Financial Sector Regulation Reform

Tomorrow a proposal to revise how the financial sector is regulated will be announced. Some of the contents of the highly detailed plan have been leaked. Some key elements include:

1. A Financial Services Oversight Council to identify systemic risk and promote interagency cooperation. This would consist of the Treasury Secretary (its chair), the Chair of the Federal Reserve, the National Bank Supervisor, the Director of the National Consumer Financial Protection Agency, the Chair of the SEC, the Chair of the CFTC, the Chair of the FDIC and the Chair of the FHFA. It would have a full time staff.

2. Federal Reserve authority to supervise non-bank firms that threaten financial stability. This is a partial repeal of the Gramm-Leach-Bliley Act that repealed New Deal legislation that had segregated commercial and investment banking.

3. A new National Bank Supervisor with authority over bot federally chartered bank and federally chartered thrifts, which will be treated as banks in the future.

4. Investment advisor registration requirements for hedge funds, venture capital funds and private equity funds which are similar to the requirements now applicable to mutual funds would be imposed, with a low assets under management threshold.

5. Increased regulation of securitizations requiring greater disclosure, increasing regulation of credit reporting agencies and requiring that issuers and orginators of securitized loans retain a five percent interest in those securities. Credit ratings agencies will be required to disclose conflicts of interest and their ratings will be given less weight by regulators.

6. Comprehensive regulation of all "over-the-counter" derivatives (and hence presumably less than comprehensive regulation of back door private derivative transactions).

7. Increased Federal Reserve authority over payment, clearing and settlement systems in the financial markets.

8. A new Consumer Financial Protection Agency that would regulate bank and non-bank lending and investment transactions with consumers with respect to disclosures, fairness and appropriateness. The agency's authority would include credit cards and mortgages, but also comprehensive regulation of other consumer transactions. This federal regulation would not pre-empt additional state regulation. It could require "balanced" disclosures of pros and cons to a deal, established "plain vanilla" safe harbor transactions, ban anti-consumer terms as universally unfair, and would be charged with enforcing fair lending laws. The new agency would be responsible for Truth in Lending laws, the Home Equity and Ownership Protection Act, the Real Estate Settlement and Procedures Act, the Community Reinvestment Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, and the Fair Debt Collections Practices Act. It would have the authority to restrict or ban mandatory arbitration clauses. The FTC would continue to control privacy regulation and would have backup authority to the new agency in areas where it already regulates financial transactions of consumers. Mortgage disclosures would be simplified and financial products marketers would be required to make "reasonable disclosures" rather than meeting the lower current standard that disclosures be "technically compliant" and "non-deceptive." Significant risk will require the most significant disclosures. Providers would be subject to agency action but not to private civil litigation for failing to meet these standards. A process for pre-approval of marketing materials similar to the private letter ruling process in tax law would be established.

9. "A new regime to resolve nonbank financial institutions whose failure could have serious systemic effects." This would use the FDIC as a model and would provide an option other than an AIG style loan and a bankruptcy for the federal government.

10. Revisions to the Federal Reserve's emergency lending authority to improve accountability. The Secretary of the Treasury would have to approve emergency loans in writing.

11. Improved international cooperation. This would include crackdowns on tax/asset protection/banking secrecy havens.

12. An office of National Insurance within the Treasury Department to coordinate insurance regulation nationally (a function almost entirely reserved to state regulations with little federal government involvement now).

Federal regulation of state banks through the Federal Reserve and the FDIC, and federal regulation of credit unions through the National Credit Union Administration would remain largely unchanged. The Securities and Exchange Commission (SEC) and Commodities Futures Trading Commission (CFTC) would remain largely unchanged although their jurisdictional boundaries would be refined and coordinated more tightly.

"Too big to fail firms" would be more closely and comprehensively regulated and would have greater capitalization requirements. Capital requirements would be tuned to the boom-bust cycle requiring more to be set aside in booms for bad time later, consider the use of guarantees or insurance against major macroeconomic risks, using debt convertible to equity to reduce cash flow pressures, and increased regulation of capital requirements against subtle risks like mixed trading positions, levels of equity investment, exposures to low credit quality firms and persons, mortgage and asset backed securities, expo sue to off balance sheet risks, and exposure to derivatives that are not centrally cleared.

Regulation may be streamlined for small simple firms relative to large complex firms. Efforts to avoid agency capture will be institute.

OTC derivative markets would have instruments with standardized terms and greater disclosure of transactions which would have to take place in a public exchange environment.

There will be new "standards and guidelines" designed to align financial executive compensation incentives with long term investor well being, a requirement that executive compensation committees be more independent, and a requirement that senior executive compensation be subject to non-binding shareholder votes.

Accounting standards would be revised to better reflect available credit information and cash flow information.

Parent companies of financial institutions would be required to be less entangled financially with subsidiaries, so that subsidiary losses don't endanger other businesses of the parent.

Investment banking regulation would be transferred from the SEC to the Federal Reserve.

Proposals to prevent runs on money market funds will be offered by a Blue Ribbon commission some time in the near future.

Proposals to reform Fannie Mae, Freddie Mac and the Federal Home Loan Bank system will be made in the near future in a joint effort by the Treasury Department and HUD.

Securities brokers and dealers who offer investment advice would have fiduciary duties to their customers. Whistle blower protections would be enhanced.

Pre-payment penalties and commissions for selling consumers inappropriate products are targeted for regulatory prohibitions.

Elimination of mandatory arbitration for broker-dealer contracts is being considered.

Establish automatic IRA and savers plans for low income employees.

Analysis

Obama' raft of reforms are for the most part, moderate, long overdue, incremental improvements of our current system. They give government sufficient power that it make take another three quarters of a century to figure out how to get around this batch of rules, and create the next big bubble and impending collapse.

The plan is heavy on how this will be implemented and organized, but light on reforms that should be made in the bankruptcy and tax laws that would allow them to better response to a financial crisis.

The plan is heavy on avoiding a financial crisis, but weak on insuring that people who create the problems are wiped out if it all falls apart, and is dim about how it proposes that failures in the financial economy can be prevented from devastating the "real economy".

The Plan also lacks a larger economic framework and conception of American history to place the current Financial Crisis in the context of any larger vision. Five years from now, what does the economic future look like? How is that new economy best described? Who wins and who loses? What new intuitions mater the most? How do tax and bankruptcy policies adjust to meet the interests of financial regulations? What changes in our real economy happen quickly and what changes take their time?

The changes are consensus proposals, more of them sensible in nature. Many daring proposals for bureaucratic consolidating crashed and burdened. But, a lot of mainstream, sensible pr grams do make it into the financial draft. I am not convinced that all of the programs proposed will be successes. But few look like they will do any harm. The Proposal is less elegant than many, essentially throwing everything at the wall, rather than focusing on a small number of critical mistakes made. In many places it errs on the side of being to timid. Still, the reforms are meaningful and deserve to be enacted so tat our financial system can grow a little more robust as a result of this natural experiment.