Overview

On June 17, the United States Department of the Treasury (UST) released a white paper (the Plan) outlining the Obama administration’s blueprint for financial regulatory reform (available here). The Plan touches on a range of topics covered in sections of the Corporate and Financial Weekly Digest, including reform of regulations regarding banking, financial markets, securitization and structured finance, private investment funds, and derivatives.

Revised Supervision of Bank and Non-Bank Financial Firms

The Plan would require all financial firms that are found to pose a systemic threat to the economy’s financial stability, whether or not they own banks, to be subject to consolidated supervision and regulation by the Federal Reserve Board, including higher standards on capital, liquidity and risk management. A new regime to resolve nonbank financial institutions whose failure could have serious systemic effects would be developed, and the Federal Reserve’s emergency lending authority would be revised to improve accountability.

A new Financial Services Oversight Council, to be chaired by the UST, would be created to facilitate coordination of policy and identify emerging risks in firms and market activities among financial regulatory agencies. The Council would have broad authority to collect information about financial firms and activities in financial markets that may pose a threat to financial stability.

The Plan would also create a new Consumer Financial Protection Agency, which would be an independent entity dedicated to consumer protection in credit, savings, and payments markets, and a new National Bank Supervisor, which would be a single agency with separate status in UST with responsibility for federally chartered depository institutions. This would entail a merger of the Office of the Comptroller of the Currency with the Office of Thrift Supervision. To promote national coordination in the insurance sector, the Plan also would create an Office of National Insurance within UST. However, the Plan would maintain the respective roles of the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) in the supervision and regulation of state chartered banks, and would maintain the authority of the National Credit Union Administration (NCUA) with regard to credit unions.

Regulation of Fund Advisors and Private Funds

The Plan provides that all advisors to hedge funds and other private pools of capital, including private equity funds and venture capital funds, whose assets under management exceed “some modest threshold” should be required to register with the Securities and Exchange Commission under the Investment Advisers Act of 1940. It then proposes that all investment funds advised by an SEC-registered investment adviser should be subject to requirements relating to disclosure to investors, creditors, and counterparties; recordkeeping and regulatory reporting. Although the Plan contemplates that reporting requirements may differ across fund types, it suggests that minimum reporting to regulators, which would be confidential, should cover the amount of assets under management, borrowings, off-balance sheet exposures and such other information necessary to assess whether any fund or fund family is so large, interconnected to other financial market participants or highly leveraged that it poses a threat to financial stability. The SEC would also be granted authority to conduct regular, periodic examinations of such funds to monitor compliance with the proposed requirements, and to share information it receives from the funds with the Federal Reserve. If the Federal Reserve determined that a fund posed a threat to financial stability due to a combination of its size, leverage, and interconnectedness, the Federal Reserve would have the authority to supervise and regulate such fund in the same manner as other institutions that are found to present systemic risk.

The Plan notes that many hedge funds are also registered with the Commodity Futures Trading Commission as commodity pool operators and calls for harmonization of the CFTC’s “principles based” approach to regulation with the SEC’s “rules based” approach.

Money Market Funds

The Plan calls for the SEC to strengthen the regulatory framework for money market funds (MMFs) to prevent runs on these funds similar to those in September 2008 and tasked the President’s Working Group on Financial Markets (PWG) with preparing a report by September 15 considering what changes would be useful in addressing systemic risk. The Plan suggests the SEC consider liquidity buffers, reducing maximum weighted average to maturity of MMF assets, making credit concentration limits stricter, improving credit risk analysis and management of MMFs and giving MMFs the abilty to suspend redemptions in extraordinary circumstances. Although the Plan contained several suggestions on what changes should be considered by the SEC and the PWG, it appeared that the administration has not yet fully determined its recommendations for strengthening regulation of MMFs.

Harmonization of Regulation of Investment Advisors and Broker-Dealers

In the same spirit as the proposals regarding creation and function of a Consumer Financial Protection Agency, the Plan recommends that the SEC be given expanded authority to improve timing and content of disclosure to investors regarding financial products and to align duties for financial intermediaries across financial products. It proposes to establish a fiduciary duty of broker-dealers when they are providing investment advice and otherwise harmonizing regulation of broker-dealers and investment advisors to achieve consistent regulation of persons providing similar products and services. The Plan includes suggestions that (i) both broker-dealers and investment advisors would be required to provide simple and clear disclosure to investors regarding the scope of the terms of their relationships; (ii) certain conflicts of interest and sales practices that are contrary to the interests of investors would be prohibited; and (iii) the fiduciary duties of broker-dealers who provide investment advice about securities to retail investors would be aligned with the fiduciary standard of investment advisors. The SEC would also be authorized to examine and ban forms of compensation that encourage both broker-dealers and investment advisors to put investors into products that are profitable to the intermediary but are not in the investors’ best interest.

Enhanced Supervision and Regulation of Securitization Markets

The Plan proposes a number of reforms to address what it calls the “breakdown in market discipline” in the securitization markets. First, originators or sponsors would be required to retain a five percent economic interest in the credit risk of securitized assets to ensure that securitizers have more “skin in the game”.

Second, to align the compensation of market participants with the longer term performance of the underlying receivables, the Plan proposes changes such as (i) eliminating the immediate recognition of gain on sale by originators under generally accepted accounting principles (GAAP) and instead require originators to recognize income over time, and (ii) requiring many securitizations to be consolidated on the originators’ balance sheets.

Third, the SEC would be given clear authority to require robust ongoing reporting by issuers of asset backed securities (ABS), and to improve and standardize disclosure practices, including requiring ABS issuers to disclose loan-level data, the nature and extent of broker, originator and sponsor compensation, and risk retention for each securitization. The Plan encourages completion of industry initiatives to standardize legal documentation and proposed that the Trade Reporting and Compliance Engine (TRACE) of the SEC and the Financial Industry Regulatory Authority (FINRA) be expanded to include ABS.

Fourth, the SEC would continue its efforts to strengthen the regulation of credit rating agencies, including measures to require that firms have robust policies and procedures that manage and disclose conflicts of interest, differentiate between structured and other products, and otherwise promote the integrity of the ratings process.

Finally, regulators would be required to reduce their use of credit ratings in regulations and supervisory practices, wherever possible.

Comprehensive Regulation of OTC Derivatives Including Credit Default Swaps

OTC derivatives, including credit default swap (CDS) markets, would be subject to a regulatory framework that would (i) impose recordkeeping and reporting requirements on all OTC derivatives; (ii) impose a prudential regulatory structure on all OTC derivative dealers; and (iii) require standardized OTC derivatives to be centrally cleared through regulated clearinghouses and executed on regulated and transparent trading venues.

The CFTC and SEC would have clear authority to police and prevent fraud, market manipulation and other market abuses involving all OTC derivatives and, further, the Plan would give the CFTC authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets.

CFTC-SEC Harmonization

To eliminate regulatory gaps and inconsistencies in the regulation of derivatives products, the Plan would require the CFTC and the SEC to submit a report to Congress by September 30 with recommendations to eliminate differences in statutes and regulations with respect to similar types of financial instruments that are not essential to achieving investor protection, market integrity, or price transparency.

Oversight of Payment, Clearing and Settlement Systems

The Federal Reserve Board would be assigned oversight of all systemically important payment, clearing, and settlement systems. In the case of clearing and settlement systems for regulated markets, the Federal Reserve Board would be required to coordinate its oversight with the CFTC or the SEC, as appropriate, which will remain the primary regulators of such systems.

Oversight of the Insurance Sector

The Plan indicates that the Obama administration will introduce legislation to create and Office of National Insurance (ONI) within UST to coordinate the fragmented state regulation of insurance and improve the ability of U.S. insurance companies to participate in the international insurance markets. ONI would be tasked with gathering information, recommending to the Federal Reserve insurance companies that should be supervised as posing a systemic risk, suggesting changes to the insurance regulatory system and increasing national uniformity, among other duties. The Plan also contemplates the possibility of federally chartered insurance companies and more effective and uniform action by the states.

Frannie Mae, Freddie Mac and the FHLB

While discussing briefly these housing finance government sponsored entities, the Plan does not make any specific recommendations and instead indicates that UST will report on government sponsored entities at the time of the President’s 2011 budget release.

International Cooperation

Finally, the Plan would focus on reaching international consensus on four core issues: (i) regulatory capital standards; (ii) oversight of global financial markets; (iii) supervision of internationally active financial firms; and (iv) crisis prevention and management. Foreign firms whose U.S. operations are deemed to pose risks to the U.S. financial system would be subject to the same prudential regulation and oversight as U.S. firms that pose risks to the U.S. financial system