The Road to Financial Regulatory Reform

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Introduction

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, 2010 warned that the financial system was "still operating under the same rules that led to its near collapse." Obama signed a financial reform package into law in July 2010 after protracted negotiations between Republican and Democratic lawmakers. Major provisions include requiring banks to spin off a portion of their lucrative swap-trading desks, empowering federal regulators to seize and dissolve large financial firms at risk of collapse, and creating a new consumer protection agency within the Federal Reserve. A Financial Stability Oversight Council of existing regulators would also be tasked with monitoring so-called "systemic risk" in financial markets. Some experts say the enacted reforms are missing major 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 (CFTC) Chairman Gary Gensler, cautioned against the House 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 doubted 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. The Senate legislation (PDF), which the Senate Banking Committee passed along party lines in March, did not exempt "end users."

The new law gives the CFTC and Securities and Exchange Commission authority to regulate over-the-counter derivatives and credit-default swaps, migrating many of them from face-to-face deals to exchanges that require higher margin costs. "End user" businesses would be exempt from trading through exchanges for derivatives used to hedge risk from producing or consuming commodities.

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 proposed (AmericanProspect) moving these responsibilities--now spread between the Federal Reserve, the SEC, the Office of Thrift Supervision, and the Federal Trade Commission--to one new agency, the Consumer Financial Protection Agency.

The financial industry opposed 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." The enacted reforms place (Reuters) the new agency inside the Fed, giving the Fed and other regulators the power to appeal the new agency’s rules if deemed to undermine financial stability or bank deposits.

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. 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 argued 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 advocated 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 council Obama proposed would decide which firms should be considered systemically important, while the Fed would be charged with regulating them. House Democrats proposed that troubled, systemically significant firms be dismantled by the Treasury and the Federal Deposit Insurance Corporation, while some Senate Democrats favored using a special bankruptcy court instead, with a separate executive branch authority used only as a last resort.

The Senate bill also gave state attorneys more authority to press for tougher consumer laws than those in place at the federal level. Delegating this authority to politically appointed agencies, some legislators said, might lead regulators to be more lenient with some failing firms than others. Others argued 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. The final law gave the Fed the power to oversee systemically important firms as part of the Financial Services Oversight Council, and empowered the council to monitor systemic risk and decide if a large complex firm needs to be dismantled.

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, and gave the Government Accountability Office (GAO), a nonpartisan congressional oversight agency, the authority to audit all aspects of the Fed’s balance sheets and its regional banks. The Senate bill gave the GAO authority to audit the Fed’s emergency lending activities.

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. The enacted reforms subject the Fed to congressional reviews of its emergency lending activities, but not its monetary policy.

Credit Rating Agencies

Credit rating 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. House and Senate Democrats 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 opposed.

Of greater concern, some experts argued, 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.

The final law includes measures to increase rating agencies’ liability. It also gives the SEC two years to propose a way to mitigate the conflicts of interest among biggest raters (Moody’s, S&P, and Fitch) arising from the "issuer pays" model. If not, the government would create a board to assign rating agencies to debt issuers, outlined in this CFR Backgrounder. Federal agencies are also required to remove references to rating agencies in their rules.

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" in January 2010, 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 argued that the tax deprives the financial industry of needed capital to stimulate economic growth through lending.

The banking industry warned (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. As a concession to some Republican lawmakers, the bank tax was not included in the enacted reforms.

The Volcker Rule

An additional Obama administration proposal, termed the ’Volcker Rule’ in recognition of former Federal Reserve chairman Paul Volcker, 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 Obama’s 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).

Under the enacted reforms, large banks are prohibited from proprietary trading and only allowed minimal investments in hedge funds and private equity funds. Large banks will also be forced to spin off some of their risky derivatives business to avoid losing access to the Fed’s emergency funds.