House Committee Passes Legislation Regulating Systemic Risk, Reforming Securitization, and Creating a Resolution Process for Failed Financial Firms

The House Financial Services Committee has passed legislation creating a systemic risk regulator, providing for a resolution authority to wind down large interconnected failed financial companies in an orderly manner, and reforming asset-backed securitization. The legislation also creates a Federal Stability Oversight Council, whose members include the Fed, the SEC and the CFTC, to monitor the marketplace to identify potential threats to the stability of the financial system. The Council, chaired by the Treasury Secretary

The Council will subject financial companies and financial activities posing a threat to financial stability to much stricter standards and regulation, including higher capital requirements, leverage limits, and limits on concentrations of risk.

Among its other duties, the Council must monitor the financial services markets to identify potential threats to the stability of the US financial system and identify financial companies and activities that should be subject to heightened prudential standards in order to promote financial stability and mitigate systemic risk. The Council must also issue formal recommendations to the SEC and other Council members to adopt heightened prudential standards for the firms they regulate in order to mitigate system risk.

Regulators’ inability to see developments outside their narrow “silos” allowed the current crisis to grow unchecked. The legislation’s information gathering and sharing requirements for the Council and all of the financial regulators, including the SEC and CFTC, will ensure constant communication and the ability to look across markets for potential risks. The Council will facilitate information sharing and co-ordination among its members regarding financial services policy development, rulemakings, examinations, reporting requirements and enforcement actions. Also, the Council must provide a forum for discussion and analysis of emerging market developments and financial regulatory issues among its members.

An important duty of the Council is to advise Congress on financial regulation and make recommendations that will enhance the integrity, efficiency, orderliness, competitiveness, and stability of the US financial markets. The Council must meet at least quarterly

The Council is empowered to require the submission of periodic and other reports from any financial company solely for the purpose of assessing the extent to which a financial
activity or market in which the financial company participates, or the company itself, poses a threat to financial stability. In an effort to mitigate this reporting burden, the Council is directed to rely, whenever possible, on information already being collected by the SEC and other financial regulators.

The Council is authorized to issue formal recommendations, publicly or privately, that the SEC and other federal financial regulators adopt heightened prudential standards for firms they regulate in order to mitigate systemic risk. Within 60 days of receiving a Council recommendation, the SEC or other federal financial regulator must notify the council of any actions taken in response to the recommendation or why the regulator failed to respond.

The Council may subject a financial company to heightened prudential standards upon determining that material financial distress at the company could pose a threat to financial stability; or the nature of the company activities could pose a threat to financial stability. In making this determination, the Council must consider a number of factors, including the amount and nature of the firm’s financial assets and liabilities and its off-balance sheet exposures, as well as its transactions with other financial companies. The company’s importance as a source of credit for households, businesses, and state and local governments must also be considered, as well as its source of liquidity for the financial system. Once a company becomes an identified financial company, heightened prudential standards can be imposed on it in order to mitigate risks to the financial system, including capital, liquidity and risk management requirements.

Federal regulators will impose heightened standards through a variety of options tailored to the specific threat posed. The Federal Reserve will serve as the agent of the Council in regulating systemically risky firms on a consolidated basis and systemically risky activities wherever they occur, ensuring broad accountability for such regulation.

Removes outmoded Gramm-Leach-Bliley Act restraints on the consolidated supervision of large financial companies by the Federal Reserve, and provides specific authority to the Fed and other federal financial agencies to regulate for financial stability purposes and quickly address potential problems.

The legislation reforms the process of securitization by, primarily, requiring companies that sell products like mortgage-backed securities to retain a portion of the risk to ensure that they will not sell garbage to investors, because they have to keep some of it for themselves. The legislation would require companies that sell products like mortgage-backed securities to keep some ``skin in the game’’ by retaining at least five percent of the credit risk so that, if the investment doesn’t pan out, the company that made, packaged and sold the investment would lose out right along with the people they sold it to. In addition, the legislation would require issuers to disclose more information about the assets underlying asset-backed securities.

The SEC is directed to adopt regulations requiring issuers of asset-backed securities to disclose for each tranche or class of security information regarding the assets backing that security. In adopting these regulations, the SEC must set standards for the format of the data provided by issuers of an asset-backed security, which must, to the extent feasible, facilitate comparison of such data across securities in similar types of asset classes.

In order to facilitate investors in performing independent due diligence, the SEC regulations must require issuers of asset-backed securities, at a minimum, to disclose asset-level or loan-level data, including data having unique identifiers relating to loan brokers or originators, The issuer must also disclose the nature and extent of the compensation of the broker or originator of the assets backing the security; and the amount of risk retained by the originator or the securitizer of such assets.

The SEC must also adopt regulations on the use of representations and warranties in the market for asset-backed securities that require each credit rating agency to include in any report accompanying a credit rating a description of the representations, warranties, and enforcement mechanisms available to investors how they differ from the representations, warranties, and enforcement mechanisms in issuances of similar securities. The regulations must also require any originator to disclose fulfilled repurchase requests across all trusts aggregated by the originator, so that investors may identify asset originators with clear underwriting deficiencies.

Currently, there is no system in place to responsibly shut down a failing financial company like AIG or Lehman Brothers. According to Treasury, the lack of a federal regulatory regime and resolution authority for large systemic non-bank financial institutions contributed to the financial crisis and, unless addressed with legislation, will constrain a federal response to future crises.
Thus, the legislation establishes an orderly process for the dismantling any large failing financial company in a way that protects taxpayers and minimizes the impact to the financial system.

If a large financial company fails, the legislation holds the financial industry and shareholders responsible for the cost of the company’s orderly wind down, not taxpayers; and protects the stability of the overall financial system. Under H.R. 3996, any costs for dismantling a failed financial company will be repaid first from the assets of the failed firm at the expense of shareholders and creditors. Any shortfall would then be covered by a dissolution fund pre-funded by large financial companies with assets of more than $50 billion and hedge funds with assets of more than $10 billion.

The FDIC will be able to unwind a failing firm so that existing contracts can be dealt with, creditors’ claims can be addressed, and parties required to bear losses do so. Unlike traditional bankruptcy, which does not account for complex interrelationships of such large firms and may endanger financial stability, this more flexible process will help prevent contagion and disruption to the entire system and the overall economy.

Costs to resolve a failing firm will be repaid first from the assets of the failed firm at the expense of shareholders and creditors, and to the extent of any shortfall, from assessments on all large financial firms. In this instance the legislation follows the “polluter pays” model where the financial industry has to pay for their mistakes, not taxpayers. The Resolution Fund is structured to spread the cost over a broad range of financial companies with assets of $10 billion or more, and provides for a flexible repayment period to avoid the procyclical effect of such assessments.

In an effort to make the Fed more transparent and accountable, the Paul-Grayson Amendment removes the blanket restrictions on GAO audits of the Fed and allows the audit of every item on the Fed's balance sheet, all credit facilities, and all securities purchase programs. The Amendment retains a limited audit exemption on unreleased transcripts and minutes. Nothing in the amendment shall be construed as interference in or dictation of monetary policy by Congress or the GAO. Also, the Amendment calls for an180-day time lag on publication of records related to specific market interventions to avoid destabilizing markets or stigmatizing individual firms.

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