A Review of the President’s Plan to Overhaul Financial Sector Regulation

Today the President said that the financial regulatory structure, in its current form is build on sand. As such the President’s financial sector regulation plan, announced today, will meet this problem by restoring “the integrity of our financial system.”

Broadly speaking, the proposal leaves a lot of blanks for Congress to fill in, leaving plenty of room for political haggling over the next couple of months. And while parts of the reform suggestions are valuable, the who structure of the proposal is build around a framework that profoundly misunderstands the nature of the financial crisis. The white paper released by the White House places all of the blame on the private sector and a lack of regulation with out mentioning the government policies that significantly contributed to developing the crisis.

The proposal also fails to understand the limitation of government. In the Obama/Geithner/Summers/Bernanke plan accurately states that during the bubble period, “risk management systems did not keep pace with the complexity of new financial products.” But neither were regulators able to keep up. And they never will be. Regulators are, by definition, behind the curve when it comes to creating rules to manage financial products. And in the 21st century, financial services are be coming increasingly complex and rapid fire. The regulation plan does a fine job of finding financial products from the past 10 years to create new rules for, but fails to create an atmosphere where risk is placed solely on the originator of an investment vehicle and the investor. Regulators will not be able to keep pace, and future losses may wind up back in the government’s lap because they remain too close to the game.

In any event, here is a breakdown of the various parts of the President’s proposal (this will be a short assessment, look for a more thorough treatment in a coming policy brief on this very topic, probably some time next week):

  • A Financial Services Oversight Council

The administration blames the crisis on 1) liquidity requirements being too low, 2) firms being too leveraged, 3) fragmented supervision of banks, and 4) a lack of oversight for hedge funds, investment banks, and mutual funds. Obama has thus proposed new Financial Services Oversight Council, chaired by the Treasury Secretary, be comprised of the major regulating agencies (the Fed, SEC, CFTC, FDIC, FHFA and the heads of the two new bank and consumer protection agencies), and be run by staff in the Treasury Department. The Council will be able to take a wide view of the financial sector to spot these kinds of problems, ensure regulations are applied consistently, coordinate regulating agencies to fill gaps, and identify emerging risks.

This is similar to the Republican’s proposed “Stability Board” except the White House version has more teeth. Through the Federal Reserve, the Oversight Council will have the power to impose strict regulation on firms deemed too interconnected to fail. A key problem with this kind of Council that is looking for systemic risk is that the concept is very vauge. What makes a firm too interconnected to fail or a risk to the system? If this is left ambiguous it will significantly complicate bank operations. Another issue is the enormity of macroprudential oversight. If the government believes this kind of Council can prevent future recessions it is destined to fail.

  • A National Bank Supervisor

Currently the safety and fiscal stability of banking institutions is overseen by four agencies: the Federal Reserve, the FDIC, the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC). The White House is proposing the creation of a National Bank Supervisor (NBS) with oversight of all federally chartered banks. This plan closes the OTS and shift some responsibilities away from the FDIC. The NBS will work with the Fed closely as the Federal Reserve will have oversight over all financial institutions that are deemed too interconnected to fail (more below).

It is probably not a bad idea to simplify the source of regulation for banks. Banks hate vague rules because they don’t know how to respond. The downside of this new agency (besides the problems that come with the creation of a new bureauracracy) is that national banks aren’t all the same and one-size-regulator-fits-all may complicate banking operations, not make it easier to follow federal rules.

  • A Consumer Financial Protection Agency

A new agency like the proposed Consumer Financial Protection Agency (CFPA) would be tasked with protecting consumers from “unfair, deceptive, and abusive practices” by credit card companies, mortgage lenders, commodities traders, mutual fund brokers, and other product management firms. This kind of agency, based on a framework developed by Harvard professor Elizabeth Warren, would work similar to other government agencies that create rules to protect consumers, like the FDA. The government proposal also increases transparency requirements and creates higher standards for consumer related financial products. These include easier to understand and more concise mortgage contracts and credit card commitments.

The concern of many, including banks, is that regulations passed down by the new authority will increase their costs of production because of compliance issues. Just as laws uniform safety standards on electronics increase the costs of those products, so too would more directed rules at financial products decrease opportunities to create wealth and limit choice for consumers. Investors who want to take more risk with the possibility of greater rewards could have their options limited by a heavy regulating hand.

  • A “Resolution” Authority

The administration proposes the creation of a new “resolution” authority to manage financial institutions not covered by the Fed. This would act like the FDIC does for banks, but be for all non-bank financial firms. The goal of this authority would be to avoid bailouts in the future, but it is really just institutionalizing the bailout process. The President wants Congress to create this authority so that non-banks, like AIG, can be taken into receivership and wound down calmly.

There is no mention for how this kind of insurance fund will be paid for. The authority would be wide reaching enough to make anyone worry about crossing the invisible systemic risk line. However, the resolution power will effectively create a bailout fund that financial institutions know is out there in case their big bets fail. This is doing little more than making the too big to fail/too interconnected to fail tacit promise of the past 20 years explicit. Of all the proposals, this is the one Congress should do the most to stay away from.

  • New Powers to the Federal Reserve

The proposal dramatically increases the power of the Federal Reserve. The Fed will have oversight over all “Tier 1” financial insitutions—firms that are deemed of systemic importance by outlined Treasury standards. The Fed will also get oversight of all payment, clearing, and settlement systems. These new powers are intended to help fill “holes” in the financial system.

Independently, different aspects of the new Fed authority are problematic (more on that later), but it is worth saying that the Fed is the best branch to get these powers. The SEC has proven quite inept under Bush administration appointed leadership and has yet to prove itself under Shapiro. The Fed is also the most independent branch of the regulatory process, since they are technically private but with extensive government powers.

  • Increase Capital Reserve Requirements

The teir standards in the White House proposal increase capital reserve requirements across the board for financial institutions. The Teir 1 firms, those intensely tied into the financial system, will have the highest standards. The written version of the proposal says: “capital and liquidity requirements were simply too low. Regulators did not require firms to hold sufficient capital to cover trading assets, high-risk loans, and off-balance sheet commitments, or to hold increased capital during good times to prepare for had times.”

As I have written before, capital reserve requirements probably could use a boost, though there are trade offs. But it is worth noting two significant caveats to that thought. First, mark-to-market regulations were a significant part of the liquidity crisis, because they forced firms to scramble somewhat unnecessarily for capital. Second, some of the financial firms simply became insolvent. It is not clear that higher capital reserve requirements would have helped a bank like Wachovia that just didn’t know what it was doing investment wise and was hit by a run. So these requirements may not be the right solution.

  • New Hedge Fund and Private Equity Regulation

The White House proposed, as expected, that hedge funds and private equity firms to register with the SEC and begin regular reporting. Critics of this proposal are worried that oversight would lead to increased regulation and restrictions on risk taking. Considering that hedge funds specialize in risk taking, this could drastically hurt their business models.

The reporting itself is also a barrier to entry. Small hedge funds with only a few clients and staff don’t want to spend two days a week filing forms. The hassle and compliance costs wind up destroying value, not protecting investors who know the risks they are taking by placing part of their investments with hedge funds. Reporting on investment activities could also damage firms if proprietary information was disclosed to the public. This could also destroy hedge funds given the competitive nature of their business.

In the end there are only a handful of firms that could cause any kind of damage to the financial market if they went under. Subjecting all of them just to bring them into the regulatory structure will cause more problems than any it might solve.

  • New Securitization and OTC Derivative Regulation

The administration has proposed new and enhanced regulation of the securitization markets. This includes raising market transparency requirements, adding regulation for credit rating agencies, and requiring that security originators retain financial interest in their loans. The proposal also would establish comprehensive regulation of over-the-counter derivatives.

Ultimately, the administration’s proposal fails to end the culture of bailouts and crystally affirm the government’s intention to not bailout firms in the future. At the very least, Congress, when assigning powers for the newly proposed “resolution” authority, they should make sure the process of being taken over by the government is so uncomfortable, and with such loss to the operators that firms closing in on bankruptcy won’t want to go anywhere hear it.