Wednesday, January 26, 2011

Key Witness Urges Congress to Fund SEC to Properly Implement the Dodd-Frank Act, While Urging Legislative Changes to D-F

It is unwise to cut the budgets of the SEC and other federal financial regulators in an attempt to control or derail the regulatory reforms prompted by Dodd-Frank, said Hal Scott, Chairman of the Committee of Capital Markets Regulation, in testimony before the House Financial Services Committee. Tightening the purse strings will not stop the rulemaking process, he emphasized, it will only make it worse. Independent agencies deprived of funds will not stop writing rules, he noted, they will only do a worse job or shift resources from other important areas such as enforcement. That said, the Chair agreed with some members of Congress that there are major problems with the implementation of Dodd-Frank, but that they should be fixed through legislation and oversight, not through withholding funds in the appropriations process.

Professor Scott recommended major legislative changes to Dodd-Frank involving proprietary trading under the Volcker provisions, funding for the Bureau of Consumer Financial Protection, and the ban on the use of credit ratings in adopting regulations. More broadly, he also called for the fundamental structural reform of the regulatory system, beyond the creation of the Financial Stability Oversight Council.

The Volcker Rule, codified in Section 619 of Dodd-Frank, prohibits financial institutions from engaging in proprietary trading. Restrictions on proprietary trading are both over- and under-inclusive, said the Chair, over-inclusive because not all banks engage in proprietary trading contributing to systemic risk, and under-inclusive because some non-banks engaged in proprietary trading that may contribute to systemic risk.

He urged regulators to define ``proprietary trading’’ narrowly and then broadly define the various exceptions, such as market making. Also, the definition should be limited to trading activities set up with segregated capital and separate teams of personnel that do not interact with customer businesses or rely on customer deposits.

While Dodd-Frank requires federal agencies to purge from regulations any reference to or requirement of reliance on credit ratings, the Act provides no solution as to what should replace reliance on these ratings beyond calling for uniform standards of creditworthiness for use by each such agency. Professor Scott noted that many important regulations like capital requirements and those of the Investment Company Act rely heavily on credit ratings.

He urged both short and long term action by Congress to correct this problem. In the short term, the Act should be amended to allow the use of credit ratings but forbid undue reliance on them. Although this approach may still give too much influence to the ratings agencies, he conceded, it will give the regulators more flexibility and discretion than an absolute prohibition while the regulators, Congress, and the public determine how to replace credit ratings.

In the longer term, the Congress can explore alternatives. One alternative might be to create a Credit Assessment Panel composed of not only rating agencies, but also other expert firms, like PIMCO, that already provide credit analysis to private financial firms. Each member of the Panel would evaluate creditworthiness using its own proprietary methodology but would provide credit assessments in a standardized format. The government could then use each firm’s contribution in forming a composite assessment. The government itself would be prohibited from devising its own ratings, he noted, and would have to rely exclusively on the input from the Panel. The Panel members would have to be compensated, which he acknowledged would be a major challenge of this approach. In principle, beneficiaries could be charged a fee.

Under Dodd-Frank, the Bureau of Consumer Financial Protection is funded from the profits of the Federal Reserve. The Bureau receives whatever amount its Director determines is reasonably necessary to carry out its authorities, subject to a cap of about $550 million. In Professor Scott’s view, funding the Bureau through Fed profits is problematic because it sets a bad precedent for appropriating Federal Reserve profits to particular budgetary needs. Budgetary determinations should be made through the normal appropriation process, he said, where justification is required.

In 2009, the Committee on Capital Markets Regulation called for the reorganization of the U.S. regulatory structure, calling it “an outmoded, overlapping sectoral model.” According to Professor Scott, the Dodd-Frank Act has not rectified the problem. Urging Congress to make real structural reform a top priority, the Chair said that regulation of the U.S. financial system should be concentrated in no more than three federal regulatory bodies.

Although the Financial Stability Oversight Council has been tasked with some oversight and coordination roles, he noted, it is not a real solution to the fragmented regulatory structure. First, it has little direct supervisory authority since authority remains dispersed among the other agencies. For example, although it has the authority to designate nonbank financial institutions as systemically important, Dodd-Frank places enhanced supervisory authority in the hands of the Federal Reserve. FSOC can make recommendations to the Federal Reserve, but cannot force it to act. Similarly, it can resolve some disputes among agencies, but its recommendations are generally nonbinding. In addition, the two-thirds supermajority vote for many of its actions may be difficult to achieve.

No comments: