NEW YORK - World finance leaders have succeeded in coaxing confessions out of big banks that sustained heavy losses from the credit crisis. Now they have to figure out how to write reforms that strike the right balance between greed and guilt.
More than half way to a 100-day deadline that world leaders set in April to lay the groundwork for shoring up financial markets, the report card looks promising. That will be welcome news for finance ministers from the Group of Eight rich countries who are meeting in Japan starting on Friday.
The longer-term task of tightening regulation and improving global oversight is filled with political pitfalls, and the prospects for enacting meaningful reform that punishes excesses without constraining markets look dimmer.
"Between greed and guilt there is a compass that needs to be found," French Finance Minister Christine Lagarde said in a recent speech in Chicago. "The needle for the compass is set by governments; our duty is to make sure that greed is sufficiently balanced by a sense of guilt."
An April report to rich nations from the Financial Stability Forum -- a global grouping of regulators who sought to identify what caused the crisis and suggest ways to fix it -- set a July deadline for financial firms to disclose losses and tighten risk management practices.
They have clearly made progress.
Goldman Sachs said the subprime crisis was "mostly over" for investors now that banks have recognized $200 billion to $250 billion in losses.
'Too good to fail'
Fulfilling other recommendations looks more complicated.
The FSF has called for raising capital requirements so that banks would have a deeper cushion when they hit the next financial trouble spot. However, Martin Feldstein, a Harvard University economics professor and head of the influential National Bureau of Economic Research, said the end result of that would be lower bank profits.
"That is likely to drive those who want to take risks and get higher rewards out of the supervised sector, out of the regulated sector, and into other parts of the financial system," he said.
Higher capital requirements would also limit the amount of money that banks can lend at a time when the credit crisis has already constrained the flow of cash to consumers and companies. That could weigh on an already sagging global economy
Feldstein said he was "not confident" that world leaders could come up with an effective regulatory framework that would prevent the next disaster.
Henry Kaufman, the head of Henry Kaufman & Co. who earned the moniker "Dr. Doom" for his bearish views in the 1970s and 1980s, said rather than entrusting the supervisors who failed to spot the credit crisis in its infancy and were slow to stop it, a strong new global regulator was needed.
"If you take those large financial institutions and you really supervise them and regulate them, you will eliminate the systemic risk," he told the Reuters Investment Outlook Summit. "They have to be too good to fail."
Kaufman said nationalism would likely hamper efforts to build consensus on reform, noting that even as the subprime crisis was gaining steam, U.S. officials were concerned that over-regulation was driving business away from Wall Street.
"There is still underlying this a desire to be that region of the world that is more liberal, more accommodating, because the more liberal and accommodating you are, the more business you can do," he said.
Moral hazard 'cookie jar'
If the U.S. Federal Reserve's experience is any guide, striking the right regulatory balance will be controversial.
The Fed in effect obtained more supervisory authority when it allowed a wider range of financial firms to borrow directly from its discount window, a move put in place after the implosion of Bear Stearns in March.
Lou Crandall, chief economist at Wrightson ICAP, noted that the Fed's role in brokering the fire sale of Bear Stearns to JPMorgan had sparked controversy -- in the Fed's own ranks as well as outside -- over whether it would encourage risky behavior in the future. Some Fed members may ask the U.S. Congress to "tie their hands" so that markets would not assume that the central bank would always bail them out, he said.
"Congress is going to have to put actual hard, new statutory limits" on the Fed's power, Crandall said. "The Fed in a crisis can always evade them the way it did this time. It probably didn't have statutory authority to do much of what it did. But it was the right thing. And so people accepted it. But you've got to put that a little bit farther out of reach, at least put the moral hazard cookie jar up on a higher shelf."