On March 26 2009 the Department of the Treasury outlined its framework for financial regulatory reform in a release and through Secretary of Treasury Geithner's testimony before the House of Representatives Committee on Financial Services.(1)
Shortly before this Senator Collins and Representative Castle introduced the Financial System Stabilization and Reform Act of 2009 as S664 and HR1754 in the Senate and House of Representatives, respectively. These are companion bills that would create a new federal systemic risk regulator to oversee regulation of the US financial markets.(2)
Concurrently with its outline for financial regulatory reform, the Treasury proposed the Resolution Authority for Systemically Significant Financial Companies Act of 2009, which would grant the Federal Deposit Insurance Corporation (FDIC) the power to take over and resolve systemically important financial companies under statutory provisions similar to the Federal Deposit Insurance Act provisions applicable to the resolution of insured depositary institutions.(3)
In a reversal of his earlier support for the expedited adoption of the Resolution Authority Act, House Financial Services Committee Chairman Barney Frank recently stated in an interview that legislation relating to the resolution of systemically important financial companies should be folded into broader legislation that would include the creation of a new systemic risk regulator. Frank also stated that he was hopeful that such broader legislation could be passed by the House of Representatives in Autumn 2009 - later than the Treasury and the administration's hoped-for adoption date.
This update summarizes the key provisions of the Treasury release and the proposed acts.
The Treasury's stated purpose of its regulatory reform initiative is to modernize the US regulatory system and create a more stable system that is better equipped to prevent and manage future crises, with stronger protection for consumers and investors.
Four components of proposed regulatory reform
The Treasury outlined four components for its financial regulatory reform:
- addressing systemic risk;
- protecting consumers and investors;
- eliminating gaps in the regulatory structure; and
- fostering international coordination.
The Treasury's initial focus has been on the systemic risk component; it plans to present detailed frameworks for each of the other components in the weeks to come.
Single independent regulator
The framework provides for a "single independent regulator with responsibility over systemically important firms and critical payment and settlement systems".
The Treasury stated that it intends to strengthen oversight for all firms, with higher standards for systemically important financial firms through the proposed regulatory reform. The Treasury intends to work with Congress to enact legislation that:
- defines the characteristics of systemically important firms;
- sets objectives and principles for oversight of these firms; and
- assigns responsibility for regulating these firms.
While Geithner stated that "we need to establish a single entity with responsibility for systemic stability over the major institutions and critical payment and settlement systems and activities", the Treasury has proposed no specifics as to which entity or entities might act in this role. As discussed below, the Stabilization and Reform Act would create a systemic risk regulator consisting of a panel of regulators rather than a single regulator. In her March 26 2009 testimony before the Senate Banking, Housing and Urban Affairs Committee hearing on enhancing investor protection and regulation of the securities market, Securities and Exchange Commission (SEC) Chairman Schapiro stated that she supports the concept of a systemic regulator or college of regulators, noting that "multiple regulators bring a lot to the table in multiple perspectives". While supportive of a new systemic regulator, Schapiro also cautioned against supplanting the role of existing agencies.
In determining which firms should be considered systemically important and thus subject to the stricter regulatory regime, the Treasury proposed that the following characteristics be considered in defining what constitutes a systemically important firm:
- the financial system's interdependence with the firm;
- the firm's size, leverage (including off-balance sheet exposures) and degree of reliance on short-term funding; and
- the firm's importance as a source of credit for households, businesses and governments and as a source of liquidity for the financial system.
The Treasury emphasized that the identification of a firm as systemically important should be based on what the firm does and its potential for systemic risk, rather than the form of the company (ie, a bank or an insurance company).(4)
The Treasury also proposed to expand federal authority for payment and settlement systems through the establishment of a regulator with oversight authority over systemically important payment and settlement systems and activities. Geithner noted in his testimony that any existing federal regulation of systems and participants should be preserved, and that the new regulator should consult and coordinate with existing regulators.
Higher standards on capital and risk management for systemically important firms
The Treasury's proposed regulatory regime would impose more stringent capital, liquidity, counterparty and credit risk management requirements on systemically important firms.
These proposed new requirements would include:
- robust capital requirements;
- stricter liquidity, counterparty and credit risk management requirements; and
- a prompt corrective action regime.
While the Treasury has provided no specifics as to the nature of these requirements, Geithner stated at the House of Representatives hearing that:
"the design and degree of conservatism of the prudential requirements applicable to such firms should take into account the inherent inability of regulators to predict future outcomes. Capital requirements for these firms must be sufficiently robust to be effective farther into the tails of potential outcomes than capital requirements for other financial firms.And they must be less pro-cyclical, requiring firms to build up substantial capital buffers in good economic times so that they can avoid deleveraging in cyclical downturns."
The Treasury also proposed that systemically important firms should be required to have the capability to aggregate "counterparty risk exposure on an enterprise basis within a matter of hours".
Finally, the Treasury called for a prompt corrective action regime similar to the federal banking regulators' power with respect to insured depositary institutions that would enable the systemic regulator to force a systemically important firm to take protective actions as the firm's capital levels decline.
Hedge funds, OTC derivatives and money market funds
In addition, the Treasury proposed regulations relating to hedge funds, the over-the-counter (OTC) derivatives market and money market funds. These regulations would require all hedge fund advisers whose assets under management exceed a certain threshold to register with the SEC and would subject all hedge funds with a SEC-registered adviser to certain disclosure and reporting requirements. The regulations would also impose governmental regulation of the OTC derivatives market and require the use of central counterparties for standardized derivatives contracts. The Treasury also called upon the SEC to propose an enhanced regulatory framework to reduce the credit and liquidity risk profile of money market funds and to make the industry less susceptible to investor withdrawals.
The Stabilization and Reform Act introduces legislation in three areas of the Treasury's financial regulatory reform initiative:
- the creation of a single regulatory authority;
- the filling of regulatory gaps; and
- the creation of a central clearing house for trading credit default swaps.
Financial Stability Council
The Stabilization and Reform Act would create a new federal systemic risk regulator, referred to as the Financial Stability Council, to oversee regulation of the US financial markets.
The Financial Stability Council would consist of a panel of federal financial regulators(5) and the chairman of the Financial Stability Council, who would be appointed by the president with the advice and consent of the Senate "from among individuals having expertise in the financial services industry".
The chairman would not be permitted to act as head of any other federal financial regulator.(6)
Under the Stabilization and Reform Act, the chairman of the council would serve as the principal adviser to the president on matters related to oversight, monitoring and prevention of systemic risk affecting the US financial system. 'Systemic risk' is defined as:
"the risk that a product or activity that is financial in nature, or that a default by a financial institution, will produce failures of, or significant losses to, other financial institutions, resulting in substantial increases in the cost of capital or substantial decreases in the availability of capital, or substantial financial market price volatility."
The chairman would also oversee and direct systemic risk regulatory policy concerning the US financial system, including the identification of gaps in regulatory authority among the federal financial regulators that may contribute to such risk. The chairman would have the authority to:
- review existing rules and regulations of federal financial regulators;
- recommend revisions for the purpose of monitoring and preventing systemic risk; and
- review potential rules and regulations.
To effectuate the purpose of the Stabilization and Reform Act, the chairman would have the authority to require any federal financial regulator to produce any data or information necessary to monitor areas of potential systemic risk, as well as to request data and information from states regarding the solvency of state-regulated insurers. The chairman would also be able to request data and information from insurers directly regarding any product or activity that the council determines may be a product or activity that is financial in nature. The chairman would report to the president and Congress twice a year on:
- the state of the US financial system;
- areas of anticipated systemic risk to the financial system; and
- areas in which the council or a federal financial regulator needs legislative authority to prevent systemic risk.
Under the Stabilization and Reform Act, the council would be required to meet at least quarterly and would have the authority to review, approve, veto or require the modification or issuance of any rule of any federal financial regulator subject to review by the chairman. The council would also have the authority to direct federal financial regulators to impose solvency requirements, including capital requirements and long-term debt ratios, on any financial institution within the regulator's jurisdiction. Finally, the council would have the authority to issue and enforce regulations designed to prevent any product or activity that is financial in nature and not otherwise within the jurisdiction or authority of a federal financial regulator from creating systemic risk to the US financial system.
Credit default swaps and investment bank holding companies
In the area of credit default swaps, the Stabilization and Reform Act would require the creation of a centralized credit default swap clearinghouse subject to regulation by the SEC and capitalized by its participants. Under the Stabilization and Reform Act, any person engaged in a credit default swap transaction would be required to use the clearinghouse to execute a trade. The Stabilization and Reform Act would also give the Federal Reserve Board authority to regulate the safety and soundness of investment bank holding companies (as defined under the Securities Exchange Act of 1934) organized or doing business in the United States. Under the Stabilization and Reform Act, other federal regulatory agencies would be required to provide the Federal Reserve Board with all requested relevant information on the activities of investment bank holding companies.
Abolishment of Office of Thrift Supervision
The Stabilization and Reform Act would abolish the Office of Thrift Supervision and transfer its functions to the Comptroller of the Currency.
Concurrently with its announcement of its financial regulatory reform framework, the Treasury proposed the Resolution Authority Act, which would grant the FDIC the power to take over and resolve systemically significant 'financial companies' under statutory provisions similar to the Federal Deposit Insurance Act provisions applicable to the FDIC's resolution of insured depositary institutions. If enacted, the act's provisions would replace the Federal Bankruptcy Code with respect to the resolution of such financial companies. This could have significant effects on transactions entered into by third parties with such institutions both prior to and after such enactment.(7)
The Resolution Authority Act would define a 'financial company' as any company organized and existing under federal law or the law of any state that is:
- a bank holding company, as defined in the Bank Holding Company Act;
- a financial holding company, as defined in the Bank Holding Company Act;
- a savings and loan holding company, as defined in the Home Owners' Loan Act;
- a holding company of an insurance company;
- a holding company of a broker or dealer registered with the SEC under the Securities Exchange Act of 1934;
- any subsidiary of any of the foregoing (other than an insured depositary institution, any subsidiary thereof, any broker or dealer registered with the SEC under the Securities Exchange Act of 1934 which is a member of the Securities Investor Protection Corporation or any insurance company); or
- a holding company of a futures commission merchant or commodity pool operator.
Systemic risk determination
Upon the recommendation of the Federal Reserve Board and the "appropriate federal regulatory agency", the secretary of the Treasury (in consultation with the president) would be authorized to make a systemic risk determination with respect to a financial company.
A 'systemic risk determination' would require a finding that:
- the financial company is "in default or in danger of default";
- the failure of the financial company and its resolution under otherwise applicable federal or state law would have serious adverse effects on financial stability or economic conditions in the United States; and
- any actions or assistance under the Resolution Authority Act would avoid or mitigate such adverse effects.
For any affiliate of an insured depositary institution or an insurance company, the appropriate federal regulatory agency would be the FDIC.
'In default or in danger of default' would mean that:
- a case has been or likely will be commenced with respect to the financial company under the Federal Bankruptcy Code;
- the financial company is critically under-capitalized;
- the financial company has incurred or is likely to incur losses that deplete its capital and there is no reasonable prospect for the company to avoid such depletion without assistance by the FDIC;
- the financial company's assets are, or are likely to be, less than its obligations to creditors; or
- the financial company is, or is likely to be, unable to pay its obligations in the normal course of business.
One unresolved issue is how affiliates of a 'financial company', as defined in the Resolution Authority Act (particularly those that are insured depositary institutions, broker-dealers or insurance companies), are to be taken into account in making a systemic risk determination with respect to the financial company. Presumably, the intent is that they be considered, although the proposed Resolution Authority Act is not completely clear as to the details.
Actions upon systemic risk determination
Following a systemic risk determination with respect to a financial company, the FDIC would be authorized to appoint itself as conservator or receiver for such company. Here too, there are unanswered questions as to the interplay of a conservatorship or receivership of a financial company under the Resolution Authority Act and similar proceedings with respect to affiliated entities (eg, Federal Bankruptcy Code debtors or depositary institutions) which are subject to alternative resolution schemes (eg, the Federal Bankruptcy Code or the Federal Deposit Insurance Act). In addition, questions remain as to the circumstances under which such affiliates could be pulled into a conservatorship or receivership of a financial holding company even where they are not themselves subject to such similar proceedings.
The FDIC would also be authorized to provide assistance to the financial company in the form of:
- loans to the financial company or any of its subsidiaries;
- asset purchases from the financial company or any of its subsidiaries; and
- the assumption or guarantee of obligations of the financial company or any of its subsidiaries, or sale or transfer of assets, liabilities, obligations, equity interests or securities of the financial company or any of its subsidiaries.
Powers of FDIC as conservator or receiver
The powers of the FDIC as conservator or receiver of a financial company would be similar to those which the FDIC has as conservator or receiver of an insured depositary institution under the Federal Deposit Insurance Act, including:
- the power to disaffirm or repudiate any contract (whether or not executory) to which the financial company is a party, the performance of which the FDIC, in its discretion, determines to be burdensome and the repudiation of which the FDIC determines will promote the orderly administration of the institution's affairs. In such case, damages for repudiation would generally be limited to actual, direct compensatory damages determined as of the date of appointment of the conservator or receiver;
- the power to enforce any contract to which the financial company is a party, notwithstanding any provision of the contract providing for termination, default, acceleration or exercise of rights upon, or solely by reason of, insolvency or the appointment or exercise of rights or powers by the conservator or receiver;
- the power to transfer assets and liabilities of the financial company without obtaining any approval, assignment or consent with respect to such transfer; and
- the power to avoid any transfer made by the financial company within five years prior to the appointment of the FDIC to an 'institution affiliated party' or debtor of the financial company, made with the intent to hinder, delay or defraud the financial company or the FDIC.
Automatic stay and claims process
The Resolution Authority Act would generally impose a 'stay' that bars any person from exercising any right or power to terminate, accelerate or declare a default under any contract to which the financial company is a party, or to obtain possession of or exercise control over any property of the financial company or affect any rights of the financial company, during the 45-day period beginning on the date of the appointment of the conservator or the 90-day period beginning on the date of the appointment of the receiver, as applicable.
Like the Federal Deposit Insurance Act, the proposed Resolution Authority Act contains a detailed claims process which creditors of a financial company would be required to follow as a condition to enforcing their claims.
Special protections for qualified financial contracts
As proposed, the Resolution Authority Act contains special protections, similar to those contained in the Federal Deposit Insurance Act, for securities contracts, commodity contracts, forward contracts,repurchase agreements and swap agreements that are defined as 'qualified financial contracts', including (in the case of a receivership, but not a conservatorship) provisions protecting the ability of a counterparty to close out net such contracts (subject to a one-day delay during which the FDIC may determine to transfer all, but not less than all, of such contracts to a third party).
Like the Federal Deposit Insurance Act, the Resolution Authority Act would establish a claims priority scheme for unsecured claims. However, unlike the Federal Deposit Insurance Act, such a scheme would provide a priority in payment to "any amounts owed to the United States", thus effectively granting priority to amounts owed as a result of financial assistance provided by the FDIC to the financial company under the Resolution Authority Act and pursuant to other governmental programmes (eg, the FDIC's Temporary Liquidity Guarantee Programme).
Written agreement requirement
The proposed Resolution Authority Act provides that an agreement which tends to diminish or defeat the interest of the FDIC as receiver in any asset of a financial company acquired by the FDIC as receiver of such company is not valid against the FDIC, unless such agreement is in writing and executed by an authorized officer or representative of such company. This is a more flexible standard than appears in the Federal Deposit Insurance Act.
Bridge financial companies
The FDIC would have the power to organize federally chartered bridge financial companies, which would be authorized to operate with or without capital and could receive assets and liabilities transferred by the FDIC from a failed financial company. A bridge financial company would be empowered to operate for a two-year period (subject to extension for three additional one-year periods). In the interim, the FDIC would be authorized to resolve the bridge financial company, including through the sale of 80% or more of the capital stock of the bridge financial company to a third party.
The Resolution Authority Act would appropriate to the FDIC such sums as are necessary to carry out the authorities granted by the act, without fiscal year limitation. The FDIC would be authorized to recover any such funds expended through one or more special assessments on financial companies. The deposit insurance fund would not be available to fund such expenditures.
For further information on this topic please contact Daniel M Rossner, Giselle M Barth or Madeleine J Dowling at Sidley Austin LLP's New York office by telephone (+1 212 839 5300) or by fax (+1 212 839 5599) or by email ([email protected] or [email protected] or [email protected]).Alternatively, please contact David E Teitelbaum at Sidley Austin LLP's Washington DC office by telephone (+1 202 736 8000) or by fax (+1 202 736 8711) or by email ([email protected]).
(2) The proposed Stabilization and Reform Act is available at http://thomas.loc.gov/cgi-bin/query/z?c111:H.R.1754.IH:
(3) The proposed Resolution Authority Act is available at www.treas.gov/press/releases/reports/032509%20legislation.pdf.
(5) The members of the Financial Stability Council would consist of the chairman of the council, the secretary of the Treasury, the chairman of the Federal Reserve Board, the chairman of the FDIC, the chairman of the National Credit Union Administration, the chairman of the SEC and the chairman of the Commodity Futures Trading Commission.
(6) The Stabilization and Reform Act defines a 'federal financial regulator' as the Comptroller of the Currency, the Federal Reserve Board, the FDIC, the National Credit Union Administration, the SEC, the Commodity Futures Trade Commission, the Treasury, the Pension Benefit Guarantee Corporation, the Federal Housing Finance Agency and any other agency or component thereof designated by the president as a federal financial regulator.
(7) For a summary of significant differences between the Federal Bankruptcy Code and the Federal Deposit Insurance Act insolvency regimes, prepared by the Congressional Research Service for members of Congress in connection with their consideration of the Resolution Authority Act, see CRS Report R40530, Insolvency of Systemically Significant Financial Companies: Bankruptcy v Conservatorship/Receivership (April 20 2009).
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