Thursday, May 28, 2009

Committee on Capital Markets Regulation Issues Broad Reform Framework Centered on Unitary Regulator

The blue ribbon Committee on Capital Markets Regulation has recommended a consolidated unitary regulator approach for the US, modeled on the UK Financial Services Authority, plus naming the Federal Reserve Board as systemic risk regulator. The Committee urged the creation of the US Financial Services Authority (USFSA) with jurisdiction over market structure and activities, safety and soundness of financial institutions, and possibly consumer and investor protection with respect to financial products. The USFSA would be comprised of the OCC, FDIC, SEC CFTC, and the OTS.

The Committee noted that the vast majority of other leading financial center countries have moved toward more consolidated financial oversight. A rapidly dwindling share of the world’s financial markets are supervised under the fragmented, sectoral model still employed by the United States.

The Committee also proposed that the Fed be given the role of systemic risk regulator, in addition to keeping jurisdiction over monetary policy. The committee offered the alternative recommendation of a third independent agency to separately regulate investor protection, which has the advantage of ensuring a sole mission focus on investor protection. The disadvantage of such an agency would be that it would not effectively weigh competing policy interests. In addition, it would be difficult to coordinate the inevitable conflicts between prudential regulation and consumer and investor protection.

The Committee on Capital Markets Regulation is co-chaired by Glenn Hubbard and John Thornton. Other members of the Committee are former SEC Commissioner Roel Campos, former NASD CEO Robert Glauber, CBOE CEO William Brodsky, and PricewaterhouseCoopers CEO Samuel DiPiazza.

The Treasury Department would coordinate the work of the Fed and USFSA. The Treasury would also be responsible for the expenditure of public funds used to provide support to the financial sector, as in the TARP. In addition, to preserve the independence and credibility of the Fed, existing Fed lending against no or inadequate collateral would be transferred to the Treasury, and future lending of this type would be done only by the Treasury Department.

The Committee believes that one regulator needs the authority and accountability to regulate matters pertaining to systemic risk. As such, the Committee rejected current proposals in Congress and elsewhere to vest systemic risk regulation in an interagency council comprising several existing regulatory agencies. As the systemic risk regulator, the Fed would set capital requirements for all financial institutions. Other types of regulation that directly bear on systemic risk, like margin requirements, would also be entrusted to the Fed.

The Committee presented three options for regulating financial institutions: 1) The Fed regulates systemically important financial institutions, and the USFSA regulates all the others; 2) the Fed regulates all financial institutions; 3) the USFSA regulates all financial institutions. Whatever framework is chosen, the committee does not believe that the regulation of holding companies should be split from the regulation of their financial institution subsidiaries. The same agency that supervises the holding company should also supervise the subsidiaries. Also, the determination of whether an entity is systemically important should be made on the basis of the fully consolidated holding company.

Hedge funds would be subject to federal regulation under the proposed scheme, but private equity firms would not. Hedge funds should keep regulators informed on an ongoing basis of their activities and leverage. Private equity, however, in the view of the Committee, poses no more risk to the financial system than do other investors. But private equity firms, if large enough, should be subject to some regulatory oversight and periodically share information with regulators to confirm they are engaged only in the private equity business.

Under existing SEC regulation AB addressing disclosure in connection with asset-backed securities dealers issuing mortgage-backed securities may, but are not required to, provide granular loan-level data regarding the underlying mortgages. Based on empirical research, the Committee concluded that Regulation AB should be amended to require issuers of mortgage-backed securities to provide loan-level data. The SEC should set forth in its regulation the particular field of loan-level data that must be disclosed. This should be largely based on investor demand and inputs. The SEC should also immediately initiate a study to refine the standardized list of residential mortgage-backed securities pool data required at inception and on an ongoing basis. This additional information would not only benefit investors in such securities, but also investors in collateralized debt obligations predicated on mortgage-backed securities.

Because the enhanced disclosures would be useful only to the extent they are actually made, the Committee encouraged the SEC to consider whether the less-than-300-holder exemption from the periodic reporting requirements of Section 15(d) of the Exchange Act was meant to apply to the typical residential mortgage-backed securities issuance otherwise covered by Regulation AB. If so, the Commission should seek a statutory change to remedy this problem.

Regarding hedge fund regulation, at least one proposal presently before Congress, The Hedge Fund Transparency Act of 2009, would eliminate current statutory exemptions and impose SEC registration and periodic disclosure requirements on hedge funds. The committee seriously doubts that the passage of this legislation would help reduce systemic risk, noting that the enormity of daily trading activity alone makes periodic disclosure a futile method for gauging the risks posed by individual hedge funds at any given moment At best, such historical information would be useless; at worst it would be misleading. The Committee believes that strengthening SEC resources for greater investigatory and enforcement work is a better-tailored solution.

Instead, the Committee proposes requiring hedge funds to confidentially report to regulators information such as fund’s total assets under management, relative measures of leverage, portfolio holdings, and list of credit counterparties. The Treasury recently recommended that newly-regulated hedge funds be required to report to the SEC on a confidential basis information necessary to assess whether a particular fund or fund family is so large or highly-levered that it poses a threat to financial stability. This information would be shared with a systemic risk regulator, which would then determine whether a given hedge fund should be subject to certain prudential standards. At this time, Treasury has not offered any specifics as to what information would be required to be disclosed confidentially.

The Committee also recommends supplementing fair value accounting with a dual presentation of market and credit values. The Committee believes that FASB should supplement the fair value standard outlined in FAS 157-4 by requiring preparers to disclose two additional balance sheet presentations that would enable investors to distinguish the influence of market and credit value inputs more explicitly.