WASHINGTON -- The Treasury Department will propose Monday that Congress give the Federal Reserve broad new authority to oversee the stability of the financial markets, in effect allowing it to send SWAT teams into any corner of the industry or any institution that might pose a risk to the overall system.
The proposal is part of a sweeping blueprint to overhaul the nation's hodgepodge of financial regulatory agencies, which many experts say failed to recognize rampant excesses in mortgage lending until after they set off what is now the worst financial calamity in decades.
Democratic lawmakers are all but certain to say that the proposal does not go far enough in restricting the kinds of practices that caused the financial crisis. Many of the proposals, such as those that would consolidate regulatory agencies, have nothing to do with the turmoil in financial markets. And some of the proposals could reduce regulation.
According to a summary provided by the Bush administration, the plan would consolidate an alphabet soup of banking and securities regulators into a powerful trio of overseers responsible for banks, brokerage firms, hedge funds and private equity firms.
The plan could expose Wall Street investment banks and hedge funds to greater scrutiny, but it carefully avoids a call for tighter regulation.
The plan would not rein in practices that have been linked to the housing and mortgage crisis, such as packaging risky subprime mortgages into securities carrying the highest ratings.
The Fed would gain some authority over Wall Street firms, but only when an investment bank's practices threatened the entire financial system.
And the plan does not recommend tighter regulation of the vast and largely unregulated markets for risk-sharing and hedging, such as credit default swaps, which are supposed to insure lenders against loss but became speculative instruments and gave many institutions a false sense of security.
Parts of the plan could reduce the power of the Securities and Exchange Commission, which is responsible for maintaining orderly stock and bond markets and protecting investors. The plan would merge the SEC with the Commodity Futures Trading Commission, which regulates exchange-traded futures for such commodities as oil, grains and currencies.
The blueprint also suggests several areas in which the SEC should take a lighter approach to its oversight. Among them are allowing stock exchanges greater leeway to regulate themselves and streamlining the approval of new products. It would allow automatic approval of securities products that are being traded in foreign markets.
The proposal began last year as an effort by Treasury Secretary Henry M. Paulson Jr. to make U.S. financial markets more competitive with overseas markets by modernizing a creaky regulatory system.
Paulson's goal was to streamline the sometimes clashing rules for commercial banks, savings and loans, and nonbank mortgage lenders.
"I am not suggesting that more regulation is the answer, or even that more effective regulation can prevent the periods of financial market stress that seem to occur every five to 10 years," Paulson will say in a speech on Monday, according to a draft. "I am suggesting that we should and can have a structure that is designed for the world we live in, one that is more flexible."
Congress would have to approve almost every element of the proposal, and Democratic leaders are drafting bills that would impose tougher supervision of Wall Street investment banks, hedge funds and the fast-growing market in derivatives such as credit default swaps.
Paulson's proposal for the Fed echoes ideas championed by Rep. Barney Frank, a Massachusetts Democrat who is chairman of the House Financial Services Committee.
Both see the Fed overseeing risk across the financial spectrum, but Frank is likely to favor a stronger Fed role and subjecting investment banks to the same rules that govern commercial banks, especially for capital reserves.
The Treasury plan would let Fed officials examine the practices and the internal bookkeeping of brokerage firms, hedge funds, commodity-trading exchanges and any other institution that might pose a risk to the overall financial system.
That would be a significant expansion of the central bank's regulatory mission.
When Fed officials agreed this month to rescue Bear Stearns, once the nation's fifth-largest investment bank, they noted that the Fed never had the authority to monitor the bank's financial condition or order it to bolster its protections against a collapse.
In two unprecedented moves, the Fed engineered a marriage between JPMorgan Chase and Bear Stearns, lending $29 billion to JPMorgan to prevent a Bear Stearns bankruptcy and a chain of defaults that might have affected much of the financial system.
For the first time since the 1930s, the Fed also agreed to let investment banks borrow hundreds of billions of dollars from its discount window, an emergency lending program previously reserved for commercial banks and other depository institutions.
Paulson's proposal would fall well short of the kind of regulation that Democrats have been proposing. Frank and other senior Democrats have argued that investment banks and other lightly regulated institutions compete with commercial banks and should be subject to similar regulation, including examiners who regularly pore over their books and quietly demand changes in their practices.
In a recent interview, Frank said he realized the need for tighter regulation of Wall Street firms after a meeting with Charles O. Prince III, then chairman of Citigroup.
When Frank asked why Citigroup had kept billions of dollars in "structured investment vehicles" off the firm's balance sheet, he recalled, Prince responded that Citigroup, as a bank holding company, would have been at a disadvantage because investment firms can operate with higher debt and lower capital reserves.
Sen. Charles E. Schumer, a New York Democrat, has taken a stance similar to Frank's.
"Commercial banks continue to be supervised closely and are subject to a host of rules meant to limit systemic risk," Schumer wrote in an op-ed article yesterday in The Wall Street Journal. "But many other financial institutions, including investment banks and hedge funds, are regulated lightly, if at all, even though they act in many ways like banks."
Paulson's proposal is likely to provoke turf battles in Congress among agencies and rival industry groups that benefit from the current regulations.
Administration officials said yesterday that they do not expect the proposal to become law this year, but they added that they hope it will help frame a policy debate that will extend well beyond the elections in November.
In a nod to the debacle in mortgage lending, the administration proposed a Mortgage Origination Commission to evaluate the effectiveness of state governments in regulating mortgage brokers and protecting consumers.
The bulk of the proposal, however, was developed before soaring mortgage defaults set off a much broader credit crisis, and most of the proposals are geared to streamlining regulation.
This plan would consolidate a large number of regulators into a few big new agencies.
Bank supervision, now divided among five federal agencies, would be led by a prudential financial regulator, which could send examiners into any bank or depository institution that is protected by federal deposit insurance or other federal backstops.
It would eliminate the distinction between banks and thrift institutions, which are indistinguishable to most consumers, and shut down the Office of Thrift Supervision.
Any effort to merge the Commodity Futures Trading Commission with the SEC is likely to provoke turf battles.
Another proposal would, for the first time, create a national regulator for insurance companies, an industry that state governments now oversee.
Administration officials argue that a national system would eliminate the inefficiencies of having 50 state regulators, who have carefully guarded their powers and are likely to fight any federal encroachment.
Arthur Levitt, a former SEC chairman who has long pushed for stronger investor protection, said his first impression of the Treasury plan was positive. Even though the SEC's powers might be reduced, Levitt said, the plan would create a broader agency to regulate business conduct in all financial services.
"It's a thoughtful document," he said. "I'm intrigued by the fact that it puts an emphasis on investor protection and that it establishes an agency specifically for that purpose, which would operate across all markets."