College of Business: University of Illinois at Urbana-Champaign

Important Site Links

D'Arcy and Kahn Agree Regulatory Overhaul Could Worsen Credit Crisis


CHAMPAIGN, Ill. — The Bush administration's sweeping plan to overhaul the nation's financial regulatory system could compound the credit crisis it seeks to cure, two University of Illinois finance professors say.

Stephen D'Arcy says regulators should let the crisis play out, learning from the lessons it provides, rather than overreacting and implementing changes that could potentially do more harm than good.

"Given that the crisis is still unfolding, it seems more appropriate to work within the current system to stabilize the economy and restore confidence in financial markets first before undertaking wholesale changes in regulation," he said. "The admonition about not changing boats midstream seems appropriate to this situation."

"Once the current crisis abates and a better understanding of the causes and consequences of the problems is evident, rational debate over the appropriate changes to financial regulation can occur and effective improvements can be adopted," said D'Arcy, the John C. Brogan Faculty Scholar of Risk Management and Insurance.

The 218-page plan unveiled this week by U.S. Treasury Secretary Henry Paulson would bring the most far-ranging overhaul of the financial regulatory system since the Great Depression, seeking to trim a jumble of overlapping oversight agencies that date back to the Civil War.

But other than giving the Federal Reserve some regulatory power over investment banks and other financial institutions, most of the proposals don't make much sense, says Charles Kahn, a finance professor and the Fred S. Bailey Memorial Chair of Finance in the U. of I. College of Business.

"Rationalizing the regulatory system always sounds like a laudable goal," Kahn said. "While the arrangements by which different regulators handle different banks are confusing, there aren't any significant problems in the U.S. financial system that will be alleviated by this rationalization."

Kahn says many of the regulatory agencies threatened with elimination provide valuable oversight, in particular the Commodity Futures Trading Commission.

"I am concerned that their special expertise could be watered down by the merger," said Kahn, who specializes in financial institutions and the economics of information and uncertainty.

On the other hand, the proposals include the creation of a new entity, the Mortgage Oversight Commission, which, Kahn says, is likely to duplicate and overlap with other regulatory agencies already charged with consumer protection.

D'Arcy, whose research centers on insurance, questions including a long-standing proposal in the plan that would establish a dual system of insurance regulation, giving insurers the option of being regulated at the federal or state level.

The insurance industry's only significant role in the current crisis was excessive amounts of credit risk taken on by financial guaranty insurers, netting ratings downgrades that are adversely affecting some credit markets, he said.

But even if the dual system had been in place, D'Arcy said, there is no guarantee insurers would have opted for federal rather than state regulation and, if they had, that federal regulators could have better limited credit risk exposure.

"Thus, the federal insurance regulation proposal has little relevance to the current problems," D'Arcy said. "There are good arguments both for and against federal insurance regulation. But the issue could be debated on its own merits more effectively than having it included in an overall financial reform package."

Related Information:

Professor Stephen D'Arcy - Faculty Profile

Professor Charles Kahn - Faculty Profile

(Story courtesy of News Bureau)

UIUC College of Business