New cats for Wall Street's mice

Like generals, financial regulators tend to fight the previous war. They write rules to foil old misconduct. But Wall Street innovation has become, well, too innovative to only look back. Now a Treasury plan aims to create nimble watchdogs to head off the next novel trigger of a financial crisis.

The plan, unveiled this week by Treasury Secretary Henry Paulson, doesn't really address the current crisis created by naive risk-takers in the mortgage business, whether they're home buyers or global banks. Its vision is broader, forward looking, and based on a year's work. The only direct reform of that industry would be in federal oversight of how states regulate mortgage lenders.

This blueprint assumes that a fast-changing financial system needs a very simple regulatory structure with broad powers to nose into new financial products and institutions – many of which are designed like a genetically modified mouse to avoid cats stuck with old ideas about mice.

One such new mouse (caught only after gnawing down the housing market): Shaky subprime mortgages sold by nonbank brokers and then resold with noninspection by nonregulated banks like Bear Stearns carrying far too much noncapitalized debt.

Under the plan, the current patchwork of more than half-a-dozen separate federal regulators – set up to deal with problems from decades ago and focused mainly on banks – would be revamped under three superagencies to deal with only broad areas:

• Overall market stability.

• Regulation of banks, thrifts, credit unions.

• Business conduct that affects investors and consumers.

And to deal with unanticipated changes in the financial industry, much of this government oversight would operate by a set of principles or guides rather than hard rules, as British regulators do.

In fact, another reason for this Treasury plan is to prevent London from overtaking New York City as the world's biggest capital market, which may explain the warm reception of the plan by a key New York Democrat, Sen. Charles Schumer. The American financial industry stands to lose its global competitiveness because new businesses are drawn to places that better guard risks and mistakes. Britain's Financial Services Authority, as a single regulator, has nurtured London's financial industry into a threat to Wall Street's preeminence.

Even with an initial welcome for the plan on Capitol Hill, it stands little chance of passage this year or even being implemented in coming years. Too many industries with a stake in the present system and too many regulators who might lose their jobs oppose it. Campaign donations to both Democrats and Republicans from the financial industry will be more than $100 million this election year. And besides, Congress would rather deal with the immediate mortgage crisis.

But wholesale reforms, rather than piecemeal steps such as the 2002 post-Enron law known as Sarbanes-Oxley, are needed for an outmoded system that plays catch-up more than gotcha. Too many institutions, such as hedge funds and private equity groups, are outside the regulatory tent but could be nurtured to grow with financial integrity under a streamlined regulatory structure. •