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If one institution clearly demonstrates the regulatory shortcomings that led to the global financial calamity, it would be American International Group Inc. As a direct consequence of its ill-advised bets on highly specialized and largely obscure financial instruments, AIG came very close to outright failure last fall, threatening the survival of banks and other institutions around the world.

AIG, once the world's largest insurance company, with operations in 130 countries, is now a ward of Washington. The federal government holds an almost 80 percent equity stake in the far-flung enterprise after pumping in about $182 billion to keep it solvent, mostly in the form of loans and asset purchases.

The near-collapse of AIG and its rescue through the use of the Federal Reserve's emergency powers and the special $700 billion financial sector bailout law enacted last October illustrate exactly why Congress and the Obama administration are preparing to engage in a difficult debate over sweeping changes in the structure and approach of U.S. financial regulation.

Fairly soon, lawmakers in the House and Senate will begin considering proposals to create a new regulator to guard against the next AIG, particularly to provide early warnings about risky behavior at institutions and to rein them in before a crisis develops. The idea is to erect an umbrella of sorts to protect the entire financial system from threats posed either by very large institutions or by large single events, such as the seizing up of the subprime mortgage market. The debate will also confront the largely unregulated world of derivatives trading, hedge funds and other financial activities that operate mostly in the shadows. And it will elevate the concerns of consumers and ordinary investors, many of whom complain that they have been lost, overlooked or stampeded as Washington has struggled to stabilize credit markets and prevent a wholesale economic catastrophe.

Turning what amounts to a notional discussion that has been building for several years into a law that remakes the regulatory environment from top to bottom is regarded in financial circles as the biggest legislative event in generations. President Obama says he wants a bill on his desk by the end of the year. But that is a tall order, and it may take lawmakers the remainder of the 111th Congress to complete their work. "This is Gramm-Leach-Bliley; this is the Banking Act of 1933," said Scott Talbott, the senior vice president for government affairs at the Financial Services Roundtable, an industry group that counts the most powerful financial institutions among its members. "This is going to talked about for decades to come."

The effort is being compared to the overhaul of financial services that took place in the United Kingdom more than 20 years ago. "The United States has never attempted a wholesale reformation of the entire regulatory system comparable to the 1986 ‘Big Bang,' " the Congressional Research Service said in a March report.

But while the restructuring of the U.K.'s regulatory agencies was designed to remove the government's hand from that country's financial system to boost its position in international markets, the intent of the current U.S. effort is largely to strengthen the grip of regulators.

Up to this point, the Obama administration has driven the conversation. By producing outlines of the general concepts that a regulatory overhaul should address, by sending actual legislative language to Capitol Hill on some aspects and by floating broad ideas on others, the administration has spent the past few months probing Congress and attempting to find a path forward.

Included in the detailed legislative proposals that have been released by Treasury Secretary Timothy F. Geithner are ways to allow the federal government to "wind down" systemically risky non-bank institutions and to begin refashioning those financial entities that currently exist beyond the purview of regulators — principally the enormous and complicated derivatives market and large investment pools such as hedge funds and private equity firms.

Some of the ideas have been fleeting, while others seem more concrete. "The proposals are coming one a day at this point," said Alan S. Blinder, a Princeton University economics professor and former vice chairman of the Fed, in an interview. "So, I don't know whether it's a real proposal or a trial balloon." With the testing almost over, the administration has circulated the major tenets of its proposal on Capitol Hill over the past two weeks. Among them are the designation of the Fed in the role of systemic-risk overseer and the creation of a consumer protection agency of sorts for financial products.

But while putting down a solid marker, the administration hasn't cleared up all major questions about how it wants to impose new constraints on financial industry players that many critics complain have engaged in transactions beyond their means for much of the past decade.

The financial system is generally regarded as stabler today than it was nine months ago, when George W. Bush administration Treasury Secretary Henry M. Paulson Jr. and Fed Chairman Ben S. Bernanke warned of an imminent meltdown.

For advocates of an overhaul of the regulatory structure, the improved condition of the industry makes their efforts more timely — because the crisis has somewhat abated — and more urgent before the reasons to act disappear from memory. But the size and scope of the legislation that lawmakers are attempting to write makes their success far from a sure thing.

"The devil is in the details," said Christopher J. Dodd, chairman of the Senate Banking Committee and a central actor in the legislative drama to come, in comments to reporters last month.

Those details, which range from setting capital and liquidity levels for all types of financial institutions to cracking down on credit rating agencies and mortgage lenders, are attracting the attention of lawmakers, economists and industry representatives alike — most of whom will attempt to sway the direction of the legislative debate.

"Good new regulation will be helpful, but it's so complex, and there are so many issues to be decided, I don't expect that will happen in the next few months," Bernanke told Congress in May. "I'm sure it's going to take a while for Congress to come to a satisfactory agreement on this."

No More AIGs
"Systemic risk" is a buzz phrase that has taken hold on Capitol Hill, generally in reference to the sort of calamity that befell financial markets in the past two years — and particularly the threat posed by the failure of a huge institution like AIG.

While many people may assume that the federal government had no regulatory interest in AIG — hence its seemingly sudden and spectacular fall — the company had for several years been under the scrutiny of the Treasury Department's Office of Thrift Supervision (OTS). But this relatively small agency, which few people have probably heard of and which by its own admission overlooked the most severe threats to the company's survival, was unprepared for the task that it was assigned. OTS was handed this responsibility — and beyond that became the lead international supervisor of AIG — when the company opened a small federal savings bank in May 2000 as part of its diversified insurance and related activities. OTS has roughly 1,000 employees and a yearly budget of $250 million, to supervise about 800 savings and loan institutions that have combined assets of roughly $1.2 trillion. But while AIG's thrift is smaller than average, the consolidated enterprise had about $1 trillion in assets all to itself.

Stretched by the sheer size of AIG's enterprise, OTS admittedly missed the dangerous mechanics of a specific unit, AIG Financial Products, which played a critical role in the company's complicated and ultimately near-fatal investments. That unit proved to be AIG's undoing and pushed the financial system to the precipice — the very definition of a systemic risk.

In one way or another, the idea of a new regulator to guard against such broad threats will serve as the core for whatever bill might be sent to Obama. But how such a regulator might be structured and what powers it might possess tend to be different for everyone who thinks about it.

"At minimum it's a regulator that is charged with looking at the entire spectrum of the financial system," said Blinder, who has taken a role as an adviser to both Obama and House Democrats in recent months. "It will be a place where information is merged, where someone would have known how many junky mortgages were being given out, even though a lot of them weren't coming from banks . . . where someone would have known the risk concentration that AIG was piling up in the Financial Products division."

Early sketches of the administration's proposal had the Fed acting in this capacity as a sort of "super-regulator," an idea first broached by Paulson more than a year ago.

In that role, the Fed would probably have unfettered access to company and market information, allowing it to identify and squash threats to the health of the system before they led to actual adverse effects. Supporters of this idea cite the fact that financial institutions routinely engage in a form of regulatory arbitrage. One example is AIG creating a savings bank that put it under the supervision of OTS, rather than a commercial bank that would have given the Fed a look at its books.

But the latest proposals have scaled back the Fed's role somewhat to have it operate more in the capacity of an "umbrella overseer" than a super-regulator. Either way, as the current lender of last resort for the financial system, the central bank is well-positioned to gauge the systemic risk of market players, say Blinder and other supporters of an enhanced role for the Fed. Likewise, many in Congress and in the banking industry agree that the Fed is the only viable choice for the single regulator of systemic risk.

At the same time, the amount of new work that would fall on the central bank raises concerns.

A systemic-risk regulator would almost certainly have new authority to monitor the activities of private equity firms and hedge funds, not to mention insurance companies, whose holdings rival those of the nation's banks. Overhaul regulation of the insurance industry alone would be a major undertaking — and a first for the federal government — but on the heels of AIG's collapse, that may be a primary component of the systemic-risk debate.

Putting the insurance industry under the Fed's supervision has given pause to many Republicans, and to some Democrats, who are both wary of increasing the central's bank's responsibilities and concerned that it hasn't done the best job in its currently delegated role as the primary regulator of bank holding companies. Handing the Fed new obligations might also hamper its work as the nation's manager of monetary policy, with the twin responsibilities of holding inflation in check and promoting maximum employment.

"I hope we don't go to giving authorities to either the Fed or anybody else which I don't actually think are capable of being achieved," said former Fed Chairman Alan Greenspan in an interview. "I'm fearful that we're putting too much power into people's hands to do things they cannot do."

As concern rises over giving only the Fed this role, other ideas have gained steam. For example, the heads of the Securities and Exchange Commission and the Federal Deposit Insurance Corporation are pushing for creation of a systemic-risk council — in which they would presumably participate — instead of a single regulator. Republican Sen. Susan Collins of Maine has introduced legislation to create such a council, and Dodd has said he is open to the idea.

Likewise, industry groups that generally support the Fed in the role of a systemic-risk regulator have hedged their bets and proposed that the new position be made part of a broader council of regulators.

"There are limits on how much regulatory change can be undertaken and implemented, particularly in the middle of a crisis," wrote Edward L. Yingling, president of the American Bankers Association, in a May 28 letter to Geithner that argued for both building on existing regulatory mechanisms and designating the Fed either as the sole systemic regulator "or as the lead regulator."

Shining Light in the Shadows
It wasn't clear, even to those regulators who were paying attention, just how much risk AIG posed until it was too late. In large part, that's because OTS had only a small window on the company's ballooning investment in complicated financial instruments called credit default swaps.

These were often characterized as little more than insurance contracts — which is why AIG got in the business — that pay out if a third party defaults on an obligation. But they are traded in private transactions between parties rather than on an open exchange, which means there is no simple way to price them. In testimony to Congress three months ago, the acting director of OTS, Scott M. Polakoff, conceded that his agency "did not foresee the extent of the risk concentration and the profound systemic impact" caused by AIG's $65 billion in credit default swaps.

The problem wasn't limited to AIG. Credit default swaps and other types of financial derivative contracts became a blockbuster industry in recent years, but they helped fuel the bust when some of the most legendary Wall Street firms were unable to meet their obligations. Often, the extent of company losses came largely as a surprise to their stock and bond holders and to the regulators charged with monitoring their performance.

That surprise factor is largely what's driving momentum for rules that would bring more transparency to the financial system overall, both in the trading of derivatives, which until now have been largely outside the purview of regulators, and in the operation of entities such as hedge funds and private equity firms that invest amounts large enough to pose systemic risk without any required public disclosure.

Particularly when it comes to derivatives, the Obama administration and Congress have started taking early steps toward requiring more disclosure. In May, Geithner released administration plans that called for requiring over-the-counter derivatives to be traded on open exchanges. He also laid out several principles he would like to see in legislation, including capital requirements for parties involved in the trades.

Some members of Congress say legislation needs to be even more restrictive than the administration has proposed.

"I would say that much of what we've seen in the past eight months is not speculative," New York Democrat Eric Massa told financial industry representatives during a February House Agriculture Committee hearing on the derivatives market. "It's either unethical, immoral, destructive or, in fact, criminal. And if it's not criminal, it should be."

The industry, meanwhile, is doing its best to stave off the furthest-reaching requirements with a strong lobbying effort and proposals for self-regulation. Large banks, many of which rely heavily on the derivatives business, have started circulating plans that would establish central clearinghouses and increased reporting requirements for certain derivatives transactions.

Other lobbyists, meanwhile, have launched a public relations offensive to promote the legitimate side of the over-the-counter derivatives market. "OTC derivatives serve a very valuable purpose," said Robert G. Pickel, chief executive of the International Swaps and Derivatives Association. "They allow companies to manage risks like interest rate risk, foreign exchange risk, commodity price risk and credit risk."

Unmasking Hedge Funds
As lawmakers ponder raising public disclosure of such transactions, they're also considering making entire institutions more transparent. Congress and the administration are poised to open the doors for regulators to peer into the inner workings of certain hedge funds and private equity firms.

Hedge funds essentially amount to unregulated mutual funds for extremely wealthy investors. Though generally subject to securities laws — which is why the SEC has sued the managers of two failed hedge funds that were operated by the investment bank Bear Stearns Cos. — these funds typically aren't required to report much information to regulators.

A panel of five of the most prominent hedge fund managers in the world, including George Soros, chairman of Soros Fund Management, told a House committee last year that the time was right for some type of oversight to be extended to their industry. But the degree of that oversight will be a major point of contention. Hedge funds largely avoid the regulatory eyes of the SEC because they are allowed to accept money only from investors with at least $1 million in assets. That in itself, some argue, should keep the funds outside the regulatory scope. But due to the sheer size of some of these funds — the largest have been estimated in the tens of billions of dollars — the failure of just one might put the whole system in jeopardy.

That's what happened in 1998, when the Fed was forced to supervise a bailout of Long-Term Capital Management, a hedge fund that imploded over the course of a few weeks when its trading strategies backfired.

The Federal Reserve Bank of New York engineered a privately financed rescue of that fund, which though worth only an estimated $4 billion in assets was on the hook for as much as $100 billion in securities holdings. The fund didn't collapse, and the market was largely unaffected after the initial shock. But fears about the possibility that such a large and interconnected hedge fund might fail have lingered in the decade since.

Several proposals are now being discussed in Congress. They include a bipartisan House measure that would require hedge funds with more than $25 million in client investments to register as investment advisers with the SEC, and a similar Senate bill with a $50 million threshold.

Others have locked onto the idea of limiting the leverage positions of particular funds.

Some form of hedge fund registration is likely to find its way into any broad regulatory measure that makes it through Congress, and Geithner made very clear during a March 26 House Financial Services Committee hearing that the administration wants to bring them under some regulator's purview.

"If an entity that is not now a bank were to rise to the point in the future where, because of its structure, because of how connected it is to the system, because of its relationships . . . it could pose systemic risk, then, in our judgment, they should be brought within a framework similar to what we're going to impose on large, complex, regulated financial institutions," he told panel members. "That means a fully elaborated set of capital requirements, requirements on liquidity, on risk management that are applied and enforced on a consolidated basis by a competent authority."

Hedge funds themselves, meanwhile, say they are amenable to a limited sort of increased transparency. But they promise to vigorously oppose rules that would require them to disclose trading secrets, such as how many shares of stock they have borrowed and sold, hoping the share price will fall and they can profit on the difference.

"Much of our work has its value in its intellectual contents and reverse engineering," said Richard H. Baker, a former House Republican from Louisiana and president of the Managed Funds Association. "You would be requiring us to disclose our Church's fried chicken or Popeye's fried chicken recipe to Colonel Sanders."

Protecting Consumers, Shareholders
It may have been AIG's enormous portfolio of seemingly worthless credit default swaps that swamped the company's balance sheet. But the fact that AIG is today a household name probably has more to do with the million-dollar bonuses paid to executives at AIG's Financial Products division.

After the Fed and the Treasury fronted tens of billions of dollars to keep the company in business, it was revealed in March that employees in the same division that made most of AIG's riskiest investments were in line to receive a total of $165 million in retention bonuses. That sparked a public outcry, and ultimately many recipients of the biggest checks returned the money.

The incident served only to feed the growing sense that the existing regulatory structure protects big institutions while doing little to shield consumers, shareholders and taxpayers from the worst forms of corporate excess. And that's why any regulatory overhaul bill sent to the White House is likely to include an emphasis on both consumer rights and investor protections — and new limits on what corporate executives can be paid.

In the wake of the financial crisis, the role of shareholders, especially, is taking on new importance. A continued flow of willing investors is seen as a critical component to the economy's recovery. For instance, the Fed and Treasury are requiring large banks and other institutions that received bailout assistance from the $700 billion Troubled Asset Relief Program to raise additional capital through stock sales before they pay back the taxpayer assistance that kept them alive so far. House Financial Services Chairman Barney Frank, the Massachusetts Democrat who is a driving force behind the demand for a sweeping regulatory overhaul, has said language addressing executive compensation will be in any legislation his committee produces. Frank's bill will probably tie pay for senior officials to the overall health of a company and not to short-term profit goals, which is often the case today.

"We have to change the heads-I-win, tails-I-break-even way that executive pay works now," Frank said.

New York Democrat Charles E. Schumer, a senior member of the Senate Banking panel, has begun a push to require shareholder votes on procedures for setting pay for company executives. Such votes would be advisory to corporate boards of directors, but would still give shareholders a sense of participation in pay decisions. Schumer also would require separate high-level advisory committees to monitor a company's risk-management practices.

Consumer Protections
More broadly, the administration and members of Congress are considering creation of a separate regulatory entity to consolidate rules designed to protect consumers of financial services, including mortgages, mutual funds, credit cards and more-complex products such as derivatives. The sense is that the current patchwork of regulators, which includes the Fed, the SEC and some other banking regulators, has allowed consumers to slip through the cracks.

The idea is largely the brainchild of Harvard Law School professor Elizabeth Warren, who heads a congressionally appointed panel responsible for oversight of the Treasury's TARP program. It has broad support from Democrats in both chambers, and bills to establish such a consumer protection commission have been introduced in the House and Senate.

Warren, an expert in bankruptcy, has long been a strong voice for consumer protection, and, with support from Obama, many of her proposals have gained traction in recent months. Most prominent of those has been the consumer commission idea.

"It is impossible to buy a toaster that has a one-in-five chance of bursting into flames and burning down your house, but it is possible to refinance an existing home with a mortgage that has the same one-in-five chance of putting the family out on the street," Warren told reporters on Capitol Hill in March. "And the mortgage won't even carry a disclosure of that fact to the homeowner."

As far as the big decisions facing Congress this year go, there appears to be more agreement on the major elements of a financial regulatory overhaul than on health care or climate change legislation. Most participants and observers, lawmakers and industry representatives alike, say some piece of legislation will reach Obama's desk by the end of 2009.

"There is a much broader consensus right now on financial regulation than on many other very major issues," Schumer said. But getting from here to there may be a struggle.

"The challenges will be separating the politics — and the personalities — from the policy," said the Financial Services Roundtable's Talbott.

In the House, Republicans on the Financial Services Committee have come out with their own proposals that would give less power to the Fed and push systemically risky institutions to unwind their investments through the bankruptcy process.

But those efforts are likely to amount to little more than a political statement. Frank has made no secret that he will be holding committee action to draft a bill as early as the end of this month — with or without the support of his GOP colleagues.

The stumbling block, if there is one, is likely be the Senate, where the simple mechanics make passage of any major piece of legislation a delicate process, even when taking into account the majority currently held by the Democratic Party.

Dodd faces significant difficulties in getting his own party in line behind a bill, said Sam Geduldig, a lobbyist at Clark, Lytle and Geduldig. "There's just so many different political aspects to consider, even within the Democratic caucus," said Geduldig, who was previously a top aide to House Republican Whip Roy Blunt of Missouri. "It's like Whac-A-Mole: Once you think you take care of one problem, you create four others. There are just so many areas that will be problematic." Some Senate Democrats are unlikely to be lock-step supporters of regulatory overhaul proposals, because their states are home to big banking enterprises. They include Thomas R. Carper and Ted Kaufman of Delaware and South Dakota's Tim Johnson.

Dodd himself represents a state that is a hub for the hedge fund and private equity industries, as well as other financial companies, and he predicts that the issue will move forward at a deliberate pace.

"Most of our colleagues, I sense, are sort of agnostic at least in terms of ideology with this question," Dodd said. "We all want to do what works, but we realize we're doing something that hasn't really been done for almost 70 years, and that is to really look at the regulatory structure and the architecture of financial services, and so we're proceeding with caution and listening to a lot of people who are very knowledgeable about what this architecture ought to look like." Overhaul proponents agree that any legislation should be carefully crafted. But they warn that it's important to act before the lessons of AIG and the financial crisis of 2008 fade.

"It's not the end of the world that this process isn't going to be a stampede; this stuff ought to be thoroughly debated and deliberated," said Robert E. Litan, a senior fellow at the Brookings Institution and a longtime industry observer. "On the other hand, I think it would be a shame if this thing takes two years."

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