By James Hamilton, J.D., LL.M.
The Obama Administration has proposed to Congress the most sweeping and fundamental regulatory reform of the US financial and securities markets since President Franklin D. Roosevelt’s New Deal. The overhaul of the US financial system is based on the themes of regulating systemic risk, enhancing transparency and disclosure, delinking executive compensation from excessive risk, expanding investor protection, and preventing regulatory arbitrage.
The Administration has set forth detailed recommendations on the regulation of hedge funds, private equity funds, and OTC derivatives, including credit default swaps, as well as draft legislation on a new resolution authority to unwind failing securities and commodities firms. The Administration also recommends major corporate governance reforms, such as shareholder advisory votes on compensation and enhanced compensation committees. The Administration also envisions a completely reformed securitization process playing an important role in the financial markets. The plan also proposes new authority for the SEC to protect investors, improve disclosure, raise standards and increase enforcement. The SEC would be directed to establish a fiduciary duty for broker-dealers offering investment advice and also harmonize the regulation of investment advisers and broker-dealers.
A new independent regulator, the Consumer Financial Protection Agency, with authority to make sure that consumer protection regulations are written and enforced. The Administration also proposes a new resolution authority to unwind failing securities and commodities firms and bank holding companies.
In a bow to international financial regulatory coordination, the Administration recommends that the Financial Stability Board and national regulators implement the G-20’s commitment to enhance arrangements for international cooperation on the regulation of global financial firms through the establishment of a college of regulators, a concept favored in the European Union.
Guiding Principles
There are a number of key principles that will guide the effort to overhaul the oversight of financial markets. A broad principle 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. A guiding principle is that the Fed must have authority over any financial institution to which it may make credit available as a lender of last resort. The Federal Reserve does not exist to bail out financial institutions, 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, another principle of the Obama reforms is enhancing capital requirements and the development and rigorous application of new standards for managing liquidity risk. A further 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, since this fragmented structure is incapable of providing the oversight necessary to prevent bubbles and curb abuses.
An important principle of financial markets reform is to establish a mechanism that can identify systemic threats to the financial system and effectively address them. Financial regulation should identify, disclose, and oversee risky behavior regardless of what kind of financial institution engages in them. This is essentially a regulation by objective approach. Another core principle is 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.
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. The Administration 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. The President took a step towards enhancing the SEC’s enforcement powers when he recently signed the Fraud Enforcement and Recovery Act (FERA) improving the enforcement of securities and commodities fraud and financial institution fraud involving asset-backed securities and fraud related to federal assistance and relief programs. The measure also authorizes additional appropriations for the SEC and other federal agencies to investigate and prosecute fraud. See related white paper on the Fraud Enforcement and Recovery Act.
Another element of reform is the need to remove negative incentives for regulators to compete against each other for clients by weakening regulation. The new financial regulatory system cannot encourage regulatory arbitrage, charter-shopping or a regulatory race to the bottom in an attempt to win over institutions. Regulators should not have to fear losing institutions, and thus the source of their funding, by being good cops on the beat.
Reform legislation must also ensure that regulators are aware of risks that the institutions they supervise are taking and effectively control them, so that they do not imperil the financial system. All institutions that pose a risk to the financial system must be carefully and sensibly supervised. This responsibility could reside with a single regulator or multiple agencies, but in either case communication and information-sharing among agencies must be streamlined and improved.
Another key principle is the need for more transparency in the financial system. Market participants need information about the risks they are taking. And, it is not acceptable to have regulators in the dark about the risks posed to and by the institutions under their watch.
Another important principle is that investor protection must be placed on an equal footing with regulations ensuring the safety and soundness of the financial system. It is now clear that investor protection and economic growth are not in conflict but, on the contrary, are inextricably linked. The crisis teaches that a failure to protect investors can wreak havoc on the financial system.
Systemic Risk Regulator
The Administration proposes the creation of a regulator to police all systemically important firms and markets as a broad consensus develops on the need for Congress to create a systemic risk regulator. This regulator would be authorized to take proactive steps to prevent or minimize systemic risk. Legislation will seek to guarantee holistic regulation of the financial system as a whole, not just its individual components.
Any financial institution that is big enough, interconnected enough, or risky enough that its distress necessitates government intervention is an institution that necessitates oversight by a federal agency responsible for managing the overall risk to the financial system. In a world where financial innovation is pervasive and where market conditions constantly change, regulators must be authorized to take a holistic view of the playing field, identifying gaps, pointing to unsustainable trends, and raising questions about new kinds of interactions. See remarks of White House economic adviser Lawrence H. Summers at the Council on Foreign Relations.
The financial crisis has demonstrated that large, interconnected financial firms and markets need to be under a more consistent, and more conservative regulatory regime. These standards cannot simply address the soundness of individual institutions, but must also ensure the stability of the system itself.
As financial institutions speculated in increasingly risky products and practices leading to the current crisis, not one federal financial regulator was responsible for detecting and assessing the risk to the system as a whole. The financial sector was gambling on the rise of the housing market, yet no single regulator could see that everyone, from mortgage brokers to credit default swap traders, was betting on a bubble that was about to burst. Instead, each agency viewed its regulated market through a narrow lens, missing the total risk that permeated the financial markets. See . Report of the Committee on Capital Markets Regulation (hereinafter Scott Report).
Thus, the Administration seeks to strengthen the system of prudential regulation across the financial sector. The Administration proposes a single regulator with responsibility for systemic stability over the major institutions and critical payment and settlement systems and activities. Major financial institutions cannot be allowed to choose among consolidated regulatory regimes and regulators or avoid consolidated regulation entirely. The plan would create higher standards for all systemically important financial firms, regardless of whether they own a depository institution, to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy.
In identifying systemically important firms, the Administration believes that the characteristics to be considered should include: the financial system’s interdependence with the firm, the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding, and the importance of the firm as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.
The systemic regulator will also need to impose liquidity, counterparty, and credit risk management requirements that are more stringent than for other financial firms. For instance, the regulator should apply more demanding liquidity constraints; and require that these firms be able to aggregate counterparty risk exposures on an enterprise basis within a matter of hours. The regulator of these entities will also need a prompt, corrective action regime that would allow the regulator to force protective actions as regulatory capital levels decline.
There was a fierce debate over whether the systemic risk regulator should be a single regulator, new or existing, or a council of regulators. The Administration proposes that the Federal Reserve Board should be the macro prudential systemic risk regulator, advised by a Financial Services Oversight Council (FSOC), whose members will include Treasury, the Fed, the SEC, the CFTC, the FDIC, and the Federal Housing Finance Authority.
The Fed will regulate systemically significant financial firms, what the plan calls Tier 1 financial holding companies, including the parent company and all its subsidiaries, foreign or domestic. The FSOC will be authorized to facilitate information sharing and coordination, identify emerging risks, resolve jurisdictional disputes among regulators, and, advise the Fed on identifying firms whose failure could pose a threat to market stability and would qualify as Tier 1 financial holding companies and be subjected to systemic risk regulation.
The FSOC would be authorized to recommend financial firms that would be subject to Tier 1 regulation, but it would be up to the Fed to accept the recommendation. The Fed would be required to consult with the FSOC in developing rules to be used to identify Tier 1 firms and in setting standards for Tier 1 firms. The Fed would also have to consult with the FSOC in setting risk management standards for systemically important activities. Also, a subset of the FSOC would be responsible for determining whether to invoke resolution authority for large, interconnected firms.
In order to identify emerging threats to market stability, the FSOC would also be authorized to require periodic and other reports from any US financial firms solely for the purpose of assessing the extent to which the firm’s activities threaten market stability.
The Fed will be the macro prudential systemic risk regulator for firms whose size, leverage, and interconnectedness could pose a threat to financial stability. In order to do this job properly, the Fed must expend beyond being a safety and soundness regulator to include regulation of the activities of the firm as a whole and the risks the firm poses to the entire market. Obviously, the Fed would have to develop new regulatory approaches to do the job of systemic risk regulator.
Definition of Systemically Significant Financial Firm
Obviously, how Congress defines a systemically important financial institution will be very critical to the scope of the systemic risk regulator’s authority. If the definition is too broad, the systemic risk regulator could usurp the authority of multiple regulators, including the SEC. The systemic risk regulator should not diminish the role of the SEC, since systemic risk should not trump investor protection.
The G-20 noted that, in determining the systemic importance of a financial institution or hedge fund or other entity, the assessment should take into account a wide range of factors, including size, leverage, interconnectedness, and funding mismatches. In addition, the increased integration of markets globally should be taken into account when assessing the systemic importance of any given financial institution, market or instrument given the potential for cross-border contagion.More specifically, the G-20 report listed three key sets of data that regulators should consider in analyzing the potential risks posed. First, data on the nature of a financial institution’s activities should be collected, including, in the example of a hedge fund manager, data on the size, investment style, and linkages to systemically important markets of the funds it manages.
Second, regulators should develop common metrics to assess the significant exposures of counterparties on a group-wide basis, including prime brokers for hedge funds, to identify systemic effects.Third, data on the condition of markets such as measures on the volatility, liquidity and size of markets which are deemed to be systemically important should also be collected. It is envisaged that regulators would use a combination of existing information sources, including data collected from key institutions and vehicles. Consideration of what regulatory, registration or oversight framework would best enable this information collection and subsequent action would be determined by financial regulators.
The Administration wants legislation specifying the factors that must be considered in determining if a financial firm poses a threat to market stability. The factors must include the impact of the firm’s failure on the entire financial system, the firm’s combination of size, leverage, including off-balance sheet exposures, and degree of reliance on short-term funding, and whether the firm is a critical source of credit for households, businesses, and state and local government, as well as a liquidity source for the financial system. This is a non-exclusive list of factors since the Fed would be authorized to consider other relevant factors in identifying a systemically risky firm. Balance sheets should be a factor, but not a determinative factor, else firms would have an incentive to conduct off-balance sheet transactions through off-balance sheet vehicles and we would be right back to firms growing outside the regulatory system.
The Fed, in consult with Treasury, will adopt rules identifying the Tier 1 firms, But Treasury would have no role in applying the rules to individual firms. In order to help the Fed identify firms in need of systemic risk regulation, Congress must authorize the Fed to collect reports from all US financial firms meeting minimum size thresholds.
The Fed should also be given access to reports submitted to the SEC and other financial regulators. The Fed’s authority to require reports and gain access to reports must be limited to those reports that aid in determining if a firm poses systemic risks. The legislation should also authorize the Fed to examine any US financial firm meeting minimum size thresholds if the Fed is unable to determine if the firm poses systemic market risks based on regulatory reports and discussions with the firm’s management. The scope of the Fed’s examination authority would be strictly limited to examinations reasonably necessary to enable the Fed to determine if the firm needs systemic oversight.
The legislation should remove the constraints that the Gramm-Leach Bliley Act imposed on the Fed’s ability to require reports from, examine, or impose higher regulatory standards or more stringent activity restrictions on the functionally regulated subsidiaries of financial holding companies.