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Regulators rush to shore up the financial system, but will there be meaningful change ahead?

Great waves of financial regulation spring from great crises. The Panic of 1907 spurred the creation of the Federal Reserve System six years later. The Great Depression prompted the Glass-Steagall Act separating the banking and securities industries, the creation of the U.S. Securities and Exchange Commission and, after World War II, the establishment of the International Monetary Fund and the World Bank.

Now, with the U.S. housing market suffering its biggest decline in decades and the Federal Reserve providing liquidity to securities firms for the first time since the 1930s, Wall Street — and much of the global financial system — is enmeshed in yet another epochal crisis, and the drumbeat of calls for regulatory reform is building. U.S. Treasury Secretary Henry Paulson Jr. late last month proposed an ambitious streamlining of the U.S.’s myriad financial regulatory bodies.

Congressional Democrats are clamoring for more-aggressive intervention, ranging from tighter regulation of securities firms to the injection of billions of dollars of taxpayer money into the mortgage market. And regulators around the world are considering proposals to boost capital requirements for banks and reform the originate-and-distribute method of securitization. As one senior U.S. regulator tells Institutional Investor when asked what the reform priorities should be, “We need to look at everything.”

The numerous initiatives suggest that the era of deregulation that began under Margaret Thatcher and Ronald Reagan and spread around the globe under the rubric of the Washington Consensus has come to an end. It was instructive that the Treasury’s “Blueprint for a Modernized Financial Regulatory Structure,” conceived a year ago with the aim of lightening regulation to enable New York to face the growing competition from London, was hastily dressed up as an effort to strengthen oversight and restore confidence shaken by the crisis. Yet it remains very much an open question whether all this activity will lead to action that actually bolsters financial stability and addresses the causes of the crisis that in March intensified with the near-collapse and subsequent Federal Reserve–led bailout of Bear Stearns Cos.

Consider the Paulson plan. The core proposal — amalgamating an alphabet soup of regulators like the OTS, OTC, SEC and CFTC into two broad agencies in charge of prudential regulation and consumer protection, respectively — has a neat management logic. “We need rules for risks, not rules for institutions that have a particular label on them,” says Hal Scott, a Harvard Law School professor who heads the Committee on Capital Markets Regulation, a private sector advisory body set up at Paulson’s behest.

Easier said than done, though. It’s harder to merge government agencies than private companies, where wholesale sackings and performance bonuses can smooth a transition, says Ronald Glancz, a partner at Washington law firm Venable and a former lawyer at both the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency. And a tidy organizational chart doesn’t mean effectiveness — witness how the U.K.’s Financial Services Authority, the model for Paulson’s prudential regulator, failed to prevent the collapse of mortgage lender Northern Rock. “The beauty of [the U.S.] system is that we have regulators who go into the banks and get into the nitty-gritty,” says Glancz.

The Treasury blueprint doesn’t contain any provision for tighter oversight of securities firms, an absence that was welcomed on Wall Street but is likely to be hotly contested in the months to come. How would a Bear Stearns–style meltdown be anticipated and averted in the future? The proposals “overemphasize the role of self-regulation, market discipline and reliance on principles rather than rules,” says Nouriel Roubini, an economist at the Leonard N. Stern School of Business at New York University.

The Federal Reserve, which supervises bank holding companies, has temporarily extended its oversight to securities firms, in turn allowing those firms to have access to its discount window last month. But the Fed’s new perception of the systemic risks posed by broker-dealers in the wake of the Bear Stearns rescue suggests it will be reluctant to let the industry out of its sights anytime soon. As Timothy Geithner, president of the Federal Reserve Bank of New York, told the Senate Banking Committee early this month, “We need to ensure there is a stronger set of shock absorbers, in terms of capital and liquidity, in those institutions — banks and a limited number of the largest investment banks — that are critical to market functioning and economic health, with a stronger form of consolidated supervision over those institutions.”

Any such major regulatory reform will almost certainly wait at least until after the November U.S. presidential election. Pressure is growing, however, for quicker action to support the U.S. mortgage market. Federal regulators last month eased restrictions on two government-sponsored mortgage entities, Fannie Mae and Freddie Mac, to allow them to buy up to $200 billion in additional mortgages and mortgage-backed securities, and enabled the Federal Home Loan Bank system to purchase an additional $100 billion of mortgage bonds over two years. But with estimates of mortgage losses at $400 billion and rising, many industry executives and economists are warming to ideas for more-aggressive action. “Restoring stability in the subprime segment of the housing and mortgage markets is an essential ingredient to arrest financial market deterioration,” says Charles Dallara, managing director of the Washington-based Institute of International Finance, a banking lobby group.

Tinkering with rules and regulatory structures, however well intentioned, can achieve only so much. For many analysts, today’s crisis has its roots in a culture of credit run amok that will be painful to correct. And the irony is that the Federal Reserve, which has ridden once again to the rescue of financial markets and which would gain a grand new role of safeguarding market stability under Paulson’s plan, is as responsible as anyone for that credit culture.

Earlier this decade the central bank resisted calls from one of its own, former Fed governor Edward Gramlich, to protect consumers from predatory lending and rein in excessive mortgage lending, notes John Makin, chief economist at Caxton Associates in New York. “The things that happened would not have happened if existing regulations had been enforced,” he says.

Others blame a history of rate cuts in response to market stress — the so-called Greenspan put — as well as the former Fed chairman’s doctrine, shared by current chairman Ben Bernanke, that the central bank can’t spot asset bubbles in the making but must stand ready to mop up the damage when they burst. The Fed’s recent intervention to provide liquidity to market participants shows that the central bank is worried about the impact of falling asset prices on the economy, says Stephen Cecchetti, a monetary policy specialist at Brandeis University’s International Business School. “All we have to ask for is symmetry on the way up,” he adds.

The European Central Bank’s conservatism, much derided several years ago when Europe’s growth performance was lagging, wins new respect today. The ECB keeps indirect tabs on asset prices by taking money growth into account in setting interest rates. Central banks need a framework for “pursuing a policy of leaning against the wind of asset prices,” says one senior European policymaker.

Such a stance would be a radical departure from recent practice for the Fed, and tricky to maintain in the growth-at-all-costs U.S. political environment. The congressional voices that decry mortgage lending excesses today would no doubt have slammed the Fed had it tried to curb lending a few years ago. But it was a former Fed chair­man, William McChesney Martin Jr., who once described the central bank’s role as taking the punch bowl away just as the party starts.

For an economy reeling from the effects of easy credit, returning to such an ethic may be the only way out of the crisis, says William White, head of the monetary and economic department at the Bank for International Settlements. “We put far too much emphasis on trying to minimize short-term pain at the cost of long-term pain.”