What should financial services reform deliver?

-Guest columnist Robert Brusca is the chief economist for Fact and Opinion Economics and the former chief of the New York Fed's international financial markets division. The opinions he expresses here are his own.-

NEW YORK (Reuters.com) -- Does the structure make the banking system or the rules? Is there a structure for financial sector regulation that could have prevented all this' from happening?

The answer is, probably not'. Structure alone is not going to prevent missteps in the financial markets.

So in thinking about what financial services reform should deliver there are three elements that will be crucial. First is the regulative body itself: who will do it? Second is the choice of rules that are to be enforced: What will they do? Third is whether those rules are going to be top-down federal rules or bottom-up state rules: Are the rules universal?

The current system suffers under a patchwork of regulators and of state/federal rules. It's a system that has mutated more than evolved and does not make much sense from an efficiency or consistency standpoint. Banks are supervised by the Fed, the comptroller of the currency, the FDIC as well as by State banking agencies. The SEC oversees nonbanks. The Fed has partial oversight when a nonbank is a primary dealer in government securities and so on.

The Paulson plan

The plan envisions making the Federal Reserve System the super regulator over banks and securities firms. This plan would stretch the Fed far beyond its current mandate. It also seems to be the most likely outcome. If the Fed is not tapped for this role, a brand new super-regulator could be formed. Yet I don't see any of the other regulators stepping up to fill the role.

Where we are going depends on who is leading

It is impossible to predict what we will wind up with since there are so many different views of the future, especially because we do not yet know which party will occupy the White House for the next four years. Democrats tend to want more hands on regulation while Republicans usually prefer less oversight. We can be sure that the current meltdown will color the mission of financial reform.

Republicans' backs against the wall

Since the meltdown occurred on the Republican watch, Republicans are going to be on the spot to defend what happened and to demonstrate that their policies were not the cause of the problem. Moreover, Alan Greenspan a life-long Republican, had pushed an aggressive agenda of deregulation as Fed chairman. He even urged one of his own governors on the Fed Board not to look into mortgage irregularities he had uncovered saying that the market will deal with it. And indeed, years later, the markets are dealing with it, just as Greenspan predicted. For more, click here

What type of regulations?

Once a regulator is picked, there is the issue of which regulation to implement or change. Congress and the president will set the agenda. There are regulations that press banks to lend more in their local communities and obey equal opportunity laws. There are regulations that focus more on consumer information and safety. The international framework called Basel II is another set of regulations. The Basel accord is aimed at the intrinsic safety and soundness of the financial institution itself, rather than at controlling the firm's dealings with customers. Bank secrecy acts have loomed as more important since Sept 11. In this realm we might include questions of how intrusive government can be in the affairs of banks, or how vigilant banks must be in reporting large cash transactions, suspicious money laundering or suspected terrorist financing activities and the like. Obviously when we speak of regulation', we're throwing a wide net.

What to expect

We can expect a Democrat-dominated regulation team to provide more attention on community banking issues and consumer protections, especially regarding mortgage lending. Expect Republicans to emphasize more of the structural reforms and enforcement mechanisms without trying to tweak the underlying law as much. While Republicans like to preserve states rights, one practice that is likely not to survive is leaving discretion to local banking authorities. In the mortgage lending up until 2008, a lot of problems with unscrupulous brokers were found to involve state rules and mortgage brokers who would jump from state to state to exploit the fact that what they did in one state was not a federal crime.