Legislation Reforming Financial Regulation Will be Dual Tracked for Systemic Risk and Investor Protection

Congress plans to complete the reform of regulation of the financial markets this year in two separate steps involving the regulation of systemic risk and restoring investor confidence. In order to enhance investor protection, the powers of the SEC and the CFTC will be strengthened, with a merger of the agencies placed on the back burner. This was the message delivered by Barney Frank, Chair of the House Financial Services Committee. While Congress will coordinate the reform legislation with the European Union and other jurisdictions, said the chair, there is no supranational plan on the agenda and nobody is going to ignore sovereignty. That said, it is also essential to prevent regulatory arbitrage. Thus, for example, there will be cooperation with the EU to produce similar regulation.

Currently, said the chair, there is a serious problem with investors afraid to put money in the financial markets. Reform of regulation must give the investor some confidence, both in systemic risk and investor protection. So, everything is going to be included, which means the systemic risk regulator will be regulating any financial activity that could cause a problem. It is not going to be by institution.

Legislation creating a systemic risk regulator will be moved first. This legislation will likely have a number of components, including hedge fund regulation, the regulation of credit default swaps and other derivatives, as well as the reform of executive compensation to delink excessive risk taking from compensation.

The legislation will reform the securitization process so that it can again play a useful role in the financial system by allowing money to circulate more quickly. This conforms to the overwhelming consensus in the US and Europe that there will be no return to an originate and hold model. The reform will put in place a regulator that can prevent irresponsible loans from being distributed throughout the financial system. Regulators will also be empowered to restrain irresponsible risk taking.

In order to restore the discipline of the lender-borrower relationship that was substantially weakened by securitization, the legislation will make it illegal for anybody to securitize 100 percent of anything. The exact percentage of retention is open for debate, said the oversight chair, but whatever percentage Congress decides to allow must follow the principle that the first dollar of loss is borne by the securitizer. This principle is correct, he reasoned, because securitizers are the ones who have to do some checking. But some liability will also be put on the originators.

The systemic risk regulator will be given some powers that neither the SEC nor the CFTC fully have right now. Undoubtedly, there will be a great deal of overlap between systemic risk and market integrity and investor protection, which are the primary roles for the SEC and the CFTC. Both the SEC and CFTC will be strengthened in their ability to protect investors and market integrity and another entity will be given the role of systemic risk protection. At this point, said Mr. Frank, a reallocation of existing power between the SEC and CFTC is not on the agenda. Congress will give them new powers and strengthen both of them.

The systemic risk regulator will also be empowered to stop people from getting over-leveraged, from getting so indebted that they can not pay their debts. There will also be authority to orderly unwind failed financial institutions in ways that do not make it a choice of either total bankruptcy or paying off everybody's debts.

A separate component of the first piece of legislation will be the reform of executive compensation. The reform will not impose a cap on the overall dollar amount of compensation, said Rep. Frank, but will eliminate perverse compensation incentives that encouraged excessive risk taking. There is a consensus that too much executive compensation took the form of people making extra money if a bet paid off and losing nothing if the bet disastrously failed. So there was an incentive to take too much risk, what the chair referred to as a kind of "heads, I win, tails, I break even," so you keep flipping the coin

The second piece of legislation will revisit is the notion of investor protection. As part of that effort, Congress will reexamine the idea that sophisticated investors do not need the protection of the federal securities laws. The theory that if you had at least $1 million to invest in a hedge fund you were smart enough and sophisticated enough to take care of yourself is debunked by the Madoff investors and investors in auction-rate securities, he averred. It has become clear that investor protection must be greatly enhanced, including protecting pension funds. This will all be out in one legislative package, separate from the systemic risk legislation, although related.

Regarding fair value mark-to-market accounting, Chairman Frank does not believe that Congress should legislate accounting standards. But he would like regulators to show some discretion when reacting to a mark down to market. He wants to see some flexibility in the application of mark-to-market. The elimination of fair value accounting is not going to happen, he noted, since that would receive a negative response from investors.