TOPICS > Economy

Calls Intensify for Expanded Financial Regulation

March 24, 2009 at 6:10 PM EDT
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Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke testified before Congress Tuesday on the flap over AIG bonuses and called for increased regulatory powers. Analysts assess the real-world impacts of strengthening financial regulation.
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JUDY WOODRUFF: In their session before Congress, Secretary Geithner and Fed Chairman Bernanke put the issue of government regulation front and center once again.

We check in now with two people who have followed this closely. Lynn Stout is a professor of corporate and securities law at the University of California at Los Angeles. She specializes in corporate governance and regulation.

And Dino Kos is the managing director of the New York firm Portales Partners, which provides research to institutional investors. He’s also the former executive vice president at the New York Federal Reserve.

Thank you both for being with us.

And, Dino Kos, I’m going to turn to you first. We just heard one member of that House committee say to Chairman Bernanke and Secretary Geithner that there are many more AIGs out there. Do you think he’s right about that?

DINO KOS, Former Vice President, Federal Reserve Bank of New York: Well, I don’t know that there’s a lot of them out there. I think the point is that there are non-bank financial institutions that are important to the economy, that are important to the financial system, and the government doesn’t really have an effective mechanism, the capacity to wind down and put those kinds of firms into conservatorship if they run into trouble.

And that’s the authority that they’re trying to get, but I wouldn’t jump to the conclusion that there are many more out there that are in the same position as AIG is.

JUDY WOODRUFF: Well, Lynn Stout, what about this power that Secretary Geithner and Chairman Bernanke are asking for? We don’t know a lot of detail yet, but essentially they’re saying the government needs the power to oversee, to regulate these non-bank financial institutions. Do you think they should have that power?

LYNN STOUT, UCLA Law School: Well, at the moment, what they seem to be discussing is what they would need to do to step in and clean up the mess when you get a disaster of the AIG sort.

It’s interesting. I would prefer to see a little bit more discussion about how you can prevent these disasters from occurring in the first place. It would be much better if, instead of focusing our attention on how to take over a failed financial institution, we maybe put a little more time into thinking about how to keep them from getting in positions where they’re failing.

A centralized federal regulator

Dino Kos
Portales Partners
We never really had an effective, consolidated regulator for the insurance business, and that's something that needs to be fixed.

JUDY WOODRUFF: Well, what do you think should have been done? There's been a lot of discussion about what went wrong, who should have done what. What do you see as the principal reasons AIG was allowed to happen?

LYNN STOUT: Well, the short answer is deregulation. Congress in 1999 and 2000 passed a couple of statutes that seriously deregulated the derivatives markets, and that includes those credit default swaps that got AIG in so much trouble, and also made it possible for old-fashioned stodgy banks and insurance companies to add trading divisions with folks who would go off and speculate in derivatives.

And so what we did was we combined some businesses, the stodgy banking and insurance companies, with these very speculative casino-like divisions. Now the casino divisions are in trouble and they're dragging down the insurance and the banking industries.

JUDY WOODRUFF: And staying with you, why wasn't there already in place a federal power, federal body to oversee that, to regulate it?

LYNN STOUT: Well, in a sense, there was. There was a big debate over whether or not derivatives trading should be regulated by the Commodity Futures Trading Commission. And one of the people who supported that was Brooksley Borne, then the chair of the CFTC, but Congress said no. And in 2000, they basically deregulated the derivatives market and said, "Anything goes."

JUDY WOODRUFF: Now, let me turn to you, Dino Kos. Do you essentially agree with that narrative, that that's what went wrong?

DINO KOS: Well, that's certainly a big part of it. I think we need to look at some other pieces.

You know, AIG is primarily an insurance company. Insurance in this country is regulated by 50 state regulators, and each one regulates the business that's in their state, but none of them really can see the totality of the institution and understand the totality of the risks.

So you had AIG with 50 state regulators, and then it had this other division that was doing credit default swaps and other businesses, mostly in London, that really was not overseen by anybody.

And so part of this is that we never really had an effective, consolidated regulator for the insurance business, and that's something that needs to be fixed.

JUDY WOODRUFF: And so, if it is fixed, how do you see it working? I mean, are we talking about one big entity that oversees all of these non-bank financial institutions?

DINO KOS: Well, this could go in one of two ways. You could first try to deal with the insurance problem by itself.

So, in banking, for example, a bank can have a federal charter or a state charter. So you might go down that direction for insurance. And that might mean that you have a federal regulator for insurance. That might be one way of dealing with the insurance part.

The other aspect of this debate is that there's a lot of debate in Washington about a so-called systemic regulator, that is, a regulator that could go to any part of the financial system where risks are building up, be that insurance, be that hedge funds, be that private equity or other types.

That needs to be fleshed out in much more detail. We only have some principles that are on the table. And that's something that needs a lot of very careful debate. There's a lot of implications. And we need to flesh that out much more than has been done to date.

Several possible solutions

Lynn Stout
University of California, Los Angeles
In terms of long-term solutions, actually we have a pretty good roadmap, and that is the way the financial system was regulated before Congress changed all the rules in 1999 and 2000.

JUDY WOODRUFF: How clear is it at this point, Lynn Stout, what the solution is? Is it something that's simply going to take time, investigation, until we better understand what the remedy is?

LYNN STOUT: I think that the short-term solution to particular cases like AIG is very complicated and difficult. I think, in terms of long-term solutions, actually we have a pretty good roadmap, and that is the way the financial system was regulated before Congress changed all the rules in 1999 and 2000.

We actually had a divided system of regulation with a bunch of regulators, the SEC, the CFTC, the state insurance regulators, the banking regulators, and they did a pretty good of controlling systemic risk. It was only when we changed that system that we got into trouble.

JUDY WOODRUFF: Lynn Stout, are Secretary Geithner and Chairman Bernanke correct when they say it would have been catastrophic for the economy if the federal government had not stepped in and rescued AIG last year and this year?

LYNN STOUT: I think there is room for an outside observer to be cynical about that. There does seem to be an excessive concern for the welfare of AIG and Goldman Sachs and some of these big companies.

Some people have suggested it would be possible to divide up those entities, to let them go into bankruptcy and receivership, let the credit-default-swaps-trading speculative part of the business fail, and preserve the serious banking and insurance portions as healthy entities, because those were not the divisions that got into trouble.

JUDY WOODRUFF: Is that a solution that might have worked, Dino Kos?

DINO KOS: I have doubts because of the cross-default provisions that many of these contracts will have. So even if the units that are healthy are not involved in some of these transactions, there's a lot of cross-default provisions in contracts.

And then there's also the human element, that is, that if one part of AIG is having troubles, it's very likely the policyholders would begin to surrender their policies, begin moving their business away from AIG, that counterparties of the healthy divisions would refuse to do business with them. And we've seen examples of that in other cases.

So it's very, very difficult to actually ring-fence and segregate these types of businesses, you know, when you're actually in the midst of a crisis.

AIG's spending choices

Dino Kos
Portales Partners
As Secretary Geithner tried to point out, the rescue plan allowed AIG to meet all of its obligations.

JUDY WOODRUFF: Well, what we know happened after this bailout is that AIG took this money and they gave it to the so-called counterparties, these other -- much of it to these other institutions, like Goldman Sachs, like overseas banks. Is that something that can be justified to American taxpayers?

DINO KOS: Well, obviously, it's not something that comes across and it doesn't make one feel good, let me put it that way, you know, but as -- I think as Secretary Geithner tried to point out, the rescue plan allowed AIG to meet all of its obligations, so those that were to people with insurance policies, be they homeowners, or with auto policies, as well as those that had some of these contracts with AIG.

So they were not being, if you will, discriminatory in how that money was used. Now, that's something that, you know, obviously, there's room for debate on that. I'm sure that that's something that people will think about going forward.

JUDY WOODRUFF: Lynn Stout, what about this notion of the counterparties, these otherwise successful institutions, like Goldman Sachs, like these European banks, that got billions of dollars through the government funds that went to AIG?

LYNN STOUT: I have to say, I think any taxpayer has got to find that very troubling, because essentially what happened was these were hedge funds in large institutions that made bets with AIG, and for a while AIG won the bets, and its Financial Products division was, as they called it, was very profitable.

And then they made some bad predictions, and then their fellow betters came up and wanted them to settle up the bet. And that's essentially where the taxpayers' money is going. Billions of dollars of the bailout funds have gone to pay off these bad bets that AIG made to Goldman Sachs and a lot of European banks. And I think as a taxpayer you have to view that as very troubling.

Bonuses 'a political distraction'

Lynn Stout
University of California, Los Angeles
It's really been a distraction and has kept people's attention focused away from the bigger issue, which is, what are we going to do to try and add safety and security to our financial system?

JUDY WOODRUFF: And very quickly, back to the question that had so many Americans and so many members of Congress riled up, and that is the bonuses. Should the government, Lynn Stout, have stepped in and prevented those contracts from being honored, those payments to AIG employees?

LYNN STOUT: I think that legally there's really a limit to what they can do without taking extraordinary measures, like punitive legislation that really seems directed at these individuals.

And I think, in a lot of ways, the fear over the bonuses is unfortunate, because it's a big distraction from the more significant issues. For every dollar of taxpayer money that's gone to AIG, less than one-tenth of one penny is going out in the form of these bonuses.

And it's really been a distraction and has kept people's attention focused away from the bigger issue, which is, what are we going to do to try and add safety and security to our financial system?

JUDY WOODRUFF: In just a few seconds, Dino Kos, on those bonuses?

DINO KOS: I fully agree. There was a way to deal with these bonuses quietly through working channels, if you will, but it's been elevated and it's become a real political distraction that can harm the ability of the government to do some of the more important things that will need to be done.

JUDY WOODRUFF: We thank you both for being with us, Dino Kos in New York, and Lynn Stout joining us from UCLA. We appreciate it.