities without tanking the housing market?

Tune in tomorrow, for another exciting performance of “As Congress Turns”.

Photo Credit: Mike Licht,