Fed nomination prospects bring new focus on Summers's regulation history

In March 2000, Lawrence Summers stood before a conference of derivatives traders in Boca Raton, Florida, to tell them how government regulators should have a limited role in protecting and supervising the financial system.

"Let me be clear, it is the private sector, not the public sector, that is in the best position to provide effective supervision," the then Treasury Secretary told the crowd. "Counterparties and creditors have more knowledge of their counterparts, more skill in evaluating risk and greater incentives than any public regulator will ever have."

More than a decade later, Mr Summers' views on regulation are in the spotlight again, as Barack Obama weighs the nomination of his first-term economic adviser as the new chairman of the US Federal Reserve.

Mr Summers's emergence as the frontrunner for the job, ahead of Fed vice-chair Janet Yellen, has flummoxed his left-of-centre critics after a financial crisis linked in part to the very securities, over-the-counter derivatives, which were left unregulated on his watch. Most staffers think that the Senate would eventually confirm Mr Summers but the outspoken Liberal Democrats who have criticised his regulatory record hold great sway on the banking committee.

The result could be something the White House would like to avoid: a messy and contentious confirmation fight that risks damaging a new Fed chairman, a position which generally operates above the political din.

Mr Summers's view was always that "markets will be markets, just get out of the way," says Simon Johnson, a professor at MIT and former chief economist of the International Monetary Fund.

But Mr Summers's defenders say this is a caricature of his pragmatic record. "He's anti regulations that he doesn't think will work and he's pro regulations that he does think will work," says Lee Sachs, a Summers lieutenant in the late 1990s who returned to the Treasury during the early years of the Obama administration.

During his time in public office, Mr Summers has supported strong systemic regulation of the finance sector, but often opposed prescriptive rules on what financial institutions can do, arguing that such rules are not effective.

The question Mr Summers, who declined to comment for this article, would have to answer if he is nominated is whether that reluctance to interfere in specific markets risks meant he did less than he might have to secure the safety of the financial system.

The first big financial reform passed when Mr Summers was Treasury secretary - the repeal of Glass-Steagall, which stopped banks from acting as securities companies - is seen by liberals as a symbolic dismantling of safety measures put in place after the Great Depression.

There is convincing evidence, however, that it was only a minor factor in the financial crisis because of the institutions that got into trouble only Citigroup had brought a securities company into the banking system. The big problem was companies not regulated as banks.

"All the entities that were outside the regulatory system in the crisis, such as Lehman Brothers and AIG, were outside before [the repeal of Glass-Steagall]," says Michael Barr, a professor at the University of Michigan, who was a Treasury official under Mr Summers in the late 1990s and again from 2009-2010.

In a speech just before the law passed, Mr Summers also called for "new measures" to make markets understand that no bank "is too big to fail", and warned about the systemic risk from housing finance agencies Fannie Mae and Freddie Mac.

But Mr Summers's reluctance to interfere in individual markets, rather than keep an eye on the overall system, was visible in the 2000 debate on how to address uncertainty about whether swaps should be regulated like futures, traded on exchanges and centrally cleared. The decision was to exempt them.

At the time, argue Mr Summers's supporters, credit default swaps barely existed, there was fierce international competition to host derivatives trading, and Republican control of Congress meant that legislation to regulate would have been difficult.

Nonetheless, the instinct to leave the market alone meant an enormous missed opportunity to expose credit default swaps to greater scrutiny, and prevent the complicated tangle of derivative obligations via which the Lehman failure threatened the entire financial system.

While out of office, Mr Summers remained sanguine about the benefits of financial innovation - most notably calling Raghuram Rajan, now the Indian central bank governor, a Luddite for questioning them at Jackson Hole in 2005 - but also warned of dangers building up in a long period of financial stability. Innovations, he wrote, would only be tested in a crisis.

When Congress came to rewrite the financial rule book in 2010, Mr Summers backed most of what became the Dodd-Frank Act. "I found Mr Summers and the entire administration very supportive," says Barney Frank, then the Democratic chair of the House Financial Services committee.

People involved in the process say that Mr Summers strongly supported most of the ideas that went into Dodd-Frank, including higher capital requirements, central clearing for derivatives, the creation of a Consumer Financial Protection Bureau and new rules to make it easier to wind up big banks.

The main exception was the Volcker rule, named after former Fed chair Paul Volcker, which banned regulated banks from speculative investing. "Larry was adamantly against the Volcker rule. If the president hadn't picked it up directly, Larry would have had it gutted," says one former administration official.

Mr Barr disputes that account. "Larry had basically two concerns. One is that the Volcker rule would end up being much more complex to implement and therefore that it would be gamed."

"His second concern was that if people were solely focused on trying to make banks safer it would undermine support for reforms to regulate shadow banking," says Mr Barr, noting that in the end Mr Summers's concerns were assuaged enough for him to sign the memo recommending the Volcker rule to the president.

The same pattern is likely to emerge if Mr Summers is nominated for the Fed job. He may surprise his critics with wholehearted support for tough capital and liquidity requirements, rules to ensure no bank is "too-big-to-fail", and strict supervision of institutions that are not banks but try to act like them.

But he may show less sympathy for structural proposals to create a simpler banking system, such as reviving Glass-Steagall, an idea pushed this year by Democratic senator Elizabeth Warren and Republican John McCain.

"He is broadly in the camp that regards Dodd-Frank as enough," says Mr Johnson, "and that we can rest of our laurels."

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