Reshaping the U.S. Regulatory System

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When the cat’s away, mice will play. Humans, too, can drift into economic bedlam, when regulators are either absent, powerless, or just napping. The implosion of the American banking system has prompted suggestions for drastic remedies in regulation. Timothy Geithner, the US treasury secretary, demanded comprehensive reform on March 26, calling for, “not modest repairs at the margin, but new rules of the road.”

Arguments will focus on how far the system should be overhauled, and whether new draconian regulation might even impede economic recovery or stifle innovation. Yet financial engineering has made giant strides in recent decades. Innovative vehicles for dispersing or transferring risk, and enhancing profits moved so quickly that old-style regulation was left in the dust. So even without the bolt of the 2008 crisis to spur action, America was already overdue a regulatory overhaul.

Today’s regime, which developed piecemeal, was created for a world that barely resembled the financial environment we inhabit. It makes sense to step away and revisit the regulatory bodies. Many of the agencies that still oversee banks and investment firms date back in history. For example, the Office of the Comptroller of the Currency (OCC), which supervises commercial banks, was set up in 1863, during the Civil War; the Federal Reserve was established as the central bank in 1913; the Federal Deposit Insurance Corporation (FDIC) was created to insure depositors’ account in 1933, during the Great Depression; and the Securities and Exchange Commission was founded the following year to protect investors. It is no wonder that many firms have cropped up subsequently, which no longer fit the original concepts behind the licenses and charters.

At the same time, gaping holes were left. Egregious examples, such as the subprime lenders, or AIG’s credit default swap business, became visible last year. The seeds were, in fact, sown many years ago during the free market heyday of the 1990s and before. The Commodity Futures Modernization Act of 2000 carved out an exemption for over-the-counter derivatives (see graph, p20), and left them unsupervised by the CFTC, then considered to be the most obvious and appropriate regulator for those products.

Ben Bernanke, the chairman of the Federal Reserve, has called for a “macroprudential” approach, to regulate on a more holistic basis. That, presumably, would encompass off-balance sheet entities, which currently make a mockery of prudential practices. Moreover, “non-banks”, such as financing companies, also slip through the net. David Brown, an attorney with Alston & Bird in Washington DC, points to the hedge funds, affiliated through partnerships with major investment banks, such as Bear Stearns. “They shared liabilities, so when the hedge funds got into trouble, the banks had to bail them out,” says Brown.

In a global network, cross border banking poses tough challenges. But even on a domestic level, interconnectedness proved viral in the complex mechanisms. Counterparty risks, it turned out, tied far flung entities together and exposed them to chain reactions. As Lehman failed, and AIG tottered, markets recognised the need to support those institutions consider­ed systemically significant. The buzz is no longer “too big to fail”, but, rather too intertwined.

In an interlocking world, how should we recognise which organisations are truly pivotal? Geithner has laid out a preliminary set of characteristics that may define whether a firm is systemically important. Features, he said, may include the following: the financial system’s interdependence with the firm, the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding and its role as a source of credit and liquidity for households, businesses and governments.

There has still not been much discussion about how to improve and empower regulators. This might entail some straightforward reforms, such as equalising pay scales for attracting and retaining talented staff. Henry Paulson, a former Treasury Secretary, has urged that the entire regulatory architecture be “modernised.” He has drawn attention to the uneven capabilities and jockeying among agencies, which blights the current framework, on top of the jurisdictional gaps.

Among structural solutions, a favoured suggested is the creation of an űberregulator with authority to preside over the whole system.

Even a year ago last March, before the full impact of the credit storm hit, Paulson’s Treasury was proposing a Blueprint for a Modern Financial Regulatory Framework. The Treasury then contemplated an optimal division of authority among three primary regulators: one to maintain regulatory stability across the financial spectrum, one to ensure the soundness of banking institutions, and one to protect consumers and investors.

A year later, Bernanke has been calling again for Congress “to direct and empower a governmental authority to monitor, assess, and, if necessary, address potential risks”.

So who should this overarching ombudsman be? Should it be a new organisation, similar to Britain’s Financial Services Authority? Or should it be an existing regulator, in which case most eyes turn to the Fed? “The central bank would be the logical solution,” says Carol Beaumier, executive vice president of global industry programs at Protiviti, a consultancy firm. “Already, it has been creative in its approach to controlling the shots. What’s more, it has a history of stepping up and taking a leadership role, going back to crises such as Long-Term Capital Management.”

Politicians are debating whether the Fed should get the job. Barney Frank, who is the powerful chairman of the House of Representatives Financial Services committee, would like to see that happen. However, his Senate counterpart, Chris Dodd, has been more cautious about vouchsafing the Fed added powers that might compromise its vital function of monetary independence.

“In any political structure, there will be compromises, but the goal remains a unified system that will allow regulators to see across multiple lines of business, in whomever’s kingdom they belong,” says Scott Mosley, owner of independent investment firm Mosley, in Madison, Wisconsin.

Before the dust settles, the new order must address charter shopping. Right now, a jumbled patchwork of agencies holds sway, depending on whether a firm is chartered at a state or federal level, or owned by a holding company. What is worse, the numerous diversified firms look to multiple regulators. Thus, many are supervised by a combination of regulators and can nimbly switch the nature of the components in the firm’s family. “We need a more consistent approach to avoid regulatory arbitrage,” says Beaumier. “If financial institutions are doing the same things, they should be supervised by the same rules.”

There is a logic to having a single regulator for an entire institution, rather than parsing out responsibility according to functions. Until now, firms with diverse activities adroitly seek out the most beneficial oversight. “If I were king,” says George Simon, at attorney at Foley & Lardner, “I’d have a functional regulator to look after the details of an industry, and that in addition to an overall risk regulator. We need to look at what you do, and not just where you put it.”

Insurance, particularly post AIG, has become the elephant in the room as a candidate for streamlining and rationalisation. (AIG, of course, was brought down by an overseas holding company.) The industry is currently regulated separately in 50 states and has “become a crazy beast, applied to consumer, retirement and employer-sponsored benefits markets at the same time,” says Mosley. You might find the same entity managing a variable annuity, a hedge fund, a mutual fund or separate accounts. Although they are wrapped up in different formats, the same activities are involved. Mosley says, “that should be taken away from the 50 states and brought into the SEC.”

It will not be easy to reshuffle along functional lines. Paul Architzel, also an attorney with Alston & Bird, explains how “most of the regulatory agencies have different goals and purposes”. For example, the Fed is invested with central bank duties, and is also a bank regulator. “Throughout its history, the Fed has displayed a schizophrenic attitude to bank lending,” says Architzel. As a regulator, it should want to promote prudence, while, in steering monetary policy, it may want to accelerate lending. At certain times, which hat is it wearing? Or consider how the FDIC is both a prudential regulator and a deposit insurer.

On another front, bank regulators’ approaches differ from that of the SEC. The latter has tended to concentrate on customer protection, whereas bank regulators focus on ensuring the safety and soundness of their institutions and banking system.

First in line as likely candidates for merger are the OCC and the OTS, the Office of Thrift Supervision, which acts as the primary regulator for savings and loan banks, in the thrift (home mortgage) industry. As the number of thrifts dwindles, a consolidation between them has emerged as the easiest path to reduce duplication. Both bureaus are agencies of the Treasury, with the same reporting structure.

“The OCC is typically viewed as a strong regulator,” says Beaumier, who worked as an examiner with the agency for 11 years and also served as an executive assistant to the Comptroller and a member of the OCC’s senior management team. “The advantage,” she adds, “is that the OCC has historically examined the larger institutions and its examiners are used to dealing with problems related to innovative products”. The OTS, on the other hand, supervises savings and loans (such as buildings societies), with their special mission to create housing loans. There is no longer a need, Beaumier argues, for a standalone agency.

The next marriage under frequent discussion is one between the SEC and the Commodities Futures Trading Commission (CFTC). “For years, people have been calling for their unification and all know it is the right thing to do, with huge areas of overlap and fungible products,” says Simon.

Nicolas Morgan, a Los Angeles-based attorney with DLA Piper, gives a hypothetical example. Suppose you were to start a fund called, say, ‘Commodities Trading Fund’ to structure it as a limited partnership and to sell it to 100 investors. On the surface, it sounds like an SEC issue. But what are you doing with the money? Investing in commodities and futures. Suppose you misrepresent your annual return, which agency should be disciplining you? Or why, in another instance, should we have S&P futures regulated by the CFTC, while individual stock futures are under the SEC?

There are, in fact, some valid reasons. Commodities markets, which are primarily driven by professionals, have far fewer investors than those in equities. Although the value of commodities contracts can be substantial, the number of participants is small. The CFTC mandate, historically, has been to protect professionals, preserving free and open markets, less able to be cornered or manipulated. In contrast, the SEC protects multitudes of investors by enforcing corporate disclosure and transparency. Moreover, the two industries exhibit different risk profiles. Futures are more highly leveraged, but mark portfolios to market on a daily basis.

“From a political view, it could be a tall mountain to unify the agencies,” Simon predicts. In the US Congress, the Banking Committee oversees the SEC, while the Agricultural Committee is in charge of the CFTC. “Neither wants to give up jurisdiction, which leads to a stalemate or turf war,” he says.

Despite years of discussion about combining agencies, a merger may be less likely.

The SEC, which is the larger agency, would normally dominate in a merger; its staff numbers about 3,500, versus only 500 at the CFTC. But the SEC is seen as having been ineffectual during the recent crisis and further tainted by the Madoff scandal. The CFTC, however, “can boast of not having taken one dime of public money”, says Brown.

Nevertheless, the CFTC has been on the defensive against charges that it failed to curb excessive speculation in oil and agricultural prices, enabling those sectors to run up to destructive levels during the summer of 2008.

Further, some profound philosophical differences would make a mix more challenging. The CFTC takes a more principles-based approach, akin to the FSA. The SEC leans toward a more prescriptive style.

Whoever ends up regulating whom, across the board from banks to securities firms, reforms will highlight a similar set of principles.

First, regulators must define prohibited activities. Beaumier muses, “Do you put added restrictions on what those types of firms can do,” she asks, “such as no proprietary activities and more plain vanilla?”

Along with restrictions may come a new roster of obligations, such as enhanced risk management. Consider the case of subprime products. It is only with hindsight we recognise that without understanding the products, purchasers could not manage the risks.

David Thetford, a consultant at Walters Kluwer Financial Services, envisions a new, required role of chief risk manager. It will be enforced, he predicts, just as that of chief compliance officer became mandatory for investment advisers a decade ago.

The main issue, however, looks to be capital adequacy. Here, the debate centers on pro-cyclicality. The current rules, derived from accounting principles, discourages banks from setting aside extra reserves during profitable periods, as a buffer to tide them over for a rainy day. The tension is that accounting rules have been designed to prevent featherbedding and stuffing the cookie jar. “But what is appropriate for accounting may not necessarily be so for the economy,” Brown points out. Now, capital adequacy demands are compelling banks to plump up their capital cushions, just when they have been taking massive hits.

In a speech on March 2, John Dugan, Comptroller of the Currency, told the Institute of International Bankers that, “loan loss provisioning has become pro-cyclical, magnifying the impact of the downturn”. While urging his audience to ask some “hard questions” about provisioning, Dugan described how the ratio of loan loss reserves to total loans went down rather than up, during the booming part of the economic cycle. “Perversely”, he added, “even though there was a broad recognition that the cycle would soon have to turn negative.”

How could a more counter cyclical effect be achieved? New bank debt might convert into equity capital, automatically in the event of deteriorating financial ratios; or gov­ern­ment could intervene as a response to a downturn. The same impetus should operate in reverse, suggests Haag Sherman, chief investment officer at Salient Partners in Houston. “People would scream, but whenever we see credit begin to expand, the logical reaction should be to raise capital requirements,” he says. Sherman reflects that European banks, in particular, have been following the opposite course in recent months. “They are making a push to increase capital requirements, just when that should be pushed into the future.”

Another key principle may be a push toward more prescriptive, even formulaic requirements. There may be more scrutiny of underlying assumptions used in financial models; not to say that the models will be abandoned, but that assumptions must be shown to be sensible and not just algorithms. “In my early days as an examiner in the late 1970s, we looked at unique institutional circumstances and moved away from formulas,” says Beaumier. “Now we see a tendency to return to hard and fast rules. Human nature almost demands that, after a crisis, we want to be more prescriptive.”

All these reforms could strengthen and reinforce the American regulatory framework. All the same, in a world economy, prohibited activities do not work. That was one of the limitations of the 1933 Glass-Steagall legislation, which separated investment and commercial operations in America. Decades later, in Europe and elsewhere, banks were thriving under a universal model.

The more promising approach, Simon urges, is to “assess the risk and force companies to hold reserves.” The alternative is to act like an ostrich, by ignoring off-balance sheet risks and letting firms bury them out of sight. In other words, we must look at each company holistically. Then, and only then, will today’s crisis lead to the foundations for an improved system.

Ms. Drucker, a former practicing lawyer in the United States, is U.S. editor of Fund Strategy (www.fundstrategy.co.uk), and the author of two business novels published by Crown.

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