The road to financial regulatory reform

By Roya Wolverson

Introduction

(January 23, Washington, Sri Lanka Guardian) Many economists, policymakers, and consumer advocates cite lax government oversight as a major cause of the 2008 global financial crisis. President Barack Obama, in proposing new limits on the size and trading activities of financial institutions on January 21, warned that the financial system was "still operating under the same rules that led to its near collapse." But as Congress and the Obama administration seek to overhaul supervision of the financial services industry, experts continue to debate the extent to which the federal government should be more involved in U.S. markets.

The Democratic majority has proposed a broad set of reforms to increase accountability and market stability in areas including credit card loans and home mortgages, Federal Reserve oversight, derivatives, and credit rating agencies. Other reforms backed by Democrats focus on creating a new consumer protection agency and monitoring "too big to fail" financial firms and so-called "systemic risk." Republicans have alternatively proposed roping consumer protections into an existing agency and curbing the Federal Reserve's supervisory powers over banks. Some experts say proposed reforms are missing key elements such as bankruptcy reform and more stringent regulation of credit rating agencies. Others worry that too much government intervention in financial markets could prove costly and ineffective while hampering U.S. economic competitiveness.

Regulating Derivatives

The number of unregulated credit derivatives--securitized bundles of mortgages and other loans sold to other investors--grew five-fold from $100 trillion to $516 trillion globally in the five years leading up to the financial crisis, according to the Switzerland-based Bank of International Settlements. During this time, the packaging and repackaging of credit risk (in the form of swaps, futures, and options) by loan originators, securitizers, and underwriters grew increasingly complex and concentrated. Bond fund manager Pimco's Bill Gross deemed the derivatives market "so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers."

To mitigate these risks, the Obama administration's reform plan (PDF), announced in June 2009, called for all over-the-counter derivatives to be traded through regulated clearinghouses to eliminate the lack of transparency and threat of widespread defaults, which have been blamed in part for the bankruptcy of Lehman Brothers and near failure of American International Group. According to the plan, clearinghouses and exchanges would provide a needed guarantee to derivatives transactions by requiring dealers and corporations to post collateral on the deals and meet daily margin requirements.

Some policymakers, including Commodity Futures Trading Commission Chairman Gary Gensler, caution against the congressional legislation that followed the White House plan, due to the exemptions granted to so-called "end user" companies, such as airlines and oil companies, which use derivatives to hedge risk on the purchase of physical commodities used in their daily operations. In a January 6 meeting at the Council on Foreign Relations, Gensler said the main beneficiaries of such an exemption would instead be Wall Street firms such as Goldman Sachs and Morgan Stanley, which often broker derivative transactions and profit more from the steeper margins that result from an opaque market. Gensler estimated (BusinessWeek) the exemption would leave as many as 60 percent of standard derivatives contracts unregulated. Other experts doubt whether simply requiring over-the-counter derivatives to trade through clearinghouses would be sufficient to prevent "systemic risk" in those markets. A July 2009 Squam Lake Working Group paper says allowing too much competition between clearinghouses could drive down minimum collateral and capital standards in the clearinghouses' attempts to lure more clients. The paper argues that regulators should be charged with setting collateral and capital requirements for clearinghouses.

Consumer Financial Protection

Some policymakers and consumer advocates argue that financial consumers were not adequately protected from the risky lending practices of banks, credit card companies, and mortgage lenders before the financial crisis, because consumer protection was spread between too many government agencies. The Obama administration and congressional Democrats have proposed (AmericanProspect) moving these responsibilities--now spread between the Federal Reserve, the Securities and Exchange Commission, the Office of Thrift Supervision, and the Federal Trade Commission--to one new agency, the Consumer Financial Protection Agency. Congressional Republicans, led by Senator Richard Shelby (R-AL), and the financial industry strongly oppose the new agency's creation, arguing that it would create unneeded bureaucracy, harm small businesses and consumers, and stifle economic growth. In a September 2009 statement, the U.S. Chamber of Commerce said the new agency would limit the ability of businesses to "extend credit to their consumers or allow their customers to pay over time, including layaway plans and gift cards."

Other experts say the new agency would not protect the economy from future housing busts, because it fails to alter the incentives consumers have to take on risky loans. These experts say reforms should focus more on regulating banks, not consumer protections. "By separating consumer protection and some of the lending enforcement from the bank regulator, you undermine bank safety and soundness regulation. The consumer financial protection agency doesn't change mortgage structures that don't require down payments," says Mark Calabria, director of Financial Regulation Studies at the Cato Institute. Despite President Obama's pointed support for the new agency, Shelby and Senate Banking Committee Chairman Christopher Dodd (D-CT) are considering an alternative proposal (WSJ) to expand the consumer protection division within an existing regulatory agency. Douglas Elliott, Economic Studies Fellow at the Brookings Institution, says existing bank regulators have a conflict of interest in protecting consumers. "Prudential bank regulators want banks to be profitable, so when banks argue that they need to impose certain fees or make certain loans, there's a tendency to allow it despite the risk to the consumer," he says.

Systemic Risk Regulation

The size and interconnectedness of troubled financial firms such as AIG and Lehman Brothers during the crisis highlighted the need for greater oversight to protect against the spread of so-called "systemic risk," or the possibility that the collapse of one large firm could threaten the stability of the financial system.

To address this risk, the Obama administration proposed the creation of a new Financial Services Oversight Council, composed of existing financial regulators, tasked with identifying emerging systemic risks among large financial firms and bridging the gaps in oversight between existing agencies. Critics of this plan argue that delegating the task to a panel of agencies, rather than one regulator, dilutes accountability and effectiveness. "You end up with a tragedy of the commons where no one is really responsible," says Calabria. Others advocate for the panel as a forum for ideas but not a tool of enforcement. "A 'council of regulators' is a useful way to get regulators to communicate and to think more holistically about the markets," says CFR's Director of International Economics Benn Steil.

The proposed council would decide which firms should be considered systemically important, while the Federal Reserve would be charged with regulating them. House Democrats have proposed that troubled, systemically significant firms be dismantled by the Treasury and the Federal Deposit Insurance Corporation, while some Senate Democrats favor using a special bankruptcy court instead, with a separate executive branch authority used only as a last resort. Delegating this authority to politically appointed agencies, some legislators say, might lead regulators to be more lenient with some failing firms than others. Senators Dodd and Shelby, who have both criticized (WSJ) the Fed's banking oversight, are negotiating a bipartisan plan to strip the Fed of its regulatory powers over banks. Others argue against assigning certain financial institutions to any "too big to fail" regulator, because it creates a "moral hazard" whereby systemically important firms assume that the government will bail them out should they run into trouble. "'Too big to fail' financial institutions are simply too big, period. Designating them is a recipe for future crises," says Steil.

Federal Reserve Oversight

Some policymakers argue that loose monetary policies and lax banking regulations at the Federal Reserve contributed to the crisis by encouraging over-borrowing and putting the economy at risk of inflation. In a January 2010 speech to the American Economic Association, Federal Reserve Chairman Ben Bernanke refuted criticism that Fed interest rate policies caused the crisis and proposed alternatives to the well-known benchmark used to judge them, the Taylor Rule. In a Wall Street Journal op-ed, John Taylor, the Stanford professor of economics who created the rule, responded that Bernanke's alternative lacked empirical evidence to show it would do any better. For their part, House Democrats have called for greater transparency and accountability in Fed policymaking, giving the Government Accountability Office (GAO) the authority to audit all aspects of the Fed's balance sheets and its regional banks.

This CFR Backgrounder details the objections of many economists to GAO auditing, which they argue could threaten the Fed's independence and lead it to seek lower unemployment more in the short run, ignoring the long-term threat of inflation. Others question whether preserving the Fed's apparent independence trumps the need for transparent policymaking. "There is a sort of façade that the Fed is cut off from the rest of the government, but the president and the Treasury meet with the Fed chair all the time. If the government is going to indirectly set monetary policy anyways, then we might as well have transparency and have Congress do it directly," says Calabria.

Credit Rating Agencies

Although the Obama administration's financial reform proposal calls for some regulation of credit rating agencies, Congress has not proposed changing the agencies' "issuer pays" business model, which some say gives the agencies a conflict of interest in evaluating the debts of businesses for their clients. The agencies, which derive most of their revenue from the issuers of bonds and other debt instruments they are paid to evaluate and rate, have been blamed in part for the financial crisis, since they failed to identify growing risk in the subprime mortgage market and elsewhere. Democrats have proposed creating an office (Reuters) at the SEC to oversee how the agencies determine their ratings. The proposal would also make suing the agencies over flawed ratings easier, a provision the rating agencies oppose.

Of greater concern, some experts say, is the fact that financial regulators use the agencies' ratings to determine capital requirements for financial institutions. The slashing of troubled insurer AIG's credit rating during the financial crisis triggered billions of dollars of collateral payments on its derivatives trades, prompting a liquidity crisis. "The fundamental problem is legislation and regulations that enshrine credit-rating agencies as gatekeepers to the capital markets. If these were stripped away, credit ratings would simply be opinions--no different from those of equity analysts," says Steil. Whether the government would have the expertise or personnel to evaluate such securities independently is another issue, says Elliott.

Bank Bonuses and TARP Repayment

The Emergency Economic Stabilization Act, which authorized the Troubled Asset Relief Program, requires that, by the year 2013, the White House propose a way to recoup taxpayer losses from the financial industry. In an early response, the Obama administration proposed the "Federal Crisis Responsibility Fee," which would tax approximately fifty financial firms with $50 billion or more in assets roughly $9 billion per year for at least ten years or until the TARP costs are fully recovered. Some experts say the proposal--which came in advance of sizeable bonus payouts at large financial firms and rising public anger about double-digit unemployment--was politically motivated. The banking industry and Republicans argue that the tax deprives the financial industry of needed capital to stimulate economic growth through lending. Elliott says lending, which is mostly driven by bank deposits, would not be affected, because the plan would only tax banks' liabilities, not their deposits.

An additional Obama administration proposal would restrict the activities of the country's largest banks, barring commercial banks from so-called "proprietary trading" (investing in hedge funds, private equity firms, or other risky investments to boost its own profits) and raise existing caps on banks' market share. Currently those caps do not allow commercial banks to own more than 10 percent of the country's deposits. Under the proposed changes, the caps would include banks' non-insured deposits and other assets, a move the banking industry says would "reduce liquidity and increase risk" (NYT).

The banking industry also warns (CSM) that companies would pass any increased costs on to customers and shareholders, stifling bank's efforts to raise more capital. Morgan Stanley estimated (Reuters) the fee could eat up 4 percent of Deutsche Bank's 2012 earnings per share and 2 to 3 percent for Swiss banks Credit Suisse and UBS. Other estimates (BusinessWeek) put the cost of the tax at 22 percent of Bank of America's expected 2010 earnings per share and 12 percent of JPMorgan's. But Elliott says the industry can afford it: U.S. banks earn roughly $200 billion in pre-tax income each year and have $13 trillion in assets, whereas the tax would collect roughly $9 billion a year. By comparison, banking industry compensation totals roughly $150 billion per year, according to the FDIC. Smaller banks, which would not be subject to the tax, would also be able to continue their lending rates, says Elliott, which would leave competitive pressure on large banks wanting to raise their loan prices.