Treasury Secretary Geithner testified recently before the House Committee on Financial Services on the subject of regulatory reform in the financial services industry. His testimony outlined four principles that the Administration will follow in seeking to restructure the regulation of financial services companies. Concurrently, the Treasury Department released proposed legislation that, if enacted, would address the resolution of Systemically Significant Financial Companies (SSFCs).

The four broad principles outlined by Secretary Geithner for financial services regulatory reform are (i) addressing systemic risk, (ii) protecting consumers and investors, (iii) eliminating gaps in the regulatory structure and (iv) fostering international coordination.

As to systemic risk, Treasury indicated that the circumstances of companies like Lehman Brothers and AIG made clear that large, interconnected firms and markets need to operate under a regulatory regime, the purpose of which is to ensure the stability of the system itself and not just to address individual companies.

The Madoff fraud scandal and subprime mortgage loan abuses were cited as examples of the need for strengthened enforcement and transparency for, respectively, investors and consumers of financial services. Secretary Geithner testified that the Administration was working on a comprehensive plan for consumer and investor protection that would simplify financial decisions and protect against unfair and deceptive practices.

Treasury’s goals as to financial services regulatory structure are to “assign clear authority, resources and accountability” for each key regulatory function. Secretary Geithner stressed that the regulatory system must be comprehensive and eliminate gaps in coverage.

Internationally, Treasury’s plan is to ensure that rules for international financial regulation are consistent with those to be implemented in the United States. That involves working with G-20 countries to promote more robust regulatory standards worldwide and to seek to address prudential supervision, tax havens and money laundering in poorly regulated countries.

Secretary Geithner’s testimony specifically addressed the first principle, systemic risk. Treasury’s position is that a single independent regulator should be created with responsibility over SSFCs and critical payment systems. He did not specify a precise definition for a SSFC but indicated that factors should include the financial systems’ interdependence with the company, the company’s size, leverage (including off balance sheet exposures) and degree of reliance on short term funding, and its importance as a source of credit and liquidity for the financial system. Secretary Geithner stressed that such a firm could be a financial company of any type, not just a bank or bank holding company. SSFCs would be regulated based on what they do and the systemic risk they pose, not by the type of charter they hold.

Treasury intends to facilitate more robust capital, liquidity, counterparty and credit risk management requirements for SSFCs and create a prompt corrective action regime similar to that now applicable to banks and savings associations. The Treasury agenda also involves registration requirements and stricter regulation of hedge funds, regulation of credit default swaps and over the counter derivatives and strengthened regulation of money market mutual funds, some of which “broke the buck” (i.e., saw a net asset value below one dollar per share) and/or suffered liquidity pressures in the wake of the failure of Lehman Brothers.

Treasury is also seeking clarified and consistent federal authority over payment and settlement systems. Weakness in settlement systems for certain funding and risk transfer markets is seen as a possible cause of the spread of financial distress systemically and internationally.

Treasury’s first systemic risk initiative is the issuance of draft legislation dealing with the resolution of SSFCs. The legislation, called the “Resolution Authority for Systemically Significant Financial Companies Act of 2009,” would generally apply to financial companies, including bank, financial and savings and loan holding companies, insurance companies, registered broker-dealers, futures commission merchants or commodities pool operators, and any affiliates or subsidiaries of such companies (except insured depository institutions, which are already subject to a resolution scheme). Secretary Geithner indicated that the authority provided by the draft legislation is intended to be permanent and may need modification to incorporate subsequent legislation concerning broader regulatory reform.

The draft legislation allows for federal government intervention with a financial company under certain conditions. Both the assigned appropriate federal regulatory agency of the SSFC (i.e., Securities and Exchange Commission for broker-dealers, Federal Deposit Insurance Corporation (“FDIC”) for depository institution affiliates and insurance companies, Commodities Futures Trading Commission for futures commission merchants or commodity pool operators) and the Federal Reserve Board (upon a vote of at least two-thirds of the board or commission members in each instance) must make a written recommendation to the Treasury Secretary describing the effect that default of the financial company would have on the economic stability or financial stability of the United States and the nature of recommended corrective actions. The Secretary (in consultation with the President) would then determine whether that (i) the financial company is in default or in danger of default; (ii) the failure of the company would have serious adverse effects on the financial stability of the United States and (iii) taking action under the resolution statute would avoid or mitigate such adverse effects.

Upon that determination, the FDIC would be given certain authority (in consultation with Treasury) over the SSFC. Such authority includes providing assistance to the company in the form of loans, guarantees, equity capital injections or asset purchases and appointing itself as conservator or receiver of the company. If the FDIC appoints itself as conservator of receiver of the company, its rights and responsibilities would be very similar to those under current law when it is appointed conservator or receiver of a failed bank or savings association, including the power to repudiate contracts, merge the company or transfer its assets or liquidate the company. The SSFC would have thirty days to challenge the appointment of a conservator or receiver in federal court. A conservatorship or receivership under the proposed legislative scheme would terminate any proceeding under federal or state bankruptcy laws. Resolutions and assistance would be funded, not through the Deposit Insurance Fund applicable to banks and savings associations, but through an appropriation out of Treasury’s general fund and/or by assessments on covered financial companies.

Treasury’s outline for regulatory reform is ambitious. As Secretary Geithner put it, the intent is “not modest repairs at the margin, but new rules of the road.” However, notwithstanding the urgency resulting from the economic turmoil, many difficult issues will need to be addressed in the legislative process. For example, the legal and policy considerations surrounding the federal government’s seizure of private non-bank financial companies differ from those involving the receivership of an insured depository institution. The latter, in effect, opts into the legislative scheme by applying for and maintaining federal deposit insurance. The situation may not be the same for other financial companies. Secretary Geithner indicated that he believes that the requirements for at least a two-thirds vote of the Federal Reserve Board and the board or commission of the SSFC’s appropriate federal agency, plus the necessity for Treasury (in consultation with the President) to make certain findings regarding the default of the company and the systemic risk posed, are sufficient safeguards to limit government intervention to the most serious cases. However, that is something that will have to be resolved by Congress during the legislative process.