By James Hamilton, J.D., LL.M.
As the nation approaches the most fundamental reform of federal regulation of the financial and securities markets since President Franklin Roosevelt’s New Deal, the most central personality to the effort will obviously be President Barack Obama. It is thus instructive to examine the six key principles that must guide next year’s reform legislation, which are contained in a briefing paper setting out Mr. Obama’s beliefs in this area. Obviously, events can work changes during the interregnum before Mr. Obama is sworn in as President next January. I recall from history that conditions deteriorated significantly during the President Hoover-President Roosevelt interregnum, which was longer because FDR was not sworn in until March of 1933. We are perhaps fortunate that this experience led to the shortening of the presidential interregnum so that the needed reform process can begin sooner.
A first broad principle enunciated by the President-elect is that the nation must devise a financial regulatory regime for the 21st century to replace one that is still essentially a 1930s regulatory apparatus. This means first and foremost ending the current balkanized framework of overlapping and competing regulatory agencies. Prior to the 1999 repeal of the Glass-Steagall Act, financial institutions fell into easily delineated categories such as commercial banks and investment banks and were regulated by specific entities such as the SEC, the FDIC and the CFTC. However, the large, complex institutions that currently dominate the financial landscape no longer fit into discrete categories. Thus, President- elect Obama endorses a streamlined system of federal oversight.
A second principle is that the Fed must have authority over any financial institution to which it may make credit available as a lendor of last resort. The Federal Reserve does not exist to bail out financial institutions, declared the President-elect, but rather to ensure stability in the financial markets. There must be prudential oversight commensurate with the degree of exposure of specific financial institutions.
In light of the widespread valuation problems of complex financial instruments such as mortgage-backed securities, a third principle of the Obama reforms will be enhancing capital requirements and the development and rigorous application of new standards for managing liquidity risk. President Obama will also call for an immediate investigation into the ratings agencies and their relationships to securities’ issuers, similar to the investigation the European Union conducted, which led to a proposal to require the registration of credit rating agencies in the EU and the end of voluntary regulation.
A fourth principle is to regulate financial institutions for what they do rather than who they are. The current oversight structure is rooted in the legal status of financial firms. This must end, said the President-elect, since this fragmented structure is incapable of providing the oversight necessary to prevent bubbles and curb abuses. President-elect Obama believes that regulation should identify, disclose, and oversee risky behaviors regardless of what kind of financial institution engages in them. This is essentially a regulation by objective approach favored by many, including the recent Volcker report. Former Fed Chair Paul Volcker is a senior adviser to the President-elect.
Barack Obama also believes, as a fifth principle, that the SEC should aggressively investigate reports of market manipulation and crack down on trading activity that crosses the line to fraudulent manipulation. In the last eight years, the SEC has been sapped of the funding, manpower and technology to provide effective oversight. The SEC’s budget was left flat or declining for three years and is currently less than it was in 2005. The President-elect cited a 2007 GAO report finding that the SEC lacked the computer systems to effectively make use of internal audits conducted by stock exchanges, which may limit the SEC’s ability to monitor unusual market activity, make decisions about opening investigations, and allow management to assess case activities, among other thing.
As a result, during a period of increasing market uncertainty and opacity, the SEC enforcement division has not effectively policed potentially manipulative behavior. The SEC’s FY2009 budget request itself shows that the percentage of first enforcement actions filed within two years of opening an investigation or inquiry fell from 69 percent in 2004 to 54 percent last year. Mr. Obama believes that there must be an effective, functioning cop on the beat to identify market manipulation, protect investors and avoid excessive speculation in financial markets.
More broadly, a sixth principle of financial markets reform is to establish a mechanism that can identify systemic threats to the financial system and effectively address them. The President-elect calls for the creation of a Financial Market Oversight Commission that would meet regularly and report to the President, the President’s Financial Working Group and Congress on the state of the financial markets and the systemic risks that face them. He also calls for the establishment of a standardized process to resolve such systemic risk in an orderly manner without putting taxpayer dollars at risk. This goal may presage the creation of a systemic risk regulator as some congressional leaders are championing.