Financial Regulation

Financial Regulatory Reform. Is this all there is?

The proposed changes to financial regulation announced by President Obama on June 17th are significant, but somewhat less aggressive than I had expected given that this is supposed to be that once in a lifetime opportunity to reform financial regulation. The following are the highlights of the announcement.

1. Regulators will look at the financial system as a whole, not simply at individual institutions, to avoid a replay of the current situation. As expected the Federal Reserve will be charged with regulating systemic risk. Moreover to ensure that there are no gaps in regulation and also to facilitate oversight of the entire financial system a new organization, the Financial Services Oversight Council, will be established. Chaired by the Secretary of the Treasury, it will include the heads of all financial industry and market regulators.
   
   
   
   
2. A new regulatory agency will be established to look after the consumers’ interests in the financial markets. The Consumer Financial Protection Agency will be akin to a Consumer Products Safety Commission for financial instruments including mortgages.
   
   
   
   
3. Simplification of regulatory agency structure falls short of resolving the current labyrinth of regulatory agencies and responsibilities. One positive development is that the Office of Thrift Supervision is no more. Its responsibilities will be merged with those of the Controller of the Currency into a new agency, The National Bank Supervisor. This reflects the end of thrift charters; all federally chartered depository institutions will be banks. However the CFTC will continue to be an independent agency rather than merged with the SEC as many observers had expected. The historical and arcane distinction between contracts, as in futures contracts, and securities will prevail for no particularly compelling reason that I can discern. To make it interesting both agencies will be given enhanced authority to regulate derivatives.
   
   
   
   
4. The Federal Reserve wins a little and loses a little. On the plus side it gets to oversee all large institutions whose failure could jeopardize the stability of the financial system. On the negative side some of the authority that will go to the Consumer Financial Protection Agency had belonged to the Fed.
   
   
   
   
5. Hedge funds exceeding a to be specified size threshold will be required to register with the SEC, and with registration comes the requirement to open your books to the regulator. Surprisingly expanded registration will also be extended to private equity and venture capital firms.
   
   
   

There are also a substantial number of less dramatic but equally important provisions contained in the proposed regulatory reforms. One that I particularly like would give the SEC the authority to require a company to allow shareholders to vote on executive compensation packages. Opponents of the governments’ potential involvement in compensation guidelines have argued that this is the responsibility of shareholders knowing full well that shareholders have no real authority in this area. Now they will (or more accurately, might).

Another interesting provision will require the issuing institution to retain 5% of the loans in a pool underlying a securitized debt issue. This is less than the 20% that had been suggested by some European regulators, but probably still a sufficient amount to provide more discipline to the securitized debt market. A 20% requirement might well have been tantamount to ending that market.

Unfortunately the rating agencies come in for little attention. There is mention made of addressing compensation arrangements to avoid conflicts of interest. The brief mention of this topic relative to other areas leaves the impression that it is not a major priority. Equally puzzling is the lack of recognition that the supervisory process is broken. Although there are loopholes in regulation, if supervisors had been doing their jobs it is unlikely that we would gotten into all the difficulties we did. New regulations and regulatory structure is one thing and robust enforcement is another.

These proposals will have to be approved by Congress, which will no doubt be assaulted by the lobbying efforts of the financial industry, one of the most powerful lobbying organizations in the country and certainly one of the wealthiest. I still expect the outcome will retain much of the overall reach of these proposals because at least for now there appears to be widespread support for regulatory reform. But as the saying goes the devil is in the details. Certain trends reflected in these proposals seem unstoppable including greater oversight of the entire financial system, not just the component parts, more consumer protection and greater transparency and reporting.

Ben Wolkowitz Headstrong June 18, 2009