Yesterday, the Congressional Oversight Panel (COP) overseeing the Troubled Asset Relief Program (TARP) released a report describing various shortcomings of the current financial regulatory framework and proposing recommendations for improvement. Of the five-member panel, the three members of the COP appointed by Democratic lawmakers, including its chairman, Harvard Law School professor Elizabeth Warren, voted to approve the report, while the two members appointed by the Republican minority voted against and expressed their dissenting views in an attachment to the majority report. This is the third regulatory reform report since the beginning of the year. The Group of Thirty released a set of recommendations on January 15, and the General Accounting Office issued a report on January 21.
The majority report concludes that the current crisis “was not unforeseeable,” as “deregulation and growth of unregulated, parallel shadow markets were accompanied by nearly unrestricted marketing of increasingly complex consumer financial products that multiplied risk at every stratum of the economy, from the family level to the global level.” The majority report focuses on the failure of the current regulatory system in three major aspects:
- Effectively managing private and public risk through better oversight of systemic risks and the “companies that are now deemed ‘too big to fail’”;
- Requiring sufficient transparency and information through better, more accurate credit ratings; and
- Ensuring protection from unfair dealing through better regulation of consumer financial products.
The majority report also presents the following recommendations for significant financial regulatory reform:
- Identify and regulate financial institutions that pose systemic risk by mandating that a new or existing agency or interagency task force regulate systemic risk within the financial system on an ongoing basis, not just when crisis appears imminent; imposing heightened regulatory requirements for systemically significant financial institutions; and establishing a receivership and liquidation process for systemically significant non-bank institutions that is similar to the existing system for banks.
- Limit excessive leverage in American financial institutions by adopting regulatory options to strengthen risk-based capital and curtail leverage.
- Modernize supervision of the shadow financial system (including unregulated financial instruments, off-balance sheet entities, hedge funds, and private equity funds) by ensuring consistency of regulation for instruments currently operating in the shadow financial system and increasing transparency in the OTC derivatives markets through regulated clearinghouses, standardized derivatives markets and public reporting requirements.
- Create a new system for federal and state regulation of mortgages and other consumer credit products by eliminating federal preemption of state consumer protection laws for national banks and creating a single federal regulator for consumer credit products.
- Create executive pay structures that discourage excessive risk taking by creating tax incentives to encourage long-term-oriented pay packages; encouraging financial regulators to guard against asymmetric pay packages in financial institutions which disproportionately reward risk but do not penalize failures; requiring executive pay contracts to provide for clawbacks of bonus compensation for executives of failing institutions; and encouraging corporate governance structures with stronger board and long-term investor oversight of pay packages.
- Reform the credit rating system by adopting regulatory options to address conflicts of interest and incentives; reforming the quasi-public role of the various nationally recognized statistical rating organizations; and creating a new public entity – a Credit Rating Review Board – that would have to approve any rating before it is added to a bank or pension fund portfolio or would audit ratings to Sensure sufficient disclosure by rating agencies of their rating methodologies.
- Make establishing a global financial regulatory floor a U.S. diplomatic priority by building alliances with foreign partners and actively participating in international organizations that are designed to strengthen communication and cooperation among national regulators.
- Plan for the next crisis by creating a Financial Risk Council of outside experts to report to Congress and regulators on possible looming challenges.
Finally, the majority report recommends that additional specialized review be undertaken by the relevant regulatory agencies with respect to such topics as accounting rules, securitization and short-selling to determine what further financial regulatory reforms will be necessary.
The dissenting report argues that misguided regulations targeting housing reform “helped set the stage for the current financial crisis,” and cautioned that over-regulation could reduce competition and increase costs to consumers. The dissenters recommended reform of the mortgage finance system, modernization of the regulatory structure for financial institutions, strengthening capital requirements and improving risk management and addressing systemic risk.