Revamping Our Financial Regulations: Some Notes on the Senate Proposal

By Adrian Ineichen

What Is It?

This week has brought us one step or 1336 pages closer to revamping our financial regulations and with that hopefully also to strengthening the financial markets: The Senate Committee on Banking, Housing & Urban Affairs unveiled its bill that picks up ideas from the bill that passed the House in 2009 and from the administration, but adds its own spin. It contains the Volcker rule (prohibiting banks from proprietary trading and investing in hedge funds and private equity), proposes the establishment of a Consumer Financial Protection Bureau (the CFPB; within the Fed, hence no longer proposed as an own agency, and thus maybe more amenable to Republicans) which consolidates powers to write rules governing all institutions that offer consumer services and products, and it aims to set up a Financial Stability Oversight Council (FSOC), which is a forum of eight regulators (and one independent), chaired by the Treasury, to reduce systemic risks. The FSOC can require Fed oversights for Non-Bank Financial Institutions (NBFI) that are deemed too risky to financial stability or order the break-up of large institutions. Large companies would be required have “funeral plans”, i.e. plans for rapid and orderly liquidation in the case of failure.

Although other proposals might pop up, the current version plans to let the SEC and CFTC regulate hedge funds and over-the-counter derivatives, and to put more trading through clearing houses and exchanges, as well as requires them to collect data to improve market transparency. The SEC would undergo some management reform, would encourage whistleblowers more strongly and would strengthen oversight of credit rating agencies. Shareholders would have a non-binding say on executive pay.

Besides a host of other things, Dodd’s crew aims to bring us even some neat stuff such as an “Office for Financial Literacy” and a consumer hotline, which one can only hope are indeed useful in bringing some more financial reason to Americans.

Is It Good (Enough)?

Without having been able to read all 1336 pages, it seems to me that the bill is a good step forward. It addresses many issues and put forth some reasonable ideas. The proposal seems more closely to a final version, as it leaves out revolutionary changes such as a unified financial super-regulator and goes the more politically feasible path (e.g. creating a council of regulators and cutting down the number of federal banking regulators from four to three, i.e. Fed, FDIC and OCC, eliminating the OTS). But, in keeping several banking regulators and adding new bureaus, their roles and coordination must be fine-tuned much better than in the past, which implies that it may take some years before the new regulatory architecture is fully effective.

However, some weaknesses persist. For example, it is unclear why the new office for national insurance should be created within the Treasury, while banking regulators are separate, independent regulators. One would not wonder when the next crisis occurs in the (re)insurance business and that thereafter a new insurance regulator would emerge….

It is not clear what use (and effectiveness) certain restrictions will have: The Volcker rule might come with good intentions, but – depending on its application in a specific regulation – could either restrict activities of certain banks too much which could make them uncompetitive and US financial markets less attractive, or they come with sufficient loopholes which make their enforcement a joke and may lead to the build-up of hidden risk.

In any case, it is likely that the current reform will come with loopholes that have not been anticipated. There may well emerge a Madoff 2.0 in the future, just as well as OTC trades that are not covered (coverable?). But too much regulation will stifle markets and render our financial system less efficient, which is bad for consumers too, and increasing unattractiveness could foster regulatory arbitrage and flight of capital abroad.

But…

Introducing some leverage caps, and stronger liquidity and capital requirements seems reasonable, but should not be too strict. Instead of blunt ratios, it might be wiser to use risk-weights for leverage caps (e.g. a lower leverage cap on high-risk deals) and potentially differentiate them between different types of financial institutions while monitoring their risk models more closely than in the past. In any case, tightened ratios should go along with allowing banks to engage in a broad range of activities to have enough business to stay competitive and profitable (hence Volcker rules are probably unwise).

It will be interesting to see what goes on abroad. The Basel Committee on Banking Supervision (at the BIS) is in the process of gathering feedback until April 16 on its consultative documents on creating a framework for liquidity risks and standards as well as measures to strengthening banking sector resilience.

Even though restrictions could reduce risks, technological innovations, market evolution, increasing linkages and not least chances to circumvent new regulations may still render them less useful than anticipated. That’s why regulations should be lean, flexible (so as to allow adaptation on time), and should foster market discipline and support the awareness that things can go wrong.

If the political climate would be more far-sighted and bipartisan, a reform with more courageous elements could pass. For example, why not abolish state bank charters? The US has a unified financial market and thus needs a comprehensive and single regulator that grants bank charters. This federal agency could still grant charters of different types to different banks (e.g. smaller banks may need less regulation and oversight), but it would possibly be a big improvement compared to the current patchwork of different state regulators. Keeping a host of underfunded, or even incapable state regulators that may or may not do their job favors non-compliance, increases risks and regulatory arbitrage.

However the log-rolling, lobbying and balancing ends, one just wishes that the final bill will be enacted and implemented quickly, and bring indeed some improvements. For Dodd, it is probably one of his last fights as Senator, as he is not running again in November. This circumstance makes one hopeful that he could press for improvements, even if they appear unpopular. In any case, he will most likely not share the fate of Pak Nam-gi, North Korea’s official who orchestrated the bungled currency reform last fall which caused food shortages and unusually large public protests. He has now apparently been executed.

For Further Reading

The summary of the Senate bill:
http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf

The full 1336-pages Senate bill:
http://banking.senate.gov/public/_files/ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf

Articles and comments on the Senate bill:
http://www.ft.com/cms/s/0/60de3ad0-3059-11df-bc4a-00144feabdc0.html
http://www.brookings.edu/papers/2010/0315_financial_reform_elliott.aspx
http://www.washingtonpost.com/wp-dyn/content/article/2010/03/16/AR2010031604208.html
http://www.economist.com/business-finance/displaystory.cfm?story_id=15711543

Greenspan’s reflections on the crisis and regulatory reform:
http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2010_spring_bpea_papers/spring2010_greenspan.pdf

The Basel Committee’s (BIS) consultative documents:
http://www.bis.org/publ/bcbs164.htmhttp://www.bis.org/publ/bcbs165.htm

The Fed’s Tarullo on regulatory reform:
http://www.federalreserve.gov/newsevents/speech/tarullo20100226a.htm

About North Korea’s executed finance chief:
http://www.nytimes.com/2010/03/19/world/asia/19korea.html?ref=world&pagewanted=print

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