With developments occurring moment to moment, and press reports focusing on different aspects of financial reform, we are sending this Update to provide you a straightforward guide to the details of The White House’s financial reform plan, Financial Regulatory Reform: A New Foundation (the Plan), announced earlier today.1 The overarching goal of the Plan is “to create a more stable regulatory regime that is flexible and effective; that is able to secure the benefits of financial innovation while guarding the system against its own excess,” said Treasury Secretary Geithner and National Economic Council Lawrence Summers.2 In remarks made to at the ceremonial unveiling of the Plan, President Obama said it is a “sweeping overhaul of the financial regulatory system, a transformation on a scale not seen since the reforms that followed the Great Depression.”
The Plan focuses on five key areas of reform to the existing regulatory scheme:
(1) Robust supervision and regulation of financial firms:
- Create a Financial Services Oversight Council to manage systemic risk. The Council will be comprised of the heads of the remaining federal financial regulators and chaired by the Secretary of the Treasury.
- Implement heightened consolidated supervision and regulation of all large, interconnected financial firms (referred to as Tier 1 FHCs).
- Strengthen capital and other prudential standards for all banks and bank holding companies (BHCs).
- Close loopholes in bank regulation and merge the OTS and OCC to create a National Bank Supervisor to conduct prudential supervision and regulation of federally chartered banks.
- Eliminate the Securities and Exchange Commission’s (SEC) programs for consolidated supervision, and require any investment bank holding company seeking comprehensive consolidated supervision to become regulated by the Federal Reserve.
- Require advisors to hedge funds and other private pools of capital to register with the SEC.
- Reduce the susceptibility to runs of money market mutual funds by strengthening the regulatory framework.
- Enhance oversight of the insurance sector through the establishment of the Office of National Insurance within the Treasury.
- Determine the future role of the Government Sponsored Enterprises.
(2) Establish comprehensive supervision of financial markets:
- Strengthen supervision and regulation of securitization markets, including requirements for originators to retain an economic interest in a material portion of the credit risk of securitized credit exposures, and aligning compensation of market participants with longer term performance of the underlying loans.
- Create comprehensive regulation of all OTC derivatives, including credit default swaps.
- Harmonize futures and securities regulation.
- Strengthen oversight of systemically important payment, clearing, and settlement systems and related activities by giving the Federal Reserve the authority to conduct oversight of such institutions.
- Strengthen settlement capabilities and liquidity resources of systemically important payment, clearing, and settlement systems by giving such institutions access to Federal Reserve Bank accounts and the discount window.
(3) Protect consumers and investors from financial abuse:
- Create a new Consumer Financial Protection Agency with rule-making and enforcement authority.
- Reform consumer protection utilizing transparency, simplicity, fairness, and access.
- Strengthen investor protection.
(4) Provide the government with the tools it needs to manage financial crises:
- Create a resolution regime for failing BHCs, including Tier 1 FHCs.
- Amend the Federal Reserve’s emergency lending authority in Section 13(3) of the Federal Reserve Act to require the prior written approval of the Secretary of the Treasury before the Federal Reserve may lend pursuant to its unusual and exigent circumstances authority.
(5) Raise international regulatory standards and improve international cooperation:
- Strengthen the international capital framework through recommendations to and cooperation with the Basel Committee on Bank Supervision (“BCBS”).
- Improve the oversight of global financial markets.
- Enhance supervision of internationally active financial firms.
- Reform crisis prevention and management authorities and procedures through BCBS guidelines on resolution of global financial firms.
- Strengthen the Financial Stability Board.
- Strengthen prudential regulations.
- Expand the scope of regulation.
- Introduce better compensation practices.
- Promote stronger standards in the prudential regulation, money laundering/terrorist financing, and tax information exchange areas.
- Improve accounting standards.
- Tighten oversight of credit rating agencies.
The New Role of the Federal Reserve and Creation of a Systemic Risk Advisor
The Plan gives the Federal Reserve a substantial role in monitoring systemic risk as well as enhanced authority to set capital standards for all institutions. The Plan calls for the Federal Reserve to have authority to require reports from, and conduct examinations of, important financial institutions, including nonbanks, whose failure would have serious adverse effects on the financial system of the U.S. economy because of the firm’s size, leverage, and interconnectedness with the financial system (Tier 1 FHCs), and their subsidiaries. The Plan would remove the so-called “Fed Lite” restrictions on the Federal Reserve’s power over BHCs that were enacted by the Gramm- Leach-Bliley Act of 1999 (GLB Act). As stated in the Plan, “The GLB Act impedes the Federal Reserve’s ability, as a consolidated supervisor, to obtain information from or impose prudential restrictions on subsidiaries of a BHC that already have a primary supervisor, including banks and other insured depository institutions.”
To aid the Federal Reserve in its role as the systemic risk regulator, the Plan calls for the creation of a Financial Services Oversight Council (Council) to facilitate information sharing and coordination, identify emerging risks, and advise the Federal Reserve on the regulation of Tier 1 FHCs. The Council will advise the Federal Reserve in its role as systemic regulator. The membership of the Council would include: (1) the Secretary of the Treasury, who shall serve as Chairman; (2) the Chairman of the Board of Governors of the Federal Reserve System; (3) the Director of the National Bank Supervisor; (4) the Director of the Consumer Financial Protection Agency; (5) the Chairman of the SEC; (6) the Chairman of the Commodity Futures Trading Commission; (7) the Chairman of the FDIC; and (8) the Director of the Federal Housing Finance Agency. The Council would replace the President’s Working Group on financial Markets. The Plan calls for the Council to have an office within Treasury with a full-time expert support staff. The Council will make recommendations on the systemic threats to the system and report annually to Congress, but will not have the power to overrule the Federal Reserve. The Council will also provide a forum for resolving jurisdictional disputes between regulators.
Merger of the OTS Into the OCC: National Bank Supervisor
Another major feature of the proposal that that has been proposed in previous regulatory reform proposals such as the Paulson Blueprint, introduced on March 31, 2008 and discussed in the Financial Services Regulation Update dated March 25, 2009,3 is a consolidation of bank regulators. The Office of Thrift Supervision will be eliminated through a merger with the Office of the Comptroller of the Currency to create one federal banking regulator, the National Bank Supervisor. The Plan does not call for as much consolidation of regulators as the Paulson Blueprint did, leaving the CFTC and SEC intact. This appears to acknowledge the political difficulties a merger of the SEC and CFTC would cause. The Plan also calls for the elimination of the federal thrift charter, with current federal thrifts becoming federally chartered commercial banks. The national bank/federal commercial bank charter will be the only charter offered by the National Bank Supervisor. Though the federal thrift charter will be eliminated the Plan calls for one of its most important benefits, interstate branching, to be passed on to all banks. The Plan would eliminate current restrictions on interstate branching by national and state banks, noting that States should not be allowed to prevent de novo branching or to impose a minimum requirement on the age of an in-state bank that can be acquired by an out-of-state banking firm.
The Plan preserves the dual banking system as the states would retain their role as chartering authorities. Additionally the Federal Reserve and FDIC would retain their current respective roles as primary federal regulators of member and non-member state-chartered banks. The Plan also calls for the closing of certain regulatory “loopholes” by giving the Federal Reserve responsibility for supervising all holding companies of an insured depository institution, including the parents of socalled “nonbank banks,” industrial loan companies (ILCs), credit card banks, and thrifts. Under the Plan, companies in control of such institutions would be required to register within five years as BHCs under the purview of the Federal Reserve. The Plan reaffirms and strengthens the separation of banking and commerce by requiring all such new BHCs to meet the activity restrictions currently imposed on BHCs.
Independent Agency To Protect Consumers: Consumer Financial Protection Agency
Under the Plan, a Consumer Financial Protection Agency (CFPA) would be created to serve as the primary protection for borrowers, investors, and other consumers. The Plan states that the new agency will be independent and will work to create transparency, simplicity, and fairness to protect consumers in the areas of credit, savings, and payment markets. The CFPA would have rulemaking power (much of which currently is held by the Federal Reserve) as well as enforcement power (currently held by the various federal banking agencies and the Federal Trade Commission). Specifically, the CFPA would be given the authority to make rules for banks and nonbank financial companies, oversee banks for compliance, and enforce compliance through regulatory orders. Moreover, it would enforce all fair-lending laws and the Community Reinvestment Act. The CFPA would have authority to impose appropriate duties of care on financial intermediaries, and the Plan calls for the CFPA to pursue measures to promote effective regulation, including conducting periodic reviews of regulations, an outside advisory counsel, and coordination with the Council. The CFPA’s rules would serve as a floor, not a ceiling, as the states would have the ability to adopt and enforce stricter laws for all institutions.
Wind Down Authority
A major impetus for regulatory reform has been the lack of authority to unwind failing BHCs or nonbank financial companies in an orderly fashion. The Plan recommends that the FDIC resolve failing BHCs, and would also have back-up examination over BHCs. For other financial firms, the proposed resolution regime is modeled on the “systemic risk exception” contained within the FDIC’s resolution regime, which lets it depart from the least cost reduction standard when financial stability is at stake. The process could be initiated by the Treasury, the Federal Reserve, the FDIC, or by the SEC when the largest subsidiary of the failing firm is a broker-dealer or securities firm. The authority to decide whether to resolve a failing firm under the special resolution regime should be vested in Treasury, which could only invoke the authority when consulting with the president and with written recommendation of the FDIC board. The proposal says Treasury should generally appoint the FDIC to act as conservator or receiver, unless the company is mostly a broker-dealer in terms of assets, in which case the SEC would likely be appointed to that role. The conservator or receiver would have to coordinate with foreign counterparties and could decide whether to sell off part of it or its assets to a bridge institution or other entity, including derivatives.
While this proposal certainly restructures the bank regulatory system, it remains to be seen how the Congress will alter the proposal, and how any final legislation will be implemented by the various agencies. There has been some discussion of the White House/Treasury supplying legislative language at some point in the next several weeks, but for the time being the Plan, in the form of a whitepaper, is what will be used for congressional consideration.
We think a particular challenge to any final form of the Plan will be in determining how to identify systemic risk when deciding which entities will in fact be subject to regulation. We also see challenges on the political front as the key to this Plan is absolute visibility into what are today numerous private entities. This will be a difficult and hard fought change, in particular for many pooled funds.
On June 18, 2009, Treasury Secretary Geithner is scheduled to testify before separate hearings of the Senate Banking Committee and the House Financial Services Committee on the Plan. House Financial Services Committee Chair Barney Frank (D-MA) has stated in media reports that he hopes to have completed its version of the bill in July, for September floor consideration. Senate Banking Committee Chairman Christopher Dodd (D-CT) has told media outlets that he does not expect his committee to turn to the Plan until the fall.
While previous calls for regulatory reform in recent years have not had much momentum in Congress, there currently appears to be a strong political will to pass legislation incorporating many of the Plan’s proposals due to the effects of the credit and financial crises. However, some of the proposals, such as closing the pre-1999 unitary thrift and ILC loopholes, or possibly more importantly the credit card bank exemption, may generate strong opposition. It appears unlikely any legislation will be finalized in both the House and the Senate in 2009, but instead will likely carry over into 2010.