On June 17, the U.S. Treasury Department released a comprehensive blueprint for financial sector regulatory reform titled “Financial Regulatory Reform: A New Foundation – Rebuilding Financial Supervision and Regulation” (the “Plan”). The Plan is designed to address the key weaknesses in financial regulation that led to the current financial crisis. The Plan proposes significant structural reforms, including heightened powers for the Federal Reserve to regulate risk across the financial system, a new Financial Services Oversight Council chaired by Treasury and including the heads of the principal federal financial regulators, and two new federal agencies, a Consumer Financial Protection Agency and a National Bank Supervisor. The Plan also calls for new substantive regulation across the financial industry, including registration of hedge fund and private equity fund advisers, strengthening of capital requirements and other prudential standards applicable to banks and bank holding companies, comprehensive regulation of over-the-counter derivatives, new requirements for the securitization markets (including a requirement that sponsors and originators retain a financial interest in securitized loans) and new conflict of interest rules for credit rating agencies. The Plan is based on five principal objectives:
- Robust supervision and regulation of financial institutions;
- Comprehensive supervision of financial markets;
- Protection of consumers and investors from financial abuse;
- Providing the government with the tools needed to manage financial crises; and
- Heightened international regulatory standards and improved international cooperation.
Some of the proposals in the Plan can be implemented through administrative rulemaking; however, many of the proposals will require Congressional action. Draft legislation will be released in the coming weeks and can be expected to give rise to intense lobbying efforts both from within the federal government and from financial industry groups.
Initial reaction to the Plan has been mixed. In particular, Congressional leaders and commentators have questioned whether the Federal Reserve should be given expansive power to regulate any firm that poses a threat to financial stability. Some have also questioned why the Plan does not seek greater consolidation of federal financial regulatory agencies – the Plan would retain a system of multiple federal bank regulators, maintain separation between the Securities and Exchange Commission (the “SEC”) and the Commodity Futures Trading Commission (the “CFTC”), and add a new consumer protection agency.
I. Supervision and Regulation of Financial Institutions
The Plan includes the following proposals designed to strengthen supervision and regulation of the largest, most interconnected and most highly leveraged financial institutions:
Financial Services Oversight Council. The Plan proposes to create a permanent Financial Services Oversight Council, which would be chaired by Treasury and would include as members the heads of the other principal federal financial regulators (the Federal Reserve, the Federal Deposit Insurance Corporation (the “FDIC”), the SEC, the CFTC, the Federal Housing Finance Agency and two newly created agencies, the Consumer Financial Protection Agency and the National Bank Supervisor). The Council would facilitate information sharing and coordination among various regulators, identify emerging risks, resolve jurisdictional disputes among regulators and advise the Federal Reserve on the identification and supervision of firms whose failure could pose a threat to financial stability due to their size, leverage and interconnectedness (the Plan refers to such firms as “Tier 1 financial holding companies” or “Tier 1 FHCs”). The Council would have a permanent staff at Treasury and would have broad statutory authority to require periodic and other reports from any U.S. financial firm for the purpose of assessing whether the firm poses a threat to financial stability.
Federal Reserve supervision and regulation of large and influential financial firms. Treasury proposes to designate the Federal Reserve as the “single point of accountability” for the consolidated supervision and regulation of all Tier 1 FHCs (irrespective of whether they own an insured depository institution). The proposal is designed to close loopholes that previously allowed many of the largest Wall Street firms to avoid rigorous consolidated regulation, and it reflects Treasury’s conclusion that ultimate responsibility for prudential standard-setting and supervision of the largest financial firms must rest with a single regulator.
Under the proposal, the Federal Reserve, upon the recommendation of the Financial Services Oversight Council, would be tasked with identifying Tier 1 FHCs in accordance with legislative criteria (which would consider, among other things, the impact of the firm’s failure on the financial system, the firm’s combination of size, leverage and reliance on short-term funding, and its importance as a source of credit and liquidity). To aid the identification of Tier 1 FHCs, the Federal Reserve would be authorized to collect reports from all U.S. financial firms that meet a specified size threshold. A firm’s designation as a Tier 1 FHC would be subject to regular review.
All Tier 1 FHCs would be subject to prudential standards established by the Federal Reserve in consultation with the Financial Services Oversight Council. The prudential standards would be stricter and more conservative than those applicable to other financial firms and would require at a minimum that Tier 1 FHCs meet the qualification requirements for financial holding company status, including (i) capital requirements that are strict enough to be effective under extremely stressful economic and financial conditions, (ii) liquidity standards that promote the integration of liquidity risk management into the overall risk management of the Tier 1 FHC and establish clear exposure limits, (iii) risk management standards that enable the identification of aggregate exposures on a firm-wide basis, (iv) enhanced public disclosures, (v) adherence to the non-financial activity restrictions of the Bank Holding Company Act, regardless of whether the Tier 1 FHC controls an insured depository institution (with a five-year grace period provided to those Tier 1 FHCs that have not been previously subject to the Bank Holding Company Act) and (vi) preparation and continuous updating of rapid resolution plans. In promulgating and enforcing these standards, the Federal Reserve would adopt a “macro-prudential” approach that takes account of risks to the broader financial system as well as the safety and soundness of individual financial firms.
The Federal Reserve’s authority over a Tier 1 FHC would extend to the parent company and any of its subsidiaries, whether regulated or unregulated, U.S. or foreign (including subsidiaries, such as broker-dealers, that have another primary regulator).
Strengthened capital and prudential requirements for all banks and bank holding companies; executive compensation recommendations. The Plan proposes to create a working group to evaluate existing capital requirements for all banks and bank holding companies. The proposal calls for capital and management requirements to be applied on a consolidated basis (rather than limited to a subsidiary depositary institution) and for stronger firewalls between banks and their affiliates. In addition, the Plan calls for new regulatory standards to better align executive compensation practices with long-term shareholder value and supports legislation requiring all public companies to propose nonbinding “say-on-pay” shareholder resolutions.
National Bank Supervisor. The Plan proposes merging the Office of the Comptroller of the Currency (the “OCC”) and the Office of Thrift Supervision into a newly established National Bank Supervisor, which would be an agency with separate status within Treasury (like the current OCC) and would be responsible for supervising all federally chartered banks and all federal branches and agencies of foreign banks. The federal thrift charter would be eliminated. In addition, the current exceptions in the Bank Holding Company Act for institutions that control thrifts, industrial loan companies, credit card banks, trust companies and grandfathered non-traditional banks would be eliminated.
Regulation of private funds. The Plan would require all advisers to private funds “whose assets under management exceed some modest threshold” to register with the SEC. Although the proposal does not define “private fund” for these purposes, it is clear that the registration requirement would apply equally to all types of private fund advisers (including advisers to hedge funds, buyout funds and venture capital funds). Private funds would be subject to additional reporting requirements and the SEC would be authorized to share the reports with the Federal Reserve for purposes of evaluating whether a private fund qualifies as a Tier 1 FHC. For more detail on this proposal, see our June 17 memorandum “Regulation of Private Fund Advisers Imminent.”
Regulation of money market funds. The Plan calls on the SEC to strengthen regulation of money market funds in order to reduce the risk of a fund “breaking the buck” and triggering a run on other money market funds (which happened when the Reserve Fund broke the buck last fall as a result of the Lehman Brothers bankruptcy). Reforms could include: (i) requiring money market funds to maintain substantial liquidity buffers; (ii) reducing the maximum weighted average maturity of assets; (iii) tightening credit concentration limits; (iv) improving the credit risk analysis and management of money market funds; and (v) empowering fund boards of directors to suspend redemptions in extraordinary circumstances to protect the interests of fund shareholders.
Office of National Insurance. The Plan proposes to establish a new Office of National Insurance within Treasury to monitor all aspects of the insurance industry and coordinate policy in the insurance sector. The Plan acknowledges that a federal charter for insurance companies would improve uniformity of standards across the current fragmented system of state regulation, but the Plan does not go so far as to recommend the enactment of such a charter.
Determine future role of government-sponsored enterprises. Treasury and the Department of Housing and Urban Development propose to develop recommendations on the future role of Fannie Mae, Freddie Mac and other government-sponsored enterprises (“GSEs”). Options for the reform of the GSEs include: (i) returning Fannie Mae and Freddie Mac to their previous status as GSEs; (ii) gradual wind-down of their operations; (iii) incorporating the GSEs’ functions into another federal agency; (iv) a public utility model where the government regulates GSE profit margins and provides explicit backing for their commitments; and (v) breaking up Fannie Mae and Freddie Mac into multiple smaller entities.
II. Comprehensive Regulation of Financial Markets
The Plan includes the following proposals designed to strengthen the regulation of financial markets and reduce systemic risk:
Regulation of securitization markets. In an effort to enhance accountability and reduce risk in the securitization markets, the Plan would generally require sponsors and originators of asset-backed securities to retain an economic interest in 5% of the credit risk of securitized credit exposures. The proposal also calls for additional regulations designed to align compensation of market participants with the longer term performance of the securitized assets. The Plan calls on the SEC to continue its efforts to increase transparency and improve disclosure in the securitization markets and to strengthen its regulation of credit rating agencies, particularly with respect to the rating of structured products.
Comprehensive regulation of OTC derivatives. The Plan would mandate comprehensive regulation of all over-the-counter (“OTC”) derivatives, including credit default swaps. Specifically, the proposal would involve amendment of the Commodity Exchange Act and the Securities Exchange Act to require clearing of all standardized OTC derivatives through regulated centralized counterparties. All OTC derivatives dealers would be subject to prudential supervision and regulation, which would include conservative capital requirements, business conduct standards, reporting requirements and conservative requirements relating to initial margins on counterparty credit exposures. The SEC and CFTC would be authorized to impose reporting and recordkeeping requirements with respect to all OTC derivatives. The proposal would also seek to improve market efficiency and price transparency by moving standardized parts of the derivatives markets onto regulated exchanges and regulated electronic trade execution systems and developing a system for timely trade reporting.
Harmonize futures and securities regulation. As noted, the Plan does not go so far as to recommend a merger of the SEC and CFTC, but it does propose to harmonize statutory and regulatory regimes applicable to futures and securities instruments. The Plan recommends that the SEC and CFTC jointly submit a report to Congress by September 30, 2009 identifying all existing conflicts in current regulations with respect to similar types of financial instruments and explaining why differences in regulation are appropriate.
Payment, clearing and settlement systems. The Plan would give the Federal Reserve oversight authority over all systemically important payment, clearing and settlement systems and activities. The Federal Reserve’s responsibilities would include setting and enforcing risk management standards and imposing reporting requirements and conducting examinations of systemically important activities. In addition, the Federal Reserve would have the authority to provide such payment, clearing and settlement systems with access to Reserve Bank accounts, financial services and, in emergency circumstances, the discount window.
III. Protection of Consumers and Investors
The Plan includes the following proposals designed to protect consumers and investors from financial abuse:
Consumer Financial Protection Agency. The Plan would establish a new regulatory agency, the Consumer Financial Protection Agency (the “CFPA”), to protect consumers of credit, savings, payment and other financial products and services. The mandate of the CFPA would be to reduce gaps in federal supervision and enforcement; improve coordination with the states; set higher standards for financial intermediaries; and promote consistent regulation of similar products. The CFPA would have broad rulemaking, supervisory and enforcement authority and its jurisdiction would extend to all financial products and services not otherwise specifically regulated by the SEC or the CFTC.
Broker-dealers and investment advisers. The Plan calls for new legislation to harmonize the regulation of broker-dealers and investment advisers, which are currently regulated under two different statutes. Specifically, the proposed new legislation would (i) require that broker-dealers who provide investment advice about securities to investors be subject to the same fiduciary obligations as registered investment advisers, (ii) require such brokerdealers to provide simple and clear disclosure to investors regarding the scope of the terms of their relationships with investment professionals and (iii) prohibit certain conflicts of interests and sales practices that are contrary to the interests of investors. In addition, the SEC would be given authority under certain circumstances to prohibit mandatory arbitration clauses in broker-dealer and investment advisory accounts with retail customers.
Point of sale disclosure. The Plan would provide the SEC with new authority to require that certain disclosures, including summary prospectuses, be provided to investors at or before the point of sale. Similar point of sale disclosure requirements have been the subject of pending SEC rulemaking for several years.
Protection for whistleblowers and expanded SEC enforcement sanctions. The SEC’s current authority to compensate sources in insider-trading cases would be extended to compensate those that bring “well-documented evidence of fraudulent activity.” In addition, the SEC would be granted authority to impose collateral bars against regulated persons across all aspects of the securities industry rather than just a specific segment of the industry.
Permanent role for the SEC’s Investor Advisory Committee. SEC Chairman Mary Schapiro recently announced the formation of an Investor Advisory Committee to give investors a greater voice in the SEC’s work. The Plan calls for the Investor Advisory Committee to be made permanent by federal statute. The Committee’s charter contemplates a broad role, including: (i) advising the SEC on matters of concern to investors in the securities markets; (ii) providing the SEC with investors’ perspectives on current, non-enforcement, regulatory issues; and (iii) serving as a source of information and recommendations regarding the SEC’s regulatory programs from the point of view of investors.
IV. Management of Financial Crises
The Plan proposes legislation in the following areas to enhance the federal government’s ability to manage future financial crises:
Resolution authority. The Plan recommends the establishment of a resolution authority (modeled on the “systemic risk exception” contained within the existing FDIC resolution regime) for failing bank holding companies and Tier 1 FHCs. The proposal seeks to establish a formal decision process for the use and implementation of this special resolution regime so that the government can address, in an orderly fashion, the potential failure of a financial firm when the stability of the financial system is at risk. The proposal tracks the legislation proposed by Treasury on March 25 with some exceptions. While the previous proposal would have given the FDIC resolution authority in all cases in which such authority was invoked, the new proposal provides that the SEC should act as conservator or receiver when the failing firm’s largest subsidiary is a broker-dealer or securities firm. In addition, while the previous proposal would have granted the FDIC the power to extend loans, purchase assets, guarantee obligations and take other actions with respect to failing firms, the new proposal expressly grants Treasury the authority to decide how to resolve a failing firm pursuant to the special resolution authority, and allows for the possibility that Treasury, rather than the FDIC, would extend such assistance.
Emergency lending authority. The Federal Reserve currently has the authority under Section 13(3) of the Federal Reserve Act to make loans to any person or entity in “unusual and exigent circumstances” provided that the loan is guaranteed or secured to the satisfaction of the Federal Reserve and the borrower is unable to obtain adequate credit from private banks. The Federal Reserve has used this authority extensively in response to the current financial crisis, loaning hundreds of billions of dollars through the Term Asset- Backed Securities Loan Facility and several other broad-based liquidity facilities and through targeted loans to AIG and other distressed financial institutions. The Plan seeks greater accountability by requiring the Federal Reserve to receive prior written approval of the Treasury Secretary before it exercises its emergency lending authority.
V. International Regulatory Standards and Cooperation
The Plan includes the following proposals for improving international financial regulatory standards and cooperation (many of which mirror proposals made at the G-20 summit in April 2009):
Strengthen the international capital framework. Treasury recommends that the Basel Committee on Banking Supervision continue to modify and improve the Basel II capital accord by the end of 2009 by refining the risk weights applicable to the trading book and securitized products, introducing a supplemental leverage ratio and improving the definition of capital. In addition, the proposal urges the Basel Committee, the Financial Stability Board and the Committee on the Global Financial System to implement by the end of 2009 the G-20’s recommendations to mitigate the pro-cyclical effects of the Basel II framework, which would include a requirement for banks to build capital buffers in good times that they can draw down in bad times.
Improve the oversight of global financial markets. Treasury urges national authorities to promote the standardization and improved oversight of credit derivative and other OTC derivative markets, particularly through the use of centralized counterparties, and to advance these goals through international coordination and cooperation.
Enhance supervision of internationally active financial firms. The proposal recommends that the Financial Stability Board and national authorities implement G-20 commitments by establishing and continuing to develop supervisory colleges as means to strengthen international cooperation on the supervision of global financial firms. Treasury also proposes the restructuring of the Financial Stability Board by September 2009.
Other proposals. Treasury urges national authorities to implement Financial Stability Board principles for cross-border crisis prevention and management, introduce compensation practices that are more in line with G-20 commitments, improve accounting standards by the end of 2009 and enhance their regulatory regimes to oversee credit rating agencies.