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Restructuring of the U.S. Financial Services Regulatory Structure

Financial Services Task Force Update James D. Friedman

In January 2009, the United States Government Accountability Office ("GAO") issued a report on how to modernize the U.S. financial regulatory system. Its report, entitled "A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System" (the "GAO Report"), followed on the heels of similar reports issued by the Financial Services Roundtable ("FSR") in late 2007 and the United States Department of the Treasury (the "Treasury") in early 2008. Each report offers its own perspective on how to update the patchwork regulatory system currently in place in the United States, with some groups offering greater detail than others. The key points of each report are summarized below, followed by a brief analysis of the apparent trends in this regulatory reform movement.

GAO Report - January 2009

The GAO offers little in terms of concrete proposals, despite recognizing the U.S. financial regulatory system is in great need of reform. Rather, the GAO report focuses primarily on establishing and explaining nine guidelines by which it hopes others will subsequently draft proposals. The nine characteristics are as follows:

  1. Clearly defined regulatory goals. The GAO recognizes the benefits of a principles-based regulatory system, but it does not advocate a straight principles-based approach to regulation, although complex, current rules provide a level of certainty that is beneficial to regulators. The GAO does, however, advocate that Congress enact specific principles and goals in the text of legislation to better focus regulators on their ultimate goals. The GAO hopes that problematic activities, as well as unsound but technically legal practices, can be prohibited by having neither a pure principles-based nor a pure rules-based system.

  2. Comprehensive. Due to the piecemeal way in which the U.S. financial regulatory structure was created, there are currently gaps in the regulatory system. The GAO is concerned about the effect of such unregulated activities on systemic risk. To limit systemic risk, the GAO desires a financial regulatory system that is very broad but recognizes that not all financial markets require the same level of oversight. By tailoring the depth of regulation in certain markets, regulators are better able to manage both individual markets and systemic risk. The GAO does single out certain market participants and products that it believes are in need of additional regulation: mortgage lenders, credit ratings agencies, collateralized debt obligations ("CDOs"), credit default swaps and banks.
  3. Systemwide focus. The GAO believes the fragmented structure of the regulatory system prevents a proper analysis of the overall financial system. No one person or entity has broad enough regulatory authority to properly monitor systemic risk. To remedy this problem, the GAO suggests creating a single entity responsible for monitoring threats to the financial system. In particular, it endorses the Treasury's suggestion of expanding the responsibilities of the Federal Reserve to create a "market stability regulator," a position discussed in greater detail below.
  4. Flexible and adaptable. Recognizing that new products and market innovations pose risks that may not be readily identifiable, the GAO states that an effective regulatory system should include a mechanism for monitoring new developments and quickly analyzing their risks. The GAO does not take a clear position on the degree of intervention warranted in most cases but instead states that some new products may require regulatory approval, yet in other instances the regulators may simply react if problems arise.
  5. Efficient and effective. A consolidation of the agencies monitoring depository institutions to achieve consistency in regulation and to lessen the regulatory burden on banks is also suggested. The GAO also believes that an optional federal insurance charter may decrease the conflict between insurance regulation across states, but it acknowledges it has not studied the issue in depth and recommends Congress investigate the matter. The GAO also proposes reorganizing regulatory agencies around goals rather than sectors. No blueprint is given as to how this is to be achieved.
  6. Consistent consumer and investor protection. As financial instruments can be quite complicated, the GAO believes the regulatory system should increase its focus on protecting consumers. In particular, it advocates extending suitability requirements to mortgage and other products and limiting or prohibiting products too complex for consumers to understand.
  7. Independent, prominent, authoritative and accountable regulators. The GAO feels regulators must possess these four characteristics for any regulatory structure to be effective. To that end, the GAO Report identified several concerns in the current structure: (1) an agency's funding mechanism may call into question its independence, (2) regulators may not have the appropriate level of attention from top government officials and members of Congress and (3) some agencies have inadequate resources and expertise to effectively and efficiently regulate the institutions within their scope.
  8. Consistent financial oversight. Stating that an effective regulatory system should apply rules consistently among similar financial institutions, the GAO Report notes that, although consolidating and harmonizing portions of the financial regulatory structure will likely prove beneficial, such actions must not be taken at the expense of the quality of regulatory oversight.
  9. Minimal taxpayer exposure. The GAO advocates clear guidelines as to when a financial institution should be allowed to fail and when regulatory intervention is appropriate. It also condones the short-term use of taxpayer funds to prevent a systemic crisis that may be a greater drain on taxpayer resources in the future. When such intervention occurs, the GAO believes there should be regulatory oversight of institutions receiving taxpayer funds.

Treasury Report - March 2008
Unlike the GAO, the Treasury's report, entitled "Blueprint for a Modernized Financial Regulatory Structure" (the "Treasury Report"), was very specific in its proposals. Recognizing that regulatory reform is a slow process, the Treasury split its recommendations into short-term, intermediate-term and long-term.

Short-Term Recommendations

First, the Treasury recommends that the President's Working Group ("PWG") should be expanded to include the heads of the Office of the Comptroller of the Currency ("OCC"), the Federal Deposit Insurance Corporation ("FDIC") and the Office of Thrift Supervision ("OTS"). The PWG would then include a representative from most, if not all, of the vital portions of the financial sector. The PWG's focus should then be expanded to include the entire financial sector and not just financial markets, particularly in regard to limiting systemic risk.

In addition, the Treasury recommends the creation of the Mortgage Origination Commission ("MOC"), composed of the principals of the Federal Reserve, OCC, OTC, FDIC, the National Credit Union Administration and the Conference of State Bank Supervisors. The MOC's role will be to set uniform minimum licensing standards for state mortgage market participants. It will also evaluate the adequacy of each state's own licensing and regulation of participants, making the rating and report public information so as to give states an incentive to improve their performance.

Finally, the Treasury believes greater transparency is needed in those instances where the Federal Reserve provides non-depository institutions access to the discount window. It also wants conditions attached to such lending.

Intermediate-Term Recommendations

The Treasury notes that the role of federal thrifts has diminished significantly in recent years due to the increased activity of government-sponsored entities and commercial banks. For this reason, it recommends phasing out the thrift charter and transitioning to the national bank charter. This would also entail the closing of the OTS, whose remaining operations would be assumed by the OCC.

The Treasury also comments that state-chartered banks are currently subject to both state and federal supervision, and either the Federal Reserve or the FDIC would be a more efficient supervisor. Before it makes a recommendation of which authority is proper, the Treasury believes a study should be conducted on the issue. In regard to payment and settlement systems, however, the Treasury conclusively states that all oversight authority should be granted to the Federal Reserve, and the payment and settlement systems should be subject to a federal charter and uniform regulations.

Although the Treasury suspects a difficult battle with regard to its suggestions on the insurance market, it nonetheless offers a concrete and comprehensive reform proposal. Currently, insurance providers are subject to different laws in different states, which the Treasury believes hinders the market as insurance grows in importance both nationally and internationally. To remedy this problem, the Treasury proposes an optional federal charter for insurers that would provide a system for licensing, regulation and supervision. Those opting into a federal charter would no longer be subject to state insurance regulation provisions but would instead be subject to the regulations governing the particular type of insurance charter received. The Treasury envisions various lines of insurance (e.g., life, property and casualty, etc.), each with its own charter and set of regulations.

To regulate this new system, the Treasury recommends the creation of the Office of National Insurance ("ONI"), lead by the Commissioner of National Insurance, who will oversee the incorporation, operation and regulation of national insurers. Treasury also wants Congress to establish an Office of Insurance Oversight ("OIO") within the Treasury to focus immediately on areas of federal interest in the insurance market.

Finally, the Treasury believes the Securities and Exchange Commission ("SEC") and the Commodities Futures Trading Commission ("CFTC") should merge, removing the inefficiencies present in the current division. The Treasury further recommends that the new joint organization adopt broad principles by which to oversee the markets, rather than volumes of specific rules.

Long-Term Recommendations

In the long term, the Treasury wants the financial regulatory system to be more objectives-based, focusing primarily on the goals to be achieved by regulation. To this end, the Treasury recommends creating three distinct regulators to manage the three stated objectives of financial regulation: (1) the market stability regulator ("MSR"), (2) the prudential financial regulator ("PFR") and (3) the business conduct regulator ("BCR").

The Federal Reserve will fill the role of the MSR. The Treasury believes the powers of the Federal Reserve should be broadened to allow it to manage and, if necessary, correct problems in the market. The Federal Reserve's new job would be to manage systemic risk by developing information reporting requirements for financial service providers and having final say on all rules developed by the PFR and BCR. Finally, the Federal Reserve's role as the lender of last resort should be expanded to include all depository institutions and not just those with federal deposit insurance.

The PFR will actually be a new agency, the Prudential Financial Regulatory Agency ("PFRA"), and it will focus on financial institutions that have government guarantees associated with their business operations. This would include federal deposit insurance and state-established insurance guarantee funds. The PRFA will monitor such institutions and set capital adequacy requirements, investment limits and activity limits. The PRFA will essentially assume the roles of the OCC and OTS.

Another task of the PFR will be to work toward establishing and supervising a federal insured depository institution ("FIDI") charter for all depository institutions with federal deposit insurance and a federal insurance institution ("FII") charter. The FIDI charter, available to all types of corporate entities, would combine the national bank, federal savings association and federal credit union charters. It would also provide preemption over state laws. To obtain federal deposit insurance, a financial institution would have to obtain a FIDI charter. The FII charter would apply to insurers offering retail products that contain some type of government guarantee.

The BCR will also be a new agency, the Conduct of Business Regulatory Agency ("CBRA"). The CBRA will supervise all types of financial firms in regard to consumer protection. In particular, it will focus on three areas: disclosure, sales and marketing practices and anti-discrimination laws. Treasury also advocates the creation of a new federal financial services provider ("FFSP") charter, managed by the CBRA, that will apply to all financial service providers who are not FIDIs or FIIs. This includes broker-dealers, hedge funds, private equity funds, venture capital funds and mutual funds. The FFSP charter will also exempt FFSP-chartered entities from state business conduct regulations.

Finally, the Treasury advocates another regulator to have responsibility over general corporate oversight in the public securities markets. This corporate finance regulator ("CFR") would fill the current roles of the SEC that are not assumed by the CBRA. In other words, the CFR would supervise corporate disclosures, corporate governance, accounting and other such issues.

Financial Services Roundtable - November 2007

The FSR also addressed the issue of restructuring the U.S. financial regulatory structure in its report entitled "The Blueprint for U.S. Financial Services Competitiveness" (the "FSR Report"). The FSR Report offered 68 distinct policy reform suggestions, most of which were driven by the FSR's belief in a principles-based regulatory system.

First, the FSR advocates creating "Guiding Principles" that can be blended with a body of rules to increase transparency in the markets and address the needs of consumers. Like the Treasury, the FSR believes the PWG should be expanded and should be a hub of regulatory coordination among all market regulations. The PWG would also monitor regulatory action plans, which would be submitted by each financial regulator and would contain that regulator's plan for implementing the "Guiding Principles."

The FSR recommends applying prudential supervision to all financial services firms and offers many suggestions as to how to reform securities and class action litigation. Additionally, the FSR believes that Congress and regulators should act to improve consumers' access to credit and opportunities for long-term financial security. They could do so by adding financial education programs into school curricula and focusing on making the process transparent and simple to use for non-sophisticated borrowers. Provisions such as these are generally consistent with the views put forth in the GAO and Treasury report.

Some FSR recommendations, however, would take more time to implement and would not be as readily accepted by the financial community. For instance, the FSR wants to move to full use of International Financial Reporting Standards ("IFRS") without any sort of reconciliation to Generally Accepted Accounting Principles ("GAAP"). Also, the FSR, like the Treasury, wants to modernize existing charters and create new charter options. In particular, the FSR recommends creating an optional national insurance charter, an optional national securities charter and an optional universal financial services charter. Similar to the Treasury's proposals regarding charters, the FSR believes that having a single set of rules will be more efficient and place less of a burden on both regulators and chartered entities.


Although the FSR Report and the Treasury Report were issued well prior to the GAO Report, the GAO Report lacked the specificity of the other two reports. However, the GAO Report was consistent with the general ideas of the FSR and the Treasury.

Based upon the three reports and the recent comments of Chairman of the Federal Reserve Ben Bernanke1, it does appear that the Federal Reserve will play a much larger role in the general oversight of the financial sector. Exactly what its role will be is yet to be determined, but it will likely receive broader powers to monitor and address systemic risk. In addition, although the reach of regulation is likely to widen to cover previously unregulated or lightly regulated markets, regulation will likely be done by fewer of the existing agencies. The OTS, in particular, may be singled out for consolidation.

Finally, it appears some type of national charter reform is going to happen. The timeline for action is unknown, but revamping the federal charters was a point of emphasis for both the Treasury and the FSR. Key players in the financial sector believe such retooling is necessary for financial institutions and products that currently are not appropriately regulated. Given the financial crisis, the public is likely to demand greater regulation of the financial services industry, and the Treasury and the FSR are prepared to lead the way.

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For more details, or if you have any questions, please contact Jim Friedman at 414-277-5735 / [email protected], Spencer Larche at 414-277-5571 / [email protected], or your Quarles & Brady LLP attorney.

A Conversation with Ben S. Bernanke, Council on Foreign Relations, Mar. 10, 2009,

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