On June 17, 2009, the Obama Administration detailed its proposal for financial regulatory reform. The proposal states that the five key objectives of the reform are to: (1) promote robust supervision and regulation of financial firms; (2) establish comprehensive supervision and regulation of financial markets; (3) protect consumers and investors from financial abuse; (4) improve tools for managing financial crises; and (5) raise international regulatory standards and improve international cooperation. These objectives are deemed to be necessary to restore confidence in the integrity of the United States' financial systems and to prevent another era of financial failure. The 85-page proposal details a plan to achieve each of these objectives.
This Client Alert provides an overview of the Administration's proposed reform and addresses each objective.
I. Promote Robust Supervision and Regulation of Financial Firms
The Administration listed four main problems with the previous supervision and regulation of financial firms that led to the current economic crises. First, capital and liquidity requirements were too low. Second, on a systemic basis, regulators did not take into account the harm that large, interconnected, and highly leveraged institutions could inflict on the financial system and on the economy if they failed. Third, the responsibility for supervising the consolidated operations of large financial firms was split among various federal agencies. Finally, investment banks operated with insufficient government oversight. The proposal seeks to correct each of these problems.
A. The proposal seeks to create a Financial Services Oversight Council to oversee financial firms.
The duties of the proposed Financial Services Oversight Council would be to facilitate information sharing and coordination, identify emerging risks, advise the Federal Reserve on the identification of firms whose failure could pose a threat to financial stability due to their combination of size, leverage, and interconnectedness, and provide a forum for resolving jurisdictional disputes between regulators. The Council would be comprised of the individuals holding the following positions:
- the Secretary of the Treasury;
- the Chairman of the Board of Governors of the Federal Reserve System;
- the Director of the National Bank Supervisor (described below);
- the Director of the Consumer Financial Protection Agency (described below);
- the Chairman of the Securities and Exchange Commission (SEC);
- the Chairman of the Commodity Futures Trading Commission (CFTC);
- the Chairman of the Federal Deposit Insurance Corporation (FDIC); and
- the Director of the Federal Housing Finance Agency. The Council will be aided by an office created within the Treasury.
The Council, which will replace the President's Working Group on Financial Markets, will be given authority to require reports and to gather information from any U.S. financial firm. The purpose of these reports will be to assess the extent to which a financial activity or financial market in which the firm participates poses a threat to financial stability.
B. The proposal suggests that the Federal Reserve Board should have the authority and accountability for consolidation and regulation of all large interconnected financial firms.
Maintaining that any financial firm whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed should be subject to more stringent supervision and regulation, the proposal provides that these types of firms, which may have avoided the more rigorous oversight regime applicable under the Bank Holding Company Act, will be subject to such oversight regardless of whether the firm owns an insured depository institution. The proposal lists factors to be considered by the Federal Reserve in determining whether a firm falls into this category. These factors include (i) the impact the firm's failure would have on the financial system and the economy; (ii) the firm's combination of size, leverage, and degree of reliance on short-term funding; and (iii) the firm's criticality as a source of liquidity for the financial system.
In addition to providing guidance for determining which firms will be regulated, the proposal also asserts that the prudential standards for these firms must be stricter and more conservative. The proposal invests the duty of determining these standards in the Federal Reserve with consultation from the Financial Services Oversight Council. The goal of the standards should be to maximize financial stability at the lowest cost to long-term financial and economic growth.
C. The proposal seeks to strengthen capital and other prudential standards for all banks and bank holding companies.
The proposal appoints the Treasury to assess various regulatory and supervisory issues in connection with banks and bank holding companies in an effort to strengthen the safety and soundness of such institutions. The Treasury is to lead working groups consisting of representatives from the federal financial regulatory agencies and outside experts in conducting a fundamental reassessment of the supervision and existing regulatory capital requirements for these institutions. The working groups are to issue reports on these matters by October 1, 2009 and December 31, 2009, respectively.
The proposal also outlines principles necessary to better align executive compensation practices of financial firms with the interests of shareholders and the stability of the firms. These principles include the following:
- First, compensation plans should properly measure and reward performance.
- Second, compensation should be structured to account for the time horizon of risks.
- Third, compensation practices should be aligned with sound risk management.
- Fourth, golden parachutes and supplemental retirement packages should be reexamined to determine whether they align the interests of executives and shareholders. The last principle that the proposal sets forth is that transparency and accountability should be promoted in the process of setting compensation.
D. The proposal seeks to eliminate loopholes in bank regulation.
The President proposes the creation of a new federal government agency, the National Bank Supervisor, which will eliminate the problems created by multiple government agencies regulating similar financial firms. This single federal agency will be dedicated to the chartering and prudential supervision and regulation of national banks and federal branches and agencies of foreign banks. The National Bank Supervisor, as stated by the proposal, will inherit the Office of the Comptroller of the Currency and the Office of Thrift Supervision's authorities to require reports, conduct examinations, impose and enforce prudential requirements, and conduct overall supervision. This single federal agency should have a separate status within the Treasury and should be led by a single executive.
The proposal also seeks to eliminate the federal thrift charter. The federal thrift charter should be eliminated, according to the proposal, because there is no longer a need for a special class of mortgage-focused depository institutions. Also, the proposal asserts that the availability of the federal thrift charter has created opportunities for private sector arbitrage of our financial regulatory system. Therefore, the President seeks to eliminate this charter subject to reasonable transition arrangements.
With the thrift charter eliminated, thrift holding companies would become bank holding companies subject to regulation. Under the proposal, many other types of companies will also become bank holding companies so as to not avoid regulation. These include industrial loan companies, credit card banks, and trust companies.
E. The proposal advances other actions to be taken in the effort to more effectively supervise and regulate financial firms.
The proposal seeks to eliminate the SEC's programs for consolidated supervision. In addition, it will require all advisors to hedge funds and other private pools of capital to register with the SEC under the Investment Advisors Act in order to acquire information to assess whether any fund poses a threat to financial stability. The proposal also recommends that the SEC move forward with its plans to strengthen the regulatory framework around money market mutual funds (MMFs) to reduce the credit and liquidity risk profile of individual MMFs and to make the MMF industry as a whole less susceptible to runs. To accomplish this, the proposal suggests that the President's Working Group on Financial Markets should prepare a report considering fundamental changes to address systemic risk more directly. Finally, the proposal seeks to enhance the oversight of the insurance sector. To this end, a federal Office of National Insurance within the Treasury has been proposed and a modern regulatory framework should be developed. Together these proposals are to provide greater supervision and regulation of financial firms.
In regard to the GSEs (Government Sponsors Enterprises), the Administration proposes that Treasury, HUD and other agencies study various initiatives and make recommendations as to the future role, if any, of Fannie Mae, Freddie Mac and the Federal Home Loan Banks. Possible options range from returning the GSEs to their previous status as GSEs, with the paired interests of maximizing returns for private shareholders and pursuing public policy home ownership goals, to dissolution.
II. Establish Comprehensive Regulation of Financial Markets
A. Strengthen supervision and regulation of securitization markets
The proposal asserts that the federal banking agencies should promulgate regulations that require the originator or sponsor of a securitized credit exposure to retain an economic interest in a material portion of the credit risk of that credit exposure. This will provide incentives for lenders and securitizers to consider the performance of the underlying loans after asset backed securities are issued. It also provides that regulators should promulgate additional regulations to align compensation of market participants with longer term performance of the underlying loans. The proposal suggests that the SEC should continue its efforts to increase the transparency and standardization of markets and be given clear authority to require reporting by issuers of asset backed securities. Finally, the proposal asserts that the SEC should continue its efforts to strengthen the regulation of credit rating agencies, however, regulators should reduce their use of credit ratings in regulations and supervisory practices.
B. Create comprehensive regulation of all over-the-counter derivatives
The proposal lists four objectives sought to be achieved by the design of the regulation. These are (1) preventing activities in the over-the-counter derivatives markets from posing risk to the financial system; (2) promoting the efficiency and transparency of those markets; (3) preventing market manipulation, fraud, and other market abuses; and (4) ensuring that over-the-counter derivatives are not marketed inappropriately to unsophisticated parties.
C. Harmonize futures and securities regulation
The proposal notes that the growth of derivatives markets and the introduction of new derivative instruments have highlighted the need for addressing gaps and inconsistencies in the regulation of these products by the Commodity Futures Trading Commission and the Securities and Exchange Commission. It asserts that eliminating jurisdictional uncertainties and ensuring economically equivalent instruments regulated in the same manner would remove impediments to product innovation, such as when two agencies have overlapping jurisdiction yet conflicting theories of regulation are issued. To address this issue and to begin implementing the harmonization of futures and securities regulation, the proposal recommends that the CFTC and the SEC complete a report to Congress by September 30, 2009 that identifies all existing conflicts in statutes and regulations and either explains why those differences are essential to achieve underlying policy objectives or makes recommendations for changes to statutes and regulations that would eliminate the differences.
D. Guidance on systemically important payment, clearing, and settlement systems
The Federal Reserve should have responsibility and authority to conduct oversight of systemically important payment, clearing and settlement systems, and activities of financial firms. In addition, Congress should grant the Federal Reserve authority to provide systemically important payment, clearing, and settlement systems access to Reserve Bank accounts, financial services, and the discount window.
III. Protect Consumers and Investors from Financial Abuse
A. A new federal agency is recommended that is devoted to consumer protection in financial services.
The most extensive proposal offered to protect consumers is the creation of a new Consumer Financial Protection Agency (CFPA). This agency will be dedicated to protecting consumers in the financial products and services markets, except for investment products and services already regulated by the SEC or CFTC. The agency's creation is supported by the assertion that consumer protection gives the public confidence that financial markets are fair and enables policy makers and regulators to maintain stability in regulation.
The proposal notes that the Federal Trade Commission (FTC) has a clear mission to protect consumers, but that it lacks jurisdiction over the banking sector and has limited tools and resources to promote robust compliance of nonbank institutions.
The proposal describes several characteristics of the CFPA.
- First, it states that the CFPA should have broad jurisdiction to protect consumers in consumer financial products and services such as credit, savings, and payment products.
- Second, the CFPA should be an independent agency with stable and robust funding.
- Third, the agency should have sole rule-making authority for consumer financial protection statutes, as well as the ability to fill gaps through rule-making.
- Fourth, the CFPA should have supervisory and enforcement authority and jurisdiction over all persons covered by the statutes that it implements, including both insured depositories and the range of other firms not previously subject to comprehensive federal supervision, and it should work with the Department of Justice to enforce the statutes under its jurisdiction in federal court.
- Fifth, the agency should pursue measures to promote effective regulation, including conducting periodic reviews of regulations, soliciting advice of an outside advisory council, and coordination with the Council.
- Sixth, the CFPA's rules should not preempt state laws, as states should have the ability to adopt and enforce stricter laws for institutions of all types.
- Finally, the new federal agency should have a wide variety of tools to enable it to perform its functions effectively.
The tools that should be utilized by the CFPA are the authority to conduct research and collect data, to collect and track complaints about consumer financial services, to provide financial education to consumers, and to promote community development investment and fair and impartial access to credit. The proposal goes further by stating that the Federal Trade Commission should be given better tools to protect consumers. Even though the CFPA is to have primary authority over financial products and services protection, the Administration believes that the FTC should retain backup authority with the CFPA for the statutes for which the FTC currently has jurisdiction. The proposal suggests that the FTC should retain authority for dealing with fraud in the financial marketplace, including the sale of services like advance fee loans, credit repair, debt negotiation, and foreclosure rescue/loan modification fraud; however, the proposal states that the FTC should also provide such authority to the CFPA. Finally, the proposal provides that the FTC should also remain the lead federal consumer protection agency on matters of data security, with front-end privacy protection on financial issues moved to the CFPA.
B. Reforms of consumer protection should be based on principles of transparency, simplicity, fairness, accountability, and access for all.
To satisfy the principle of transparency, the proposal suggests a new proactive approach to disclosure and authorize the CFPA to require that all disclosures and other communications with consumers be reasonable. To be reasonable, the proposal states that the communications should be balanced in their presentation of benefits, and clear and conspicuous in their identification of costs, penalties, and risks. In regard to simplification, the proposal states that the regulator should be authorized to define standards for products that are simpler and have straightforward pricing. The proposal satisfies the principle of fairness by requiring the CFPA to place tailored restrictions on product terms and provider practices. The proposal also authorizes the CFPA to impose appropriate duties of care on financial intermediaries. Lastly, the proposal seeks to assure access by stating that the Agency should enforce fair lending laws and the Community Reinvestment Act and otherwise seek to ensure that underserved consumers and communities have access to prudent financial services, lending, and investment.
Recommended consumer protections include:
- Promoting concise and clear information for consumers.
- Protecting consumers from unfair and deceptive practices.
- Creating higher standards and level playing field across bank and non-bank firms.
- Stronger supervision and compliance examinations.
- Creating standards for "plain vanilla" products with straight forward pricing, with alternative products subject to greater scrutiny.
- Banning unfair terms and practices and imposing heightened duties of care on financial intermediaries.
C. The framework for investor protection should also be strengthened by focusing on principles of transparency, fairness, and accountability.
In light of the recent investment scandals such as the Madoff Ponzi scheme, the proposal also seeks to make the investment market a more secure place for investors. The proposal states that this goal has already been undertaken by the SEC in their current efforts to strengthen and streamline its enforcement process and to expand resources for enforcement. However, the proposal suggests that further measures are necessary to ensure investor protection; these measures should focus on the principles of transparency, fairness, and accountability.
To adequately satisfy these principles, the proposal suggests expanded authority, new tools, and a coordinating council.
- First, the proposal asserts that the SEC should be given expanded authority to promote transparency in disclosures to investors.
- Second, the SEC should be given new tools to promote fair treatment of investors such as the establishment of a fiduciary duty for broker-dealers offering investment advice.
- Third, the proposal states that financial firms and public companies should be accountable to their clients and investors. This may be accomplished by expanding protections for whistleblowers, expanding sanctions available in enforcement actions, and requiring non-binding shareholder votes on executive compensation packages.
- Fourth, the proposal suggests that to address potential gaps in consumer and investor protection and to promote best practices across different markets, a coordinating council should be created. This council should include the heads of the SEC, FTC, the Department of Justice, and the CFPA or their designees, and other state and federal agencies. These practices, according to the proposal, will establish a system that promotes the principles of transparency, simplicity, fairness, and accountability.
IV. Provide the Government with the Tools It Needs to Manage Financial Crises
To establish this objective, the proposal recommends the creation of a resolution regime for failing bank holding companies, including those financial firms discussed earlier that have the greatest risk of affecting the economy if they fail. The use of such a resolution regime would avoid the disorderly resolution of failing bank holding companies if a disorderly resolution would have serious adverse effects on the financial system or the economy. This regime would serve as a supplement to, and be modeled on, the existing resolution regime for insured depository institutions under the Federal Deposit Insurance Act.
The proposal states that the authority to decide whether and how to resolve a failing firm under the special resolution regime should be vested in the Treasury, which could invoke the authority only after consulting with the President and only upon written recommendation of two-thirds of the members of the Federal Reserve Board and two-thirds of the members of the FDIC Board. To invoke this authority, the proposal suggests, the Treasury should have to determine that: (1) the firm is in default or in danger of defaulting; (2) the failure of the firm and its resolution under otherwise applicable law would have serious adverse effects on the financial system or the economy; and (3) use by the government of the special resolution regime would avoid or mitigate these adverse effects. This process should provide a framework to better handle the failure of a bank holding company and avoid disorderly resolution of financial firms.
V. Raise International Regulatory Standards and Improve International Cooperation
Since financial regulation is set in a national context, localized financial stress can spread throughout the world due to the lack of an international regulatory system. The proposal suggests that an international consensus regarding financial regulation would alleviate the risk facing the global financial system in the face of a localized economic meltdown. Some proposals listed to accomplish this goal are to strengthen the international capital framework, improve the oversight of global financial markets, enhance supervision of internationally active financial firms, strengthen prudential regulations, improve accounting standards, and tighten oversight of credit rating agencies. These proposals are part of an eight-part declaration by the G-20 Leaders during the London Summit in April 2009. The purpose of the London Summit declaration was to outline a comprehensive plan for financial regulatory reform.
VI. Stay Tuned
Fault lines emerged immediately after the release of the proposal. Trade groups such as the American Bankers Association, which represents thousands of banks owned by tens of thousands of community leaders, swiftly criticized the proposal; "The inclusion of the highly controversial Consumer Financial Protection Agency will undermine chances of enactment of needed reform," said Ed Yingling, the Association's president. Furthermore, many Republicans are opposed to expanding the Federal Reserve Board's powers, because they fear it will corrupt the central bank's basic mission to regulate economic growth, and they believe the plan needlessly imposes new layers of oversight on the markets. Others believe that the Federal Reserve Board failed in protecting consumers and in regulating large banks and do not favor expanding the agency's powers.