The Blueprint for Regulatory Reform

In what quite possibly is the last major domestic initiative of the Bush Administration, the Treasury Department has announced a Blueprint for Regulatory Reform. Here is what is proposed and what I think of these proposals:

New Powers For the Fed

[T]he Federal Reserve's market stability role would continue through traditional channels of implementing monetary policy and providing liquidity to the financial system. . . .

[A new] role would replace the Fed's more limited role of bank holding company supervision because we recognize the need for enhanced regulatory authority to complement market discipline to deal with systemic risk. . . . the Fed would have to be able to evaluate the capital, liquidity, and margin practices across the entire financial system and their potential impact on overall financial stability. . . . the Fed will collect information from commercial banks, investment banks, insurance companies, hedge funds, commodity pool operators, but rather than focus on the health of a particular organization, it will focus on whether a firm's or industry's practices threaten overall financial stability. It will have broad powers and the necessary corrective authorities to deal with deficiencies that pose threats to our financial stability.

To illustrate . . . systems requiring the attention of our market stability regulator would include the interconnected OTC derivatives markets with their lack of a cohesive design for clearing, settlement, and novation protocols. Similarly, a market stability regulator would have the authority to review certain private pools of capital, such as hedge funds and private equity, which have the potential to contribute to a systemic event.

Analysis: Good ideas implemented with the wrong agency. It is a good idea to have a federal regulator in charge of gathering the information necessary to evaluate systemic risks including those that arise from privately held companies and private transactions that impact public securities markets. Liquidity practice, margin practices and settlement practices all have these effects. Adequate regulation of these practices could greatly mitigate future financial crisises.

The Fed is the wrong institution to carry out this role. We already have regulatory agencies who are charged with carrying out these functions. They are the SEC and the CFTC. They have boards appointed in a more politically legitimate method (pure Presidential appointment with Senate confirmation) than the Fed (Presidential appointment with Senate confirmation from a pool of bank president's chosen by directors chosen by directors of for profit banks). The SEC and CFTC also have experience regulating and gathering information from many key players in these industries. When consolidated, the SEC and CFTC will be in a particularly good position to refocus on looking at systemic risk as opposed to only firm and individual transaction level risks. But, instead of strengthening the hand of the SEC, the plan would take power from the SEC and give it instead to the Fed.

If the SEC and CFTC lack the powers to gather this information from all players and to impose regulation on non-publicly held firms or private transactions, the combined agency's powers should be revised to reflect this need.

Near Term Recommendations

* President's Working Group Executive Order

The President's Working Group on Financial Markets, the PWG . . . was developed to coordinate across the current US structure. . . . We should formalize the current informal coordinating practice among the US regulatory community by amending and enhancing the Executive Order which created the PWG.

The new executive order will emphasize the importance of coordination and communication. It will clarify the PWG's mission of attempting to mitigate systemic financial risk, enhancing financial market integrity, promoting consumer and investor protection, and supporting capital markets efficiency and competitiveness. It will also increase the PGW membership to include all federal financial regulators so that information is shared in an appropriate, timely and efficient manner.

One thing that the PWG will work on immediately is determining whether the government has all the tools and powers it needs to deal with a financial crisis. As part of this, as I mentioned in my remarks last week, the PWG should examine the lessons of the current temporary liquidity facility the Fed has established for investment banks, and examine a number of issues regarding the proper level of oversight that should apply.

Analysis: Indifferent. Mostly harmless. A talk shop and federally sponsored think tank on preventing financial crisises doesn't hurt, and since it lacks the power to act on its own, can't do harm on its own.

* Create "a new federal-level commission, the Mortgage Origination Commission. This commission, the MOC, would be led by a director appointed by the President. The Commission membership would include federal banking regulators and appropriate state representation." It would "establish minimum standards which should include personal conduct and disciplinary history, minimum educational requirements, testing criteria and procedures, and appropriate licensing revocation standards . . . . [and] would evaluate, rate, and report on each state's adequacy for licensing and regulation of participants in the mortgage origination process."

Analysis: Bad idea. Potentially harmful and unlikely to be helpful. States are capable of regulating this field and mostly have done in the wake of the mortgage crisis. A federal government body in charge of telling state governments what to do and gathering information about them would not be helpful, and if this body establishes a bad standard which is not fact based, it could be hard to reform and deny credit to people who deserve it.

The private mortgage collateralization market is more than adequate to gather information and evaluate risk, and the players who failed to perform this function adequately are almost all either out of business now as a result or have taken immense losses on this line of business which have taught them a lesson. The part of the subprime market and most of the Alt-A market driven by poor underwriting and excessive funding of collateralized mortgages have been obliterated. New underwriting standards are emerging through the FHA and private mortgage insurance companies.

Intermediate Term Recommendations

* Create a federal charter for systemically important payment and settlement systems overseen by the Federal Reserve.

Analysis: Indifferent. We are 97% of the way there already. As the report notes "There is no crisis." An "if it ain't broke don't fix it" tempers enthusiasm for what seems like a basically sensible idea. Presumably, Colorado based First Data, a few credit card processing companies and a handful of nominee ownership firms and security transfer processing firms would be the primary target of this regulation.

* Merge SEC and CFTC.

Analysis: Good idea. Harmless to slightly positive. Sooner would be better as it would provide a better basis for reducing systemic risks involved in financial market derivatives and hedge funds. Probably bad for the Chicago economy, which is the heart of the commodities industry in the United States, at the expense of the New York City economy, which is the heart of the securities industry in the United States.

* Establish "a federal insurance regulatory structure to provide for the creation of an Optional Federal Charter for insurance companies, similar to the current dual-chartering system for banking. This system would be built on a proven model and we recommend, as in the banking sector, that this federal agency be housed within the Treasury Department." Federal insurance companies would be entitled to ignore state insurance laws.

Analysis: Bad idea. This would gut well developed state regulation of the insurance industry and allow questionable insurance practices to flourish. It would also seriously impair efforts to reform the health insurance system. If this had been done when the industry was in its infancy, it might have been a good approach, but it would do more harm than good to transition from state to dual regulation at this point in time.

* Eliminate the regulatory category of Savings and Loans (also known as thrifts) and convert them to commercial banks regulated by the Comptroller of the Currency. It appears that the FDIC might also be rolled into this agency.

Analysis: Good idea. Mostly harmless, not urgent. The existing regulatory structure was adequate to mitigate most direct harms and abuses in the mortgage crisis in the commercial banking and savings and loan sectors.

Important Omissions

Some key reforms needed to reduce systemic financial risk were omitted from the proposal.

* Pension Benefit Guarantee Reform.

Many defined benefit pension systems are underfunded. The Pension Benefit Guarantee System lacks the resources to handle a major episode of defined benefit pensions that cannot meet their obligations. The existing system also insufficiently protect the pensions of employees and retirees with larger pensions due to them, and provides no protection for retiree health benefits. This system must be improved if we want to avoid another S&L crisis class government bailout of fiscally irresponsible private companies. Funding requirement formulas need to be improved, the scope of coverage needs to be increased, and premiums need to be increased.

* Insurance Benefit Security.

There is no reliable system of federal or state protection to guard against insurance companies growing insolvent and failing to provide promised benefits. Fiscal irresponsibility on the part of a large insurance company that prevents it from paying benefits is an important source of systemic risk in the economy. For example, imagine what would happen if Allstate or State Farm went bankrupt immediately after a hurricane produced a record sized multi-billion loss.

History suggests that this is a particular risk in the case of shareholder owned insurance companies (as opposed to mutual companies like Northwestern Mutual) who have much to gain from leveraging to secure upside gains, but can limit their losses by passing them onto shareholders if bad times strike. Until the FDIC was established, periodic waves of bank collapses for similar reasons were endemic.

The risks are particularly great for policies in which insureds have a long term reliance interest, such as annuities, life insurance, disability insurance and long term care insurance policies, and in casualty policies that involve a high risk of mass claim events, like homeowner's insurance and business comprehensive general liability insurance polices.

This does not require comprehensive federal insurance company regulation or broad pre-emptive legislation at the federal level. While state regulation in most aspects of the insurance business is properly a matter of state regulation, some analog to the FDIC for shareholder owned insurance companies would be appropriate. Like the FDIC's protection, it could be limited to some dollar amount, such as $1,000,000 of benefits per insurance company. Premiums could be low in low risk lines (e.g. automobile insurance and health insurance which are dominated by large numbers of independent small risks) and high in high risk lines (e.g. small annuity and life insurance companies and home insurance companies).

This might also encourage consumer behavior, like spreading high dollar benefit policies across multiple companies, that would reduce systemic risk in the economy.

* Debt-Equity Incentives.

The federal tax code strongly prefers debt to equity in the financing of publicly held companies. Profits allocated to interest payments are not subject to corporate income taxes, while profits allocated to retained earnings or dividends are subject to corporate income taxes. Qualified dividend treatment at the shareholder level and preferential tax treatment for long term capital gains mitigates this effect (interest payments on bonds, in contrast, are ordinary taxable income). But, the existing system does so in an awkward way that still preferences debt.

While not all economic participants can be expected to be rational economic actors, publicly held companies making financing decisions are likely to come close to this model. So, it is fair to assume that tax preferences for debt produce greater leverage within publicly held companies.

There are several sensible ways that the tax treatment of debt and equity can be equalized (e.g. a dividend withholding tax form of corporate income taxation that gives dividend receiving shareholders a tax credit for corporate taxes paid, a dividend paid deduction, a comprehensive shareholder level dividend received exclusion, elimination of the interest paid deduction, or a market capitalization tax in lieu of a corporate income tax). From the point of view of systemic risk, it doesn't really matter which method is used. But equalizing the tax treatment of debt and equity is likely to produce less heavily leveraged publicly held companies.

Companies with less leverage are less likely to go bankrupt, because a company is insolvent when its asset to liability ratio is 1:1 and contractual debt obligations are the principal liability of public companies. Reducing the risk that big businesses will go bankrupt reduces systemic risk in the marketplace.

UPDATE:

Links to additional analysis can be found here and here and here and here. Particularly interesting is this letter from the state securities regulator's association (the NASAA) concerning the plan:

There have been 24 major proposals for regulatory restructuring that have been made (but not acted on) since the bulk of the federal regulatory system was instituted in the early 1930s. Each set of proposed reforms was proclaimed with equal vigor to be “essential,” and the fate of the United States capital markets and/or banks supposedly hung in the balance. Ultimately, our regulatory system—without these reforms—has facilitated the development and growth of the world’s most robust financial markets. . . .

A common argument put forward to justify “regulatory reform” is that our capital markets cannot maintain competitiveness because alternative regulatory structures abroad are more reasonably regulated. . . . This argument is profoundly wrong because it is based on incorrect data. Both 2006 and 2007 to date have been record years for global IPO activity. In 2006, U.S.-based companies generated the largest number of IPOs globally and raised the second-largest amount of capital ($34.2 billion) through November. This was an increase of 14 percent over the $29.9 billion raised during the same period in 2005. The 2006 IPO year through November yielded the largest amount of capital raised by U.S. domiciled companies since 2000. The final year-end reporting shows that U.S. IPO volume increased to $43 billion in 2006a 26% increase over the previous year. . . .

Anyone arguing responsibly for change has an obligation to demonstrate two things: that the current system is inadequate, and that the proffered alternative is better. The advocates of major regulatory reform in securities fall short on both counts. They mischaracterize the nature of the current system. . . . For example, the notion that the United States is solely rules-based and that the Sarbanes-Oxley Act of 2002 is excessive and repellant is simply wrong. In point of fact, the whole of the federal and state securities laws are less voluminous than the laws of many other regulators, including the FSA. And as for the Sarbanes-Oxley Act itself, its passage afforded investors in U.S. securities the most significant protections enacted throughout the globe since the 1930s.

Investors throughout the world revere the Sarbanes-Oxley Act for what it offers them. Furthermore, they have demonstrated a willingness to pay a premium for its protections. The Sarbanes-Oxley Act is a magnet for foreign capital investment in the U.S. The protections of the Sarbanes-Oxley Act are a primary reason why large foreign institutional investors invest in U.S. equities. Currently, the Sarbanes-Oxley Act is being replicated in countries around the world. To the extent it ever posed an actual problem, the issue of the audit requirement for internal controls under Section 404 has been remedied by management guidance and the AS5 standard issued by the PCAOB. As mentioned earlier, the number of foreign IPOs on U.S. exchanges in 2007 will surpass the existing record, which was set just last year.

We also note that European hedge funds have gone public in the U.S. this year. In terms of proceeds, non-US issuers comprised 44% of the total value in the third quarter of this year, up from 18% in the second quarter and up 11% versus the third quarter of 2006. If our regulatory structure is so repellant and punitive, then why is this so? Foreign participants in our markets uniformly report two primary drivers. First, the cost of capital is low. Secondly, they want to demonstrate to investors that they meet the highest standards in the world. Indeed studies consistently show that shares cross-listed in the U.S. will sell at a premium of 15- 30% greater than the shares in home markets. . . .

"Many schemes to defraud investors involve locally generated pyramid schemes, misrepresentations, and scams. Without state regulation accompanied by civil and criminal enforcement of the law in state courts, there would be little hope of redress for many victimized investors. State enforcement is also available when there are fraudulent schemes involving federal covered securities. In effect, Congress and the SEC have acknowledged that federal regulators are unable to cope with all the enforcement that needs to be done."

Also, another important omission is meaningful shareholder participation in selecting members of corporate boards of directors who are now generally elected on the basis of nominations from self-perpetuating boards that hold Soviet style director elections. Shareholder power often discourages reckless actions that could wipe out their interest. Empirical evidence shows that proxy fights won by dissenter increase shareholder value.

Notably, the Blueprint also fails to even mention the important regulatory role played by private securities fraud litigation. A recent study indicates that while "voice" rights in connection with class action securities fraud litigation is ineffectual, that the right to opt out of a securities fraud action and instead bring individual suits in state courts has proven very effective for institutional investors. Regulators have, however, repeatedly failed to recognize the capacity that institutional investors have to recognize risk and take collective action if the regulatory scheme facilitates this kind of action rather than discouraging it.