InfoBytes Regulatory Restructuring Report, Issue One, June 18, 2009
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Obama Administration Releases Proposal to Reform Financial Regulatory System
On Wednesday, June 17, 2009, the Obama Administration released a white paper entitled “A New Foundation: Rebuilding Financial Supervision and Regulation” (the “White Paper”). As expected, the White Paper sets forth a wide array of proposals designed to overhaul the nation’s financial regulatory oversight structure in the wake of the current financial crisis.
If enacted by Congress, the plan set forth in the White Paper to reform the financial oversight structure would have a profound effect upon institutions of every type, from national banks and federal thrifts to state-regulated non-bank lenders and brokers, from credit card banks to investment advisers, from private equity firms and hedge funds to multinational insurance companies. The White Paper is the first substantive step toward what the Administration hopes will be the most sweeping update and expansion of the nation’s financial regulatory system since the time of the Great Depression. While we understand that Treasury officials are currently drafting legislative language to effectuate the White Paper proposals, in many ways, the White Paper is perhaps best seen as the Administration’s opening gambit in a complex negotiation over the reformation of the financial services regulatory structure.
The sweeping proposals would effect enormous change on both the legal environment in which retail financial services providers do business and the economics of retail financial services. Among many other changes, the White Paper proposes to:
- Create a new Consumer Financial Protection Agency that would take over both rule writing and enforcement of all existing federal consumer protection laws and the Community Reinvestment Act, including broad new rule-writing authority to create new requirements and disclosures;
- Effectively eliminate federal preemption of consumer protection laws for all entities, including federally chartered banks (although it remains unclear whether this would include preemption of state usury limits or subject banks and their subsidiaries to state licensing); and
- Require loan originators or sponsors to retain five percent of the credit risk of securitized exposures, including a prohibition on hedging or otherwise transferring the risk retention piece but giving bank regulators the ability to adjust the amount or structure of the risk retention.
As the debate moves forward on financial regulatory restructuring, BuckleySandler will provide coverage of and commentary on significant developments in the process through the publication of the BuckleySandler Regulatory Restructuring Report.
The Administration’s proposals are framed within the construct of five overarching regulatory objectives. These objectives, along with many of the key proposals, are outlined below.
(1) Supervision and Regulation of Financial Firms. This objective is designed to address the need to adequately regulate all financial firms, and especially any financial firm that poses significant risk. The specific proposals include the following:
- Provide new authority to the Federal Reserve to supervise all firms that could pose a threat to the financial system (i.e., Tier 1 Financial Holding Companies (“FHC”)). Supervision would extend to the parent company and all subsidiaries (regulated or not, domestic or foreign), including regulation of safety and soundness of the entire organization, and not just the bank subsidiary. The Administration is recommending legislation to specify factors that the Federal Reserve must consider when determining whether a firm represents a systemic threat, while preserving the ability of the Federal Reserve to consider additional factors at its discretion. In addition, Gramm-Leach-Bliley restrictions on the ability of the Federal Reserve to require reports from, examine if necessary, and impose requirements on functionally regulated or depository institution subsidiaries of FHCs would be removed. These proposals would result in significant expansion of the formal powers and duties of the Federal Reserve.
- Increase capital and other prudential standards for all firms, including higher standards for large, “interconnected” firms. Tier 1 FHCs would have stricter and more conservative capital, liquidity and risk management standards, but standards would generally be raised for all financial institutions. Banks and Bank Holding Companies would be subject to capital rules that cover all lines of businesses, considers the relative risk of various types of exposures, is transparent, and is comparable across firms. Treasury will lead working groups to report on appropriate standards. The accounting standard setters such as FASB and IASB would be encouraged to review accounting standards to review loan-loss provisioning practices and fair value accounting rules. Further, regulators would issue standards and guidelines that set forth rules for executive compensation, including aligning compensation programs with long-term shareholder value.
- Create a new National Bank Supervisor. This would be a single agency with separate status within Treasury with the charge of conducting prudential supervision and regulation of all federal chartered depository institutions and all federal branches of foreign banks. This agency would replace the prudential responsibilities of the OCC and the OTS, and would simultaneously eliminate the federal thrift charter. However, interstate branching rules would be preserved and applied to state and national banks. Notably, the FDIC, the Federal Reserve, and the NCUA would retain their roles in supervision and regulation of their respective institutions.
- Close “loopholes” that allow institutions to circumvent bank holding company regulation by the Federal Reserve. The White Paper states that loopholes in the legal definition of “bank” allowed financial institutions to shop for the regulator of their choice, citing in particular loopholes in the BHC Act for thrift holding companies, industrial loan companies, credit card banks, trust companies, and grandfathered “nonbank” banks. All large, interconnected firms would be subject to consolidated supervision by the Federal Reserve under the BHC Act, regardless of whether the firm owns an insured depository institution. The White Paper states that the policy of separating banking from commerce should be “reaffirmed and strengthened.”
- Create a new “Financial Services Oversight Council” that includes prudential regulators, tasked to identify emerging systemic risks and facilitate interagency cooperation. The FSOC would replace the President’s Working Group on Financial Markets and would be chaired by the Treasury and include the heads of the principal federal financial regulators (including the newly created National Bank Supervisor and the Consumer Financial Protection Agency). A permanent staff would be located within Treasury. Among other things, the FSOC would have the authority to gather information from any financial firm, recommend which firms should be subject to Tier 1 FHC supervision, and refer information regarding emerging risks to the appropriate regulator.
- Eliminate the SEC programs for consolidated supervision. The SEC has already terminated the Consolidated Supervised Entity Program. The White Paper proposes eliminating the Supervised Investment Bank Holding Company program, stating that any investment banking firms seeking consolidated regulation should be subject to Federal Reserve oversight.
- Require registration of advisers of hedge funds and other private pools of capital with the SEC. Hedge fund advisers, private equity funds, and venture capital funds whose capital exceeds a certain (undefined) threshold would be required to register with the SEC under the Investment Advisers Act and required to report on the funds they manage.
- Create the Office of National Insurance. A new agency would be created within Treasury to collect information and coordinate policy in the insurance arena. The agency would also recommend firms to the Federal Reserve that should be supervised as Tier 1 FHCs.
- Determine a role for the GSEs. The White Paper tasks Treasury and HUD, in consultation with other agencies, to develop recommendations on the future of Fannie Mae, Freddie Mac, and the Federal Home Loan Bank system by the time of the 2011 budget release in the first quarter of 2010. Potential options include returning them to their previous status, a gradual wind-down and liquidation, incorporating them into a federal agency, a conversion to a public utility model with government regulation of profit margin, guarantee fees, and with explicit government backing of commitments, a conversion to providing insurance for covered bonds, or dissolution into many smaller companies.
(2) Establish Comprehensive Supervision and Regulation of Financial Markets. The purpose of this objective is to ensure that the financial markets are strong enough to withstand system-wide stress and/or the failure of one or more large institutions.
- Enhance regulation of securitization markets. Agencies are encouraged to promulgate regulations that require originators or sponsors to retain an economic interest in a “material portion” of the credit risk of securitized credit, set at 5% of the credit risk of securitized exposures (but with the ability of agencies to raise or lower the threshold or provide exemptions). Agencies would also have the authority to apply these requirements on securitization sponsors as opposed to loan originators if circumstances dictate. Further, the regulations should align compensation of market participants with longer-term performance of the underlying loans. The SEC should be given authority to require ongoing reporting by ABS issuers.
- Provide for comprehensive regulation of all over-the-counter derivatives, including credit default swaps. The goals would be to prevent these vehicles from posing risk to the financial system, promote efficiency and transparency in these markets, prevent market manipulation and fraud, and prevent marketing of these vehicles to unsophisticated parties. Oversight should include record-keeping and reporting requirements on all OTC derivatives, and include capital requirements that are more conservative than existing bank regulatory capital requirements for OTC derivatives. In addition, all standardized OTC derivative transactions would have to be executed in regulated and transparent venues and cleared through regulated counterparties.
- Provide authority for the Federal Reserve to oversee payment, clearing and settlement systems. Legislation should broadly define the characteristics of systemically important covered systems – generally tied to systemic risk – and set risk management standards for operation. Covered systems should be subject to regular and robust on-site safety and soundness exams, and the Federal Reserve should have authority to compel corrective action.
- Meld the regulatory regimes for futures and securities. The White Paper does reiterate that both the SEC and CFTC would retain current responsibilities, but the regulatory regimes should be harmonized to improve oversight and reduce conflicting jurisdictional overlap.
- Increase regulation of credit rating agencies, including measures to manage and disclose conflicts of interest.
(3) Enhance Consumer Protection. A major aspect of the reform plan is comprehensive reform of consumer protection regulation and oversight. The White Paper raised the failure of the regulatory framework to adequately protect borrowers from abusive lending practices as a key aspect of the financial crisis. Although the factual basis for this assertion was not presented, the White Paper insists that the consumer protection issue arose in part because the regulatory framework had gaps and conflicts of interest existed between state and federal enforcement. The White Paper states that consistency and strength of regulation of consumer financial services will be primary to this objective, with a focus on transparency, simplicity, fairness, accountability, and access.
- Establish a new, independent agency called the “Consumer Financial Protection Agency.” The CFPA would be the primary federal regulator, dedicated to consumer protection in credit, savings and payments markets. One key purpose will be to reduce gaps in federal supervision and improve coordination with state enforcement agencies, as well as provide consistent regulation of similar products. The CFPA would have sole rule-making authority for consumer protection statutes (including TILA, RESPA, HOEPA, ECOA, FDCPA, and notably HMDA and CRA), and enforcement and supervisory authority over all persons covered by the statutes it implements, including to nonbanking institutions. The CFPA would not obtain oversight of investment products and services already regulated by the SEC or CFTC. In addition, the White Paper proposes the establishment of an outside advisory panel to promote and assess CFPA’s accountability.
- Federal Preemption for Federally Chartered Banks will be substantially curtailed and the CFPA’s rules will set a floor, not a ceiling, for consumer protection regulation. States would have the ability to adopt and enforce stricter laws for institutions of all types (including national banks) and to enforce federal law concurrently. The White Paper does not specify whether rate and fee limits will lose exportation preemption. Nor does it address whether banks or their operating subsidiaries would be subject to state licensing. It also would give states concurrent enforcement of federal rules.
- Reform consumer protection, focusing on transparency, simplicity, fairness, and access.
a. CFPA would be authorized to impose a “duty on providers and intermediaries to require that communications with the consumer are reasonable,” meaning that disclosures and other communications with consumers are “balanced in their presentation of benefits, and clear and conspicuous in their identification of costs, penalties, and risks.”
b. CFPA would be authorized to define standards for “plain vanilla” products and require all providers to offer these products prominently and alongside alternative products.
c. CFPA would be authorized to place restrictions on product terms and lending practices, if necessary, and to impose duties of care on financial intermediaries.
d. CFPA would collect HMDA data and enforce fair lending laws and the Community Reinvestment Act. The White Paper’s inclusion of the Community Reinvestment Act, which is not a consumer protection statute and which would presumably require a cadre of specialized bank examiners to administer, is not further explained.
e. CFPA would be authorized to impose duties of care on financial intermediaries, such as for mortgage brokers a duty of best execution with respect to available mortgage loans and a duty to determine affordability for borrowers.
- Provide the Federal Trade Commission new authority and resources to enforce consumer protection laws. The FTC would retain authority for dealing with fraud, remain the lead consumer protection agency for data security (but with privacy protection on financial issues moving to CFPA) and should retain backup authority with the CFPA. The FTC would be given authority to conduct rulemaking for unfair and deceptive practices.
- Provide the SEC new authority to protect investors and improve disclosures. Among other things, the SEC would establish a fiduciary duty for broker-dealers offering investment advice, and should harmonize regulation of investment advisers and broker-dealers. In addition, the SEC would expand protections for whistleblowers and require non-binding shareholder votes on executive pay plans.
- Establish the Financial Consumer Coordinating Counsel. This would be created under the leadership of the Financial Services Oversight Council, with membership of a broad number of federal and state consumer protection agencies, and a permanent role for the SEC’s Investor Advisory Committee. The FCCC would be tasks with identifying gaps in consumer protection and to facilitate coordination of consumer protection efforts.
(4) Improve Tools to Manage Financial Crises. This objective attempts to create a structure for orderly resolution of major institutions to avoid future bailout situations. Judicial bankruptcy will remain the dominant tool for handling institution failures, unless this resolution regime is triggered due to concerns about financial market stability.
- Provide ability to resolve non-bank financial institutions that pose systemic risk. The model will be based on the existing authority of the FDIC.
- Revise Federal Reserve’s emergency lending authority. The Federal Reserve would receive prior written approval from the Secretary of the Treasury to provide emergency lending under “unusual and exigent circumstances” authority.
(5) Raise International Regulatory Standards and Improve International Cooperation. This objective is aimed to ensure that financial institutions do not attempt to evade stronger regulation by relocating activities to jurisdictions with looser standards.
- Reform international regulation. This will require the United States to utilize its role in the G-20, the Financial Stability Board and the Basel Committee to promote global initiatives that are compatible with the proposed domestic regulatory reforms.
- Strengthen capital requirements implemented by the Basel Committee. This would include measures to refine risk weighting applicable to trading book and securitized products, introducing a supplemental leverage ratio, and improving the definition of capital. It also encourages a comprehensive review of the Basel II framework to assess and mitigate procyclical effects.
- Improve oversight of global financial markets. National authorities should promote standardization and improved oversight of CDOs and other OTC markets.
- Coordinate supervision of international firms. The Financial Stability Board and other national authorities should implement G-20 commitments to improve and strengthen international cooperation on supervision of global financial firms.
- Enhance crisis management. The Basel Committee should expedite work to improve cross-border resolution of global financial firms, including developing recommendations by the end of 2009.
- Strengthen Prudential Regulations. The Basel Committee should improve liquidity risk management standards for financial firms.
- Expand Regulation Scope. National authorities should determine the appropriate Tier I FHC definition and its application to foreign financial firms, and to implement by the end of 2009 the commitment to require hedge funds or their managers to register and disclose information sufficient to assess systemic risks they may pose.
- Introduce Revised Compensation Practices. National authorities should establish guidelines that align compensation with long-term shareholder value and promote structures that do not incentivize excessive risk taking.
- Establish Stronger Standards for Money Laundering, Terrorist Financing, Tax Information Exchange, and Prudential Regulation. The Financial Stability Board should establish and coordinate peer reviews to assess the implementation of international regulatory standards. The United States should implement the updated International Cooperation review Group peer review process.
- Improve Accounting Standards. Accounting standard setters should make significant progress towards global accounting standards, clarify and coordinate the application of fair value accounting standards, and improve standards for loan loss provisioning.
- Improve Oversight of Credit Rating Agencies. As with domestic priorities, national authorities should enhance oversight of credit rating agencies consistent with international standards and the G-20 Leaders’ recommendations.
This outline is just a summary of key aspects of the Administration’s proposal. For the full text of the White Paper, please see: http://www.financialstability.gov/docs/regs/FinalReport_web.pdf