Major Financial Regulation Shakeup Will Take Years To Pass And Implement

April 2008

Library Sections:

Last week the U.S. Treasury released its “Blueprint for Financial Regulatory Reform”. The over 200-page document proposes the most sweeping regulatory changes since adoption of the Securities Exchange Acts of 1933 and 1934. Because of the need for Congressional approval and all of the political issues that arise with this, no changes will likely be passed during the Bush administration.

Fewer Regulatory Agencies

The plan is premised on the notion that fewer regulators are better. The plan consolidates authority in a smaller number of more important authorities. This is the model used by the UK, Japan, and certain other developed countries that provide the U.S. with competition in international markets. For example, in London (which provides significant and expanding competition to New York as a financial center), Britain’s Financial Services Authority oversees the entire market as a single super-regulator.

The plan primarily suggests rearrangements and clarifications of current regulatory responsibilities. There would be three large financial regulators, as follows:

"a regulator focused on market stability across the entire financial sector, a regulator focused on safety and soundness of those institutions supported by a federal guarantee, and a regulator focused on protecting consumers and investors."

Here are the details:

The Federal Reserve would receive broad responsibility for market regulation and stability. The Federal Reserve’s role would be greatly expanded to encompass the Securities and Exchange Commission’s (SEC) current disclosure, accounting, and governance regulatory functions. Until now, the central bank has had only a portion of the banking system under its supervisory authority. Under the plan, the Fed would obtain the authority to inspect institutions, insist on corrective action, and examine books of anyone that borrows through its discount window.
A "prudential financial regulator" would replace the Office of the Comptroller of the Currency (OCC) and Office of Thrift Supervision (OTS). This authority would focus "on regulation that ensures the safety and soundness of institutions with federal guarantees". The study suggests that this regulator could also take on the role of supervising state-chartered banks.
A “Conduct of Business Regulatory Agency” would take over consumer protection functions of the SEC and the Commodity Futures Trading Commission (CFTC). The regulator "would assume many of the current roles of the CFTC, the SEC, and the consumer protection and enforcement roles of our insurance and banking regulator".

The proposal allows insurance companies to opt out of state regulation in favor of a new federal insurance regulator. Much of the insurance industry is likely to agree with this, because it eliminates the fifty state regulators that are now involved. State oversight is costly and has stymied the development of national products.

Based on responsibilities under the plan, the SEC is the big loser, while the Fed gets vastly increased powers as the chief regulator for the safety and soundness of financial markets. In the past, the Federal Reserve (aka the Fed) has been responsible for banks’ safety and soundness, while the SEC oversaw Wall Street firms.

Substantive Regulation Changes (or lack thereof)

In an obvious reaction to the current subprime mortgage mess, the proposal seeks a new Mortgage Origination Commission. It would (i) award grades to be used when packaging loans into securitization pools, (ii) oversee federal minimum standards for mortgage brokers and (iii) establish licensing and qualification standards, records of personal conduct, and standards under which a broker could lose a license. However, states would enforce these new federal regulations covering mortgages.

It should not surprise anyone that Treasury Secretary Henry Paulson, the former CEO of Goldman Sacs, delivered a plan that is sympathetic to Wall Street wishes. The plan does not recommend dramatic new regulation. There are some new requirements for previously unregulated entities (including hedge funds and private-equity firms) to provide additional information, but there are few restrictions beyond disclosure.

The blueprint calls for additional disclosure for financial institutions. Specifically:

"Given the significance of financial institutions to overall financial market stability and the importance of market discipline, enhanced public disclosures over and above the requirements applicable to other publicly traded companies would be important."

Those added disclosures could be part of a separate section of the company's financials or part of the company's Management’s Discussion and Analysis.

In some cases, regulation is decreased. For example, some of the SEC’s current powers would be shifted to industry groups, called self-regulatory organizations in the plan. Using this approach, investment advisors would no longer be regulated by the SEC but a yet-to-be formed trade group.

The new rules are not intended to fix the current risk of recession, and will not likely keep us from entering a future slowdown.

Fulcrum Inquiry is a forensic accounting and economics consulting firm.