Commentary: Washington will be forced to revisit regulation

Guest columnist Cornelius Hurley is director of the Morin Center and a banking law professor at Boston University. Formerly, he was the Assistant General Counsel of the Board of Governors of the Federal Reserve System. The views expressed here are his own.

By Cornelius Hurley

Regulation is on the minds of the voters and the lips of the politicians as we witness the largest financial meltdown since the Great Depression. The candidates for president are vying for pole position as to who will be the toughest regulator of our financial institutions come January 20.

In light of John McCain's record of railing against regulation in almost any form during his career in the Senate, I would give Senator Obama better odds at winning this leg of the race. Regrettably, with just six weeks to go until the election, it is unlikely that the heat of this debate will shed much light on the substantive issues facing the next administration.

One of the problems with this debate, in addition to its taking place in the context of a presidential campaign, is that the very word "regulation" long ago was politicized with one party branding itself as the party of deregulation (read: smaller government) and the other party being perceived as more comfortable with governmental regulation (read: bigger government). These banalities became the slings and arrows of politics and often stood in the way of meaningful reform.

For example, before the 1999 repeal of the Glass Steagall Act, which separated commercial banking from investment banking for over a half century, could be passed, Congress had to neutralize the divisive issue of regulation. Investment bankers and insurers feared the heavy hand of the Federal Reserve if Glass Steagall's protective walls were removed.

"Functional regulation" became the enabling mantra for the passage of the Gramm Leach Bliley Act, the combination of Travelers and CitiBank, and, under considerably different circumstances, the acquisition of Merrill by Bank of America. With functional regulation at its core, the essence of the 1999 law was to enable financial institutions to slip out of their silos while confining regulators to theirs. Few imagined at the time that this facile political compromise would sow the seeds of such destruction less than a decade later or that our financial lexicon would grow to include such terms as: SIVs, CDOs, credit default swaps, CLOs, alt-A mortgages, Level 3 valuations, and much, much more.

The next administration and the next Congress will be forced to revisit the functional regulation compromise. When they do, it would be well to put the rhetoric about regulation aside and keep a few thoughts in mind.

First, there is much to commend the way commercial banks, as contrasted with investment banks, are regulated. Bank examiners have access to all of the books and records of the institutions they regulate. SEC examiners do not. In larger banks, examiners are on site continuously. We will never know whether the toxic instruments that are now part of our vocabulary would have been created under the gimlet eye of more robust examiners&but we can guess.

Second, we the people now own the largest insurance company in the land. How shocking to learn that our company is a major player in the $62 trillion (the "t" is not a typo) credit default swap industry and that the price tag for this poster child of functional regulation is $85 billion and counting.

Third, when Louis Brandeis penned Other People's Money and How Bankers Use It at the early part of the last century, he sparked a movement that led to disclosure (sunlight) as a guiding regulatory principle. We now know from painful experience that disclosure is an inadequate instrument for protecting the financial system.

In addition to mere disclosure, we need transparency that communicates meaning not just words and numbers and does so in a way appropriate to the audience, be it customers, regulators, shareholders, boards of directors and, yes, even managements. Finally, audience-appropriate transparency has to be accompanied by accountability and not be allowed to devolve into a shield against liability as has been the case with disclosure.

It's going to be a lively debate.