Early last summer, the Obama administration proposed a sweeping revision of U.S. financial regulation. Among its notable features are the elevation of the Federal Reserve to the role of primary financial regulator and the creation of a Financial Services Oversight Council to monitor so-called systemic risks, i.e., those exposures that risk a cascading series of failures based on the collapse of one entity.
A number of observers (including former Fed Chairman Paul Volker) have focused on the notion that the proposal will create moral hazard by codifying certain institutions as "too big to fail," concerns that were not assuaged by Treasury Secretary Tim Geithner's recent Congressional testimony. However, my concern is that the proposals ultimately will be ineffective in managing risks to the financial system. If this turns out to be the case, the resulting complacency will create an environment ripe for new problems.A poorly conceived and structured regulatory regime risks giving market participants unjustified confidence that systemic exposures are under control, even as the financial system's risks could actually be growing. (This brings to mind the Long Term Capital Management crisis in 1998, in which a fairly obscure firm had positions large enough to threaten the viability of the financial system.) The events of the past few years show how dangerous complacency on the part of managers and regulators can be.