The next Congress will make overhauling the financial regulatory system one of its first priorities, Sen. Charles Schumer yesterday told financial executives.

The changes will seek to fix an outdated system that allowed many financial institutions and products to go unregulated, which helped lead to the excess risk-taking that has played a part in the current crisis, the New York Democrat said yesterday at a Securities Industries and Financial Markets Association conference on the Treasury Department's $700 million Troubled Asset Relief Program.

"A complex overhaul of the nation's financial regulatory system will be difficult, complex, and time-consuming, but it must be done," said Schumer, who is a member of the Senate Banking Committee and is chairman of its subcommittee on housing, transportation, and community development.

Schumer criticized financial firms and credit rating agencies for relying too heavily on computerized models of risk. The companies used technology in place of good judgement, creating risks that were not fully understood, he said.

"There's no Tooth Fairy, no Santa Claus, and there's no such thing as a financial instrument that delivers great returns with little risk," Schumer said.

Regulators failed to keep up with the pace of change in the financial markets, and in today's interconnected markets, even small firms can pose great systemic risks, he said.

In addition, the line between commercial banks, investment banks, hedge funds, and other financial institutions has blurred, meaning the old system of many regulators focusing on specific types of firms cannot work. Schumer cited the downfall of insurance giant American International Group Inc. as an example of the problems with a divided system. State regulators had oversight of certain insurance functions of the firm, but other parts went unregulated, essentially acting as hedge funds without oversight.

Schumer suggested the government should consolidate regulatory functions, perhaps into one large agency. The U.S. could model its system on Britain's Financial Services Authority, and should seek to work with companies before problems develop, rather than after they occur, he said.

Likewise, any new regulation scheme would need to cover the market for complex financial instruments, such as derivatives and credit-default swaps. The new system must make clear what agency has responsibility for any new products, so none can "slip through the cracks," Schumer said.

In addition, the new system must seek to create greater transparency and recognize that a completely laissez-faire attitude is not appropriate for modern financial markets, Schumer said. Strong and efficient regulation has helped the U.S. become one of the safest and most liquid markets, but confidence has eroded in the markets over the past 24 months, he noted.

But Schumer cautioned that any U.S. solution should not be too aggressive. The economy needs a global solution so firms do not flock to unregulated economies if the U.S. begins to oversee certain financial instruments.

In addition, any good regulatory system needs to monitor properly without stifling financial innovation.

"Regulation requires a very careful balancing act," Schumer said.

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