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Markets

Can We Stop the Next Panic?

Watching regulators make the sausage isn't pretty, but getting the oversight right is crucial.

In normal times, there are few things more abstruse and unexciting than financial-market regulation. But you had better believe it's a hot topic now.

When the markets have stabilized, policymakers will turn to righting the wrongs that contributed to the crisis. Their first step will be recognizing that the regulatory architecture of the past century is woefully inadequate for 21st-century finance -- akin to depending on the caretaker of a Sears Kit Home when we live in a high-tech high-rise.

The starting point for discussion will likely be a blueprint laid out by the Treasury Department in March. Among the most controversial proposals is one for the Federal Reserve Board to monitor the entire financial sector for risks to the economy. Proponents say such an authority might have spotted the red flags raised by the intertwining of financial institutions in a web of bad debt. Those signs weren't clear when looking at institutions in isolation.

Next will come the tweaking (down to the subparagraph) of scores of regulations. The Securities and Exchange Commission has reinstated a rule limiting the amount of debt that big investment banks can take on relative to their equity -- a symbolic move for now because the biggest firms have either failed or converted to bank holding companies. Debate has turned to the accounting provision, known as mark-to-market, that governs how exotic securities trading in illiquid markets should be valued -- whether they should be based on the price the market will bear right now, or at a price that reflects expected cash flows and longer-term prospects.

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The state of New York has said it will begin to regulate credit-default swaps -- the undoing of insurance giant AIG -- and there are calls for optional federal regulation of insurers. Swaps are supposed to insure against the default of bond issuers. But only a portion of the $60-trillion market actually serves as insurance; the rest is speculation, New York's insurance superintendent told Congress. Such contracts may soon become standardized and trade on an exchange.

Credit-rating agencies, blamed for not accurately reflecting the value of mortgage pools bundled together and sold to investors, may soon have to disclose default rates for each of their rating grades. And short sellers, who use borrowed shares to bet that stock prices will fall, can expect a re-examination of the uptick rule, adopted in 1938 and eliminated in 2007, which prevented short sales until a stock was moving higher.

Some federal oversight of mortgage brokers seems likely, with rules for simpler disclosures and uniform licensing qualifications. As for those exorbitant Wall Street salaries, says corporate-governance watchdog Nell Minow, Congress should require executives to return bonuses they received based on financial reports later found to be erroneous.

Will a renewed focus on regulation stifle innovation and hamstring the market? No one wants to go back to the heavy-handed days when Wall Street commissions were fixed and banks couldn't pay interest on checking accounts. But a watchful eye won't hurt.