Obama Plan Overhauls Financial Services Regulation
Financial Services Task Force Update 07/30/09 James D. Friedman
On June 17, 2009, President Obama released his proposal to restructure the U.S. financial regulatory system (the "Proposal"). The Proposal focuses on meeting five primary objectives: (1) promoting robust supervision and regulation of financial firms, (2) establishing comprehensive regulation of financial markets, (3) protecting consumers and investors from financial abuse, (4) increasing government power to manage financial crises and (5) raising international regulatory standards and improving cooperation. To achieve each objective, the Proposal notes specific tasks and changes necessary to complete the overhaul of the financial regulatory system. The Proposal's recommendations are outlined in the summary below, which concludes with a brief discussion of the Proposal's effect on certain businesses and the likelihood of its elements' passage.
Promoting Robust Supervision and Regulation of Financial Firms
The Proposal cites the lack of proper regulatory authority as a key cause of the 2008 financial crisis. Aiming to correct the problem, the Proposal recommends additional supervisory programs and an increase in governmental authority as means to prevent another financial collapse. In fact, the Proposal advocates for strongly regulating any financial firm whose failure could threaten the stability of the overall financial markets. Also a priority in the Proposal is encouraging accountability in the oversight and supervision of financial markets.
The Proposal first suggests the creation of the Financial Services Oversight Council (the "Council"), which is a body of regulators whose primary tasks would be to identify systemic risks and improve cooperation among various agencies. In this role, the Council will help the Federal Reserve identify those firms that pose risks to the financial markets. The Council will be chaired by the United States Department of the Treasury (the "Treasury") and includes the heads of the principal federal financial regulators. The Council is designed to replace the president's Working Group on Financial Markets.
The Proposal also states that the Federal Reserve should be given increased authority to supervise financial firms whose size, leverage and interconnectedness could pose a risk to market stability. Such firms would be known as Financial Holding Companies ("FHCs"). Even firms that do not control insured depository institutions could be considered FHCs. Under the Proposal, the Federal Reserve would be the consolidated supervisor of the FHC, its parent company and any subsidiaries. To aid in the identification of FHCs, the Federal Reserve would also be able to require reports from firms over certain size thresholds, even those that already have primary supervisors. Finally, the Federal Reserve would have the authority to set capital requirements, liquidity standards and other prudential standards, all of which the Proposal believes should be strengthened to limit systemic risk during stressed times. According to the Proposal, several working groups are scheduled to make reports in late 2009 regarding restructuring the Federal Reserve, reassessing the supervision of banks and bank holding companies, and evaluating the current capital requirements for banks and bank holding companies.
In addition to strengthened regulations, the Proposal calls for the creation of the National Bank Supervisor ("NBS"), which would be a federal agency in charge of chartering and regulating national banks and the federal branches and agencies of foreign banks. The NBS would take over the prudential responsibilities of the Office of the Comptroller of the Currency ("OCC") and all of the responsibilities of the Office of Thrift Supervision ("OTS"). The Proposal further recommends the abolishment of the federal thrift charter. In addition, the Proposal advocates placing restrictions on troubled banks' ability to switch charters and supervisors while also seeking to eliminate restrictions on interstate branching by banks.
The Proposal additionally suggests significant changes to the Bank Holding Company Act that would require all thrift holding companies, holding companies of industrial loan companies, holding companies of credit card banks, holding companies of trust companies and holding companies of "nonbanks" to become bank holding companies. Such firms would have five years to comply with the Bank Holding Company Act.
The Proposal advocates mandatory registration of investment advisors of hedge funds and other private pools of capital. It also proposes that all investment funds advised by investment advisors registered with the Securities and Exchange Commission ("SEC") should have to keep certain records, make certain disclosures to investors, creditors, and counterparties, and report to the SEC on a confidential basis the amount of assets under management, borrowings, off-balance sheet exposure and any other information necessary for the government to assess whether the fund creates systemic risk.
Finally, the Proposal desires to establish the Office of National Insurance ("ONI") within the Treasury to coordinate insurance policy in the insurance market. The ONI would also aid the industry's development internationally, allowing the United States' insurance industry to present a unified viewpoint in international meetings.
Establishing Comprehensive Regulation of Financial Markets
Believing a lack of comprehensive regulation to be partly at fault for the 2008 financial crisis, the Proposal advocates regulating previously unregulated products and imposing additional restrictions on the securitization markets. In particular, the Proposal asserts that federal banking agencies should require loan originators and sponsors to retain 5% of the credit risk of securitized exposures. The hope is that originators will make better decisions if they bear a greater amount of the risk associated with the loans. The Proposal also suggests linking the compensation of brokers, originators, sponsors and underwriters to the long-term performance of the securitized assets by altering Generally Accepted Accounting Principles ("GAAP") to recognize gains on loans over an extended period of time, rather than solely when the loan is originated. In addition, the Proposal calls for credit rating agencies to be more explicit in describing precisely what risks their ratings assess and to publicly disclose additional information regarding credit rating performance measures.
The Proposal also recommends that all Over-the-Counter ("OTC") derivatives be subject to comprehensive regulation. Most notably, the Proposal calls for a central clearinghouse of all standardized OTC derivatives. In addition, all OTC derivatives dealers whose activities in OTC derivative markets create substantial exposures to counterparties will have to follow significant prudential regulations. The Proposal further states that the SEC and U.S. Commodity Futures Trading Commission ("CFTC") should be allowed to impose recordkeeping and reporting requirements on all OTC derivatives.
Furthermore, the Proposal states that the CFTC and SEC should complete a report to Congress, noting ways in which SEC and CFTC statutes or regulations conflict. The report should then explain either why the differences are important to protect investors or how the regulations can be modified to eliminate discrepancies. As the two commissions currently exist, there is frequently jurisdictional overlap. The Proposal believes that the commissions should work together to develop a principles-based structure that is more precise than the one currently utilized by the CFTC.
The Proposal also maintains that additional power should be granted to the Federal Reserve to oversee systemically important payment, clearing and settlement systems as well as related activities. The Federal Reserve would have the authority to collect information from any payment, clearing or settlement system to assess whether or not it is systemically important. Such systems would also be subject to onsite safety and soundness examinations conducted by the system's regulator. Ultimately, though, the Federal Reserve would have the authority to compel the system to take any necessary corrective action.
Protecting Consumers and Investors from Financial Abuse
Seeking to rebuild trust in the financial markets, the Proposal recommends focusing on protecting consumers and investors from financially dangerous products and practices. The Obama administration has already released draft legislation on this topic, the Consumer Financial Protection Agency Act of 2009 (the "Act"), which seeks to codify the consumer protection aspects of the Proposal.
As part of the Act, the Consumer Financial Protection Agency ("CFPA") would be created. It would be an independent agency charged with protecting consumers from unfair, deceptive and abusive practices. The CFPA would be composed of the consumer protection departments from several different agencies, which would be splintered off and regrouped together. While logistically challenging, the Proposal states that the idea was to create one entity, focused solely on consumer protection, to promote accountability and prevent regulatory arbitrage.
In addition, the CFPA is designed to have sole authority over making and interpreting regulations pertaining to certain existing financial services and fair lending statutes. By structuring the CFPA in such a way, the Proposal speculates that gaps between the various existing laws can be filled. The costs and benefits of any new regulation must be weighed by the CFPA before the regulation can be enacted, and the CFPA would likely have supervisory and enforcement authority over banking institutions, bank affiliates and, in some instances, non-banking institutions.
The CFPA, as proposed, would have a wide range of powers, ranging from the authority to restrict or ban mandatory arbitration clauses to the power to require all providers and intermediaries to provide "plain vanilla" financial products with straightforward pricing. The CFPA would also be involved in educating consumers about financial matters, handling complaints regarding financial products and practices, and researching data on consumer behavior. It may also help craft duties of care that would be imposed on financial intermediaries to ensure that consumers are not harmed by intermediaries with conflicts of interest.
Aside from the CFPA, the Proposal also advocates additional powers be given to the SEC to protect consumers. For example, the Proposal suggests that the SEC impose a fiduciary duty on broker-dealers, as is the case for investment advisors, because the distinction between the two has become increasingly blurred. In addition, the Proposal recommends that the SEC expand sanctions against those who break federal securities laws and develop a fund to pay whistleblowers for information.
As a last suggestion to encourage coordination in consumer protection, the Proposal seeks the creation of the Financial Consumer Coordinating Council, which would be composed of the heads of the SEC, Federal Trade Commission, Department of Justice and CFPA. The council would meet quarterly to identify gaps in consumer protection and offer potential solutions.
Increasing Government Power to Manage Financial Crises
In an effort to avoid the disorderly resolution of systemically important, non-bank failing institutions, the Proposal advocates the creation of a resolution authority for systemically important bank holding companies and FHCs. The authority would be modeled after the "systemic risk exception" contained in the current Federal Deposit Insurance Corporation ("FDIC") resolution regime. Essentially, if the Treasury determines that a firm's failure would have significant adverse effects on market stability, then with the approval of two-thirds of the Federal Reserve Board and two-thirds of either the FDIC or the SEC, the Treasury would gain access to a variety of tools to mitigate the failure.
Once the Treasury has decided to utilize the resolution regime, it has various options. It could establish a conservatorship or receivership, provide loans to the firm, purchase assets from the firm, guarantee the firm's liabilities or make equity investments in the firm. The Treasury would decide which tools to use after carefully weighing the costs and benefits of each method. The Proposal speculates that vesting the Treasury with such options could help manage the overall systemic shock of an important firm's failure.
Raising International Regulatory Standards and Improving Cooperation
Recognizing that the 2008 financial crisis was global in nature, the Proposal makes recommendations for the global regulatory system. In particular, it encourages foreign regulatory bodies to require firms to maintain capital buffers during good times to alleviate financial pressure during recessions. The Proposal also recommends that significant global financial institutions share information among one another during distressed financial times. In addition, the Proposal urges foreign regulators to require the registration of hedge funds, to develop an international framework for cross-border bank resolutions for failing firms, to improve accounting practices for complex financial instruments and to make progress toward a set of global accounting standards. Finally, the Proposal recommends that the Federal Reserve, in conjunction with the Treasury, develop a set of rules to identify those foreign firms that would be considered FHCs.
The Proposal advocates significant changes to the regulatory landscape. However, it is hardly surprising that the Proposal calls for increased supervision and regulation over many previously unregulated or lightly regulated financial products and services. Similarly, the Proposal's focus on managing systemic risk and consolidating regulatory authority was expected by many in the financial services industry.
Much of the Proposal mirrors the ideas put forth in the March 2008 report by the Treasury, entitled "Blueprint for a Modernized Financial Regulatory Structure" (the "Treasury Report"). The Proposal was specific, though, where the Treasury Report was vague. In particular, while it was expected that the regulatory net would be thrown wide, it was not known how wide. For businesses that are holding companies of industrial loan companies, credit card banks, trust companies and other "nonbanks," the Proposal's recommendation that they be forced to comply with the Bank Holding Company Act may have come as a surprise, and for that reason, among others, the recommendation may be politically difficult to implement. Likewise, the consolidation of federal agencies and the rearranging of their duties may also be met with resistance from agencies being forced to cede power.
It remains unclear how much of the Proposal will be approved by Congress through various legislative proposals. However, with the introduction of the draft CFPA Act in late June 2009, the administration has made it clear that it desires to implement its agenda by striking while the iron is hot.
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