Thursday, July 23, 2020

Joel Seligman discusses his new book 'Misalignment'

By Mark S. Nelson, J.D.

Securities historian and scholar Joel Seligman, in his new book titled "Misalignment: The New Financial Order and the Failure of Financial Regulation," published by Wolters Kluwer Incorporated, proposes a new financial regulatory structure that is more tightly integrated than the current system, which he has called "atomized and industry-specific and lacking accountability at the federal level." Seligman views the next session of Congress as potentially being pivotal to the facilitation of legislation that could restructure the U.S. financial system to address modern financial threats by eliminating the siloed approach to regulation that now separates regulators of markets for securities, commodities, banking, housing, and insurance.

Seligman, who is also the long-time co-author of the treatise "Securities Regulation," along with the late Louis Loss and more recently with former SEC Commissioner Troy Paredes ("Securities Regulation" is also published by Wolters Kluwer Incorporated), recently spoke to Securities Regulation Daily about his book "Misalignment" during interviews conducted over two days.

Fixing regulatory misalignments. In "Misalignment," Seligman seeks to address the perceived shortcomings of the Dodd-Frank Act. In doing so, he views his proposed regulatory restructuring as being much broader and more fundamental than some extant alternatives, such as the legislative proposal to resurrect a stronger separation of banking and securities via a 21st Century Glass-Steagall Act (See, e.g., H.R. 2585; S. 881 in the 115th Congress and H.R. 2176 in the 116th Congress), something that was to be partially achieved through the Dodd-Frank Act’s Volcker Rule. Instead, Seligman places emphasis on changing up the existing financial regulatory alignment to better coordinate how the federal government responds to systemic economic risks.

Seligman has repeatedly called the Financial Stability Oversight Council (FSOC) a "toothless" entity, and towards that end he proposes in "Misalignment" a new, empowered FSOC-like entity called the Federal Regulatory Authority. In times of economic crisis, the proposed systemic risk regulatory body would work in conjunction with Treasury and the White House, but otherwise would maintain a degree of independence from the executive branch. The proposed restructuring also would reduce the 10 voting members of FSOC to seven voting members in the new entity via the consolidation of existing federal financial regulators.

As a result, the new systemic risk regulatory body would include Treasury, the Fed, and CFPB (reformulated as a five member commission) in largely the forms they currently possess albeit with some changes in the scope of their responsibilities. However, the biggest changes would be reserved for the numerous "alphabet" financial regulators, which would be restructured into three presidentially-appointed commissions. The proposed National Banking Commission would house the OCC, the FDIC, and the NCUA. The proposed Investment Commission would house a combined SEC and CFTC along with the DOL’s pension-related authorities. Finally, insurance matters would be represented by a National Insurance Commission.

Readers of "Misalignment" might ask why housing regulators seem not to have a seat at the table in the proposed Federal Regulatory Authority. For example, could the proposed Housing Finance Regulatory Commission join the Federal Regulatory Authority once Fannie Mae and Freddie Mac exit conservatorship? "I’m not sure the Housing Commission would join the Federal Regulatory Authority," said Seligman. "It’s possible but the challenge is that the more members there are then the more difficult it is to manage the economy, much like FSOC with its too many members. My proposal would have a smaller membership on the Federal Regulatory Authority in order to avoid members’ turf battles."

Federal Regulatory Authority prudential rulemaking. Another key aspect of the proposed Federal Regulatory Authority would be its powers to impose prudential rules on all constituent members. This would be an expansion of powers beyond the recommendatory powers now held by the FSOC. However, questions could arise regarding how likely it is that a future Federal Regulatory Authority would use those powers. One of Seligman’s critiques of the current FSOC is that it has not always effectively used its power of recommendation.

An example from 2012 involving the SEC’s money market fund (MMF) reforms perhaps demonstrates the tensions that can arise between a systemic monitor like FSOC and its constituent members. Then-Treasury Secretary Timothy Geithner (who also was FSOC’s chair) issued a letter urging the FSOC to recommend that the SEC move forward on its MMF reforms, an effort that had stalled after the SEC’s initial round of such reforms in 2010. The FSOC later proposed to recommend that the SEC pursue further MMF reforms. A combination of Geithner’s and FSOC’s public pressure on the SEC coupled with a response by the SEC’s economics division (now called DERA) to a request for additional market data from a bipartisan block of SEC commissioners (Luis Aguilar (D), Troy Paredes(R), and Daniel Gallagher (R)) likely secured the votes needed to propose the SEC’s second round of MMF reforms, which were finalized in 2014. Paredes, who left the Commission before the final version of the MMF reforms was adopted, said at the time of the proposal that he believed the Commission would have pursued the reforms even without pressure from FSOC.

In light of the SEC’s experience with FSOC, how would one ensure that the proposed Federal Regulatory Authority will be more likely to use its prudential rulemaking authorities than FSOC has been in using its recommendatory authorities? "You can’t know for sure, but leadership is important and if you give it the staff, budget, and independence, it is more likely to use the powers it would have," said Seligman.

Implications for the SEC. Seligman, a leading historian of the SEC, also discussed some of the possible implications of his reform proposal for the SEC. First, Seligman proposes in "Misalignment" to combine the SEC and the CFTC into a single Investment Commission. The SEC-CFTC merger idea has been floated before and has failed to happen, at least in part, because of a desire by Congressional committee leaders to retain their existing oversight authorities, something Seligman acknowledges in "Misalignment."

Second, a key factor in combining both agencies would be the degree to which Congress may need to significantly increase its appropriations for a proposed Investment Commission. Currently, the SEC receives fairly regular but modest increases in its annual appropriation. The CFTC, despite its greatly expanded authority over swaps and derivatives markets in the post-Dodd-Frank Act regulatory environment, continues to be held to a comparatively small annual appropriation. Seligman also would add to the SEC-CFTC merger the DOL’s authorities for sales practices related to pensions (the DOL, however, would retain its authorities for labor regulation).

"Yes, more money would be needed," said Seligman. "But the purpose in combining the DOL pension authorities with the SEC and the CFTC, regardless of budget, is to cover a larger part of the economy so the proposed commission deserves a place at the table." Seligman explained more generally that a Federal Regulatory Authority with fewer members would have less need for its members to contest jurisdiction, and it would have the advantage of one rulebook and one enforcement mechanism.

Another intriguing implication of Seligman’s proposed merger of the DOL’s pension authorities with the SEC is the prospect of a future SEC uniform fiduciary standard for investment advisers and broker-dealers, an option authorized by the Dodd-Frank Act but one that a majority of the Commission decided not to invoke when it issued Regulation Best Interest. Seligman suggested that one of the consequences of bringing DOL’s pension authorities into the proposed Investment Commission could be to eliminate competition between the SEC and the DOL such that the SEC could find it easier to implement a uniform fiduciary duty.

The origins of "Misalignment." Seligman clearly had been thinking about and developing his book "Misalignment" for some time. In 2011, barely six months after the Dodd-Frank Act became law, and again in 2015, Seligman would publish articles calling for a new regulatory order that better addresses the potential for systemic risk in the U.S. and global financial system. These articles would set out many of the concepts addressed in much greater detail by "Misalignment" (See, Joel Seligman, Tyrrell Williams Memorial Lecture: Key Implications of the Dodd-Frank Act for Independent Regulatory Agencies, 89 Wash. U. L. Rev. No. 1 (2011); Joel Seligman, The New Financial Order: An Essay for Alan Bromberg, 68 SMU L. Rev. No. 3, Art. 24 (2015)).

Seligman had explained in both the Washington University and SMU articles how faults in U.S. financial regulations may have made the U.S. financial system more susceptible to the Great Recession of 2008-2009. For example, Seligman recalled that the financial milieu of the early 2000s had come to be dominated by a particular type of entity called the financial holding company, which offered investors a cornucopia of investment possibilities, including derivatives. The FHC had its origins in the 1998 merger of Citicorp (banking) and Travelers (insurance), a combination once prohibited by law that would be legislatively blessed the following year through the enactment of the Gramm-Leach-Bliley Act, which established activity restrictions for bank holding companies that are not financial holding companies. As compared to the New Deal era, the 2000s-era financial supermarket concept provided far more opportunities for investors than just stocks, debt, and bank accounts.

But the standard understanding of the Great Recession of 2008-2009, in Seligman’s view, was missing a key piece. The conventional explanation tended to focus on the Great Recession’s origins in failures of the housing and credit markets that seriously weakened some highly interconnected financial firms leading to the collapse of some of these firms and to government bailouts of others. Put another way, a bubble in one sector of the economy (housing) ultimately led to a lack of confidence in that sector which, because of the interconnectedness of U.S. and global financial firms and markets, allowed a financial contagion to spread throughout the financial system. But what was the missing key ingredient? Said Seligman in the SMU article:

While this is a useful catalog of many of the causes of the crash, I now believe it is more illuminating to distinguish proximate causes such as an ongoing economic emergency initially rooted in the housing and credit markets from ultimate causes, of which one, the misalignment between financial regulation and the new financial order, is by far the most important.

The Congressional response, Seligman said in the earlier Washington University article, was to enact the Dodd-Frank Act and thereby strengthen key financial regulators. But Seligman said those reforms not only failed to address the persistent misalignments in financial regulations but the reforms also eluded pre-2008-2009 failures by the now reformed financial regulators:

This, then, is the paradox of the new financial order: Since the stock market crash of 1929–1933, no set of financial regulators was so incompetent in predicting a financial catastrophe, so slow in response, so rigid in regulatory approach, so inadequate in enforcing existing law as the regulators in charge during the 2008 crisis. Yet the principal winners in the Dodd-Frank Act are the very same set of financial regulators who so spectacularly failed.

By the time Seligman wrote the 2015 SMU article, he had assembled many of the pieces of "Misalignment," including the outline of a "hybrid system" in which an empowered FSOC-like entity would house a consolidated and simplified group of financial regulatory agencies for which the Treasury Secretary would take the lead during times of crisis, but which would allow its constituent members to operate in a more "atomized" (and more independent) manner during prosperous times.

As to the likelihood such a reformed FSOC and system of federal financial regulatory agencies could be established, Seligman in 2015 posited:

Will this type of approach ever occur? The conventional wisdom today is that political considerations make any approach like this improbable. This is, of course, correct under current circumstances. But someday there may be yet another financial meltdown and the misalignment of the current system of the financial regulator to the new financial order will be writ large. I hope that day never comes. But if it does, I hope we more effectively address the structure of our financial system than we have to date.

In "Misalignment," Seligman proposes in greater detail how he believes the federal financial system should be restructured to meet modern financial risks. According to Seligman, the ongoing COVID-19 pandemic and consequent economic downturn provide the next Congress an opportunity to enact financial regulatory reforms that can build upon the most beneficial aspects of the Dodd-Frank Act to enable financial regulators to better detect, prevent, and mitigate the next financial crisis.

In this regard, Seligman cautions in "Misalignment’s" closing chapter against the "delusion" that financial regulatory restructuring is a cure-all for economic woes that will inevitably arise, but he also describes what might have been the economic benefit of such restructuring had it been in place before the COVID-19 pandemic: "The new Federal Regulatory Authority in all probability would have stimulated a faster and better coordinated response. An independent Federal Regulatory Authority chair would have had a greater capacity to earlier ring alarm bells than a Secretary of Treasury, who was a leading member of a political administration."