New regulatory framework for financial institutions

Treasury Secretary Timothy Geithner is petitioning Congress for a set of new regulatory powers which would enable the federal government to seize certain financial companies which are near insolvency, similar to powers the FDIC has in taking control of troubled banks. The idea is to prevent another bailout disaster similar to AIG, but is such drastic new legislation really necessary, or could a more moderate increase in federal regulatory powers serve to fulfill the same purpose?

Let’s review the bank situation Mr. Geithner is attempting to draw a parallel with. The Federal Deposit Insurance Act, which created the FDIC, contains provisions under which that entity can take over certain troubled banks, including conditions of “assets insufficient for obligations”, “unsafe or unsound condition”, “cease and desist orders”, “violations of law”, and “losses”. This Act was passed soon after FDR took office in the early 1930s, when bank failures were commonplace, and provided a mechanism for the government to take early action to prevent catastrophic failure of a critical component of the economy. Since bank failures can suppress economic growth and lead directly to both short and long-term distress for bank account holders, there is a good basis for this law even today.

But even with the public outrage over the AIG situation, is there a more moderate approach to handling new regulatory measures for non-banks? First off, both President Bush and a Democratic Congress failed to expressly write conditions under which AIG should use the bailout funds, so public outrage should first and foremost be directed at the federal government. If you give a bunch of crooks some money without police escort, what would you expect?

Alas, we could play the political blame game to infinity without achieving any significant progress, so here is a solution to the regulatory problem which will allow some level of government intervention when appropriate while allowing non-banks to function in a manner deemed appropriate by their directors: amend the Investment Company Act of 1940. An “investment company” is one whose primary business is in investment, i.e. trading stocks and bonds and other securities and derivatives to achieve profit. AIG currently does not qualify as an investment company because its primary business is insurance, not investing. And yet, poor investing is what put this insurance giant into distress. So why not amend the Investment Act of 1940 to require certain publicly-traded companies, i.e. firms required to register under the Securities Act of 1933 or Securities Exchange Act of 1934, as investment companies? There could be an exception for companies who only invest extra cash into savings accounts or other publicly-traded companies, but otherwise if a publicly traded company (1) engages primarily in investing, (2) has a subsidiary engaged primarily in investing (i.e., AIG Financial Products) or (3) invest cash in anything other than demand deposits or other publicly-traded securities, that company would also have to register as an investment company.

What intervention authority should the federal government have over investment companies? For starters, companies classified as “investment companies” under provision (2) or (3) above should have more stringent and frequent reporting requirements so both investors and federal authorities would be more likely to catch any particular trouble spots. This would exclude firms such as hedge funds and other companies engaged primarily in investing activities from these reporting requirements. And federal authorities should then be allowed to file for a cease and desist order in federal bankruptcy court to prevent dangerous activities by those companies, but not for the government to simply take over those companies. The companies could then either play ball and cooperate with the government, or appeal the order first in bankruptcy court then in district court. In this manner, more consumer and overall economic protection would be provided without allowing the government too much control over the daily operations of non-banking private companies.