What's wrong with U.S. financial regulators?

Put simply, they don’t understand risk, according to former SEC Chair Harvey Pitt.

Pitt wants the President’s Working Group on Financial Markets to consider forming a Risk Management Committee that could help identify financial time bombs in the economy — before they force the government to mount costly bailouts.

“Historically, there have been signs that these excesses were on the horizon long before they morphed into economic catastrophes,” Pitt writes in Compliance Week.

Such a committee could be charged with making an annual, top-down, risk-based assessment of the U.S. financial system. It could suggest steps that should be taken to keep small problems from turning into big ones.

It would also be available when the inevitable crisis arises to coordinate a response and to identify additional concerns that the crisis might exaggerate.

“Private-sector participation is essential,” Pitt writes. “My years in government have taught me that government seems far more adept at examining the past than anticipating the future.”

Pitt points out that management at JPMorgan Chase and Goldman Sachs knew the subprime market was overheating long before the first articles appeared or hearings commenced.

Which is precisely why Goldman Sachs has been able to sidestep the subprime catastrophe — and why JPMorgan Chase was able to backstop Bear Stearns.

“Unfortunately, that type of experience seems always to be gained only by first suffering hard lessons in financial markets,” Pitt writes. “And it is altogether nonexistent in government.”

Pitt says it's absurd that the federal government requires transparency from the finance world but doesn’t require at least as much of itself.

“Repeatedly being caught off-guard should have signaled to regulatory agencies that they were lacking fundamental tools regarding the identification of problems before they actually arise,” he says.

“Given the traumas of the past two decades, and even more specifically the tragedies of the past year, it’s time to entertain new concepts,” he writes.

According to Pitt, the mortgage-related catastrophe was only one of at least four “meltdowns” which required government intervention that the U.S. financial markets have experienced since the late 1980s.

With a risk management committee in place, the 1987 October equity market sell-off, the 1990 real estate crisis, the Long Term Capital Management crisis and the growth-stocks tumble of 2000-2001, all would have had less impact on the U.S. economy.

Moreover, establishing such a committee can be done without legislation or years of study and debate.

“If creating a governmental Risk Management Committee could avoid or ameliorate even one financial crisis, it would prove to be well worth whatever costs are associated with its creation,” he writes.