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Systemic Risk: Are the Pending Proposals Sufficient to Forestall or Mitigate a
Future Economic Crisis?
By Lisa H. Nicholson
Introduction
The 2008 collapse of Lehman Brothers1 and the near collapse and seemingly
forced sales of Bear Stearns to JPMorgan Chase2 and Merrill Lynch to Bank of America3
can only be viewed as paradigm-shifting events in the U.S. capital markets. Arguably,
these events arose in the context of continual diminution of government oversight of the
financial services industry over the last decade.4 Proponents of deregulation of the
financial industry argued that such actions were necessary to prevent the United States
from losing its edge in the global financial markets.5 They argued that too much
1
On September 15, 2008, Lehman Brothers Holdings, Inc. initiated Chapter 11 bankruptcy proceedings,
listing total bank and bond debt of approximately $768 billion and assets worth approximately $639 billion.
cite
2
See discussion, infra at _____.
3
See discussion, infra at ______..
4
See generally, Congressional Oversight Panel, Special Report on Regulatory Reform, submitted under
Section 125(b)(2) of Title I of the Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-343,
January 2009 (noting, “policymakers began to see regulation as a barrier to efficient functioning of the
capital markets rather than a necessary precondition for success. This change in attitude had unfortunate
consequences. As financial markets grew and globalized, often with breathtaking speed, the U.S.
regulatory system could have benefited from smart changes.”).
5
See The Department of the Treasury, Blueprint For a Modernized Financial Regulatory Structure (March
2008), w.w.w.treasury.gov (“Blueprint”), at 2 (in recommending changes to the existing regulatory
structure, the Treasurer note, “maturing foreign financial markets and their ability to provide alternate
sources of capital and financial innovation in a more efficient and modern regulatory system are pressuring
the U.S. financial services industry and its regulatory structure. The United States can no longer rely on the
strength of its historical position to retain it preeminence in the global markets.”). See also Bethany
McLean, Wall Street Whiners, Fortune Magazine at 28 (April 14, 2008) (reporting that politicians and
members of the business community had angled for less regulation, arguing that too many rules were partly
responsible for the decline of the U.S. empire and noting that “the ‘vast majority’ of those surveyed by
McKinsey & Co.,” whose report was backed by New York Mayor Michael Bloomberg and Senator Charles
Schumer to argue for less regulation argued “The pendulum of regulation in the U.S. has swung too far in
recent years.”) ; cite also Paul Atkins testimony; Phil Gramm testimony during passage of both Acts.
1
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regulation would harm U.S. financial activities and force traders to take their business
overseas. Indeed, foreign countries have developed cost-effective capital markets to
compete with the U.S. capital markets in recent years.6
The deregulatory climate championed, and led by then-Senator Phil Gramm,
culminated in enactment of the Gramm-Leach Bliley Act of 1999 (“GLBA”)7 and the
Commodities Futures Modernization Act of 2000 (“CFMA”)8 during the Clinton
administration. Together, these statutes allowed many nonbank financial institutions and
trading products to be subject only to purported market discipline, which supposedly
should have ensured that these entities would be responsibly run.9 The GLBA, for
example, split oversight of financial conglomerates among several regulatory agencies.
While the Securities and Exchange Commission (“SEC”) retained oversight over the
brokerage activities of a company, the bank regulators (including the Federal Reserve)
retained supervision over the company’s bank operations. However, no single agency
maintained supervisory authority over the entire company. Similarly, the CFMA was
enacted to forestall future federal regulation of the derivatives and swaps10 markets,
6
See The Department of the Treasury, Blueprint For a Modernized Financial Regulatory Structure (March
2008), w.w.w.treasury.gov (“Blueprint”).
7
Pub. L. No. 106-102, Nov. 12, 1999, 113 Stat. 1338 (1999) (codified in scattered sections of 12, 15, 16,
18 U.S.C.A.). The GLBA removed barriers between commercial and investment banks that had been
erected over 60 years earlier, enabling commercial banks, securities firms and insurers to offer an array of
services by way of a financial supermarket.
8
cite
Cite to Testimony of Phil Gramm, Former Texas Senator who “insisted that market forces would provide
ample protection against excessive risk.” Robert H. Frank, Pursuit of an Edge, In Steroids or Stock, NY
Times (October, 5, 2008)
9
10
Swaps are contracts that act as insurance policies to limit investment risks. For example, credit default
swaps, a more popular type of derivative, were used to protect the holder of mortgage-related securities
against a possible default. See discussion of credit default swaps, infra at ____.
2
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excluding these hybrid securities from the otherwise applicable statutory definition of
securities. The Act specifically exempted many types of derivatives from federal
oversight. The over-the-counter (“OTC”) market for credit default swaps (“CDS”) also
benefited from being shadowed from the glare of federal oversight – the market had
ballooned to $62 trillion before coming down to $55 trillion in late September 2008.11
The current economic crisis has exposed the failure of purported market selfdiscipline. That assumed discipline did not and could not prevail. On the road to
speculative profits, banks and non-bank financial institutions over-leveraged their assets,
notwithstanding the possibility of self destruction.12 The near-collapse of Bear Stearns is
a telling example. The 85 year old investment bank became the first prominent U.S.
casualty of the economic crisis.
Troubles began at Bear Stearns almost a year prior to its near-collapse. The firm
let two of its hedge funds collapse in June 2007 because of mortgage-backed securities
problems.13 Bear, nevertheless, appeared to weather the storm – at least until early
March 2008 when counter-parties and customers began to question whether Bear had the
cash to execute their trades. The firm had lost $17 billion in cash as of March 10, 2008.
In fact, “Bear had $11.1 billion in tangible equity capital supporting $395 billions in
assets, a leverage ratio of more than 35 to 1. And its assets were less liquid than many of
its competitors.”14 The cost of insuring $10 million in Bear debt via credit default swaps,
11
See Mathew Philips, The Monster That Ate Wall Street, Newsweek at 46 (October 6, 2008).
12
cite to Citigroup and Merrill
13
See Roddy Boyd, The Last Days of Bear Stearns, Fortune at 86 (April 14, 2008); Allan Sloan, On the
Brink of Disaster, Fortune at 80 (April 14, 2008). For a more detailed look into the events leading up to,
and including, Bear Stearn’s last days, see also, William D. Cohan, House of Cards, Doubleday (2009).
14
Roddy Boyd, The Last Days of Bear Stearns, Fortune at 86 (April 14, 2008).
3
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which had hovered near $350,000 in the month before, had shot past $1 million.15 By the
time Bear issued a press release on March 10, 2008, suggesting that rumors of an
impending liquidity problem were just that, the firm had entered a death spiral. Unable to
secure short-term funding through “repo loans”16 in its last days, Bear’s liquidity was
down to $2 billion by March 13.17 Bear’s final trading day was March 14, 2008. In the
end, Bear Stearns was swallowed by J.P. Morgan Chase in a renegotiated share exchange
valued at $10 per share (100% higher than originally agreed).18
The Bear Stearns saga was the perfect backdrop against which then-Treasury
Secretary Henry L. Paulson introduced the Bush administration’s proposal to overhaul
the way the U.S. financial system is regulated. The Blueprint for a Modernized Financial
Regulatory Structure, was designed to promote “economic growth and stability in the
United States” by reforming the regulatory structure applicable to the banking, securities,
insurance and futures industry away from the current system of functional regulation.19
The Blueprint’s focus was not investor protection. The Treasury proposed a regulatory
approach that would have established distinct regulators focused on one of three
15
Id.
A “repo loan” is shorthand for a repurchase agreement pursuant to which a borrower uses a financial
security as collateral to obtain a cash loan at a fixed rate of interest from the lender. Typically, the
borrower agrees to sell immediately the security to the lender while simultaneously agreeing to purchase
the same security from the lender at a fixed price at some later date. Technically, a repo is equivalent to a
cash transaction combined with a forward contract. In other words, the cash transaction results in transfer
of money to the borrower in exchange for legal transfer of the security to the lender, while the forward
contract ensures repayment of the loan to the lender and return of the collateral of the borrower. These
agreements are used to finance proprietary trading, and to cover short positions in securities. CITE
16
17
Roddy Boyd, The Last Days of Bear Stearns, Fortune at 86 (April 14, 2008).
18
cite NY Times article
19
The Department of the Treasury, Blueprint For a Modernized Financial Regulatory Structure (March
2008), w.w.w.treasury.gov (“Blueprint”).
4
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objectives: market stability regulation, safety and soundness regulation (otherwise
known as prudential regulation), and business conduct regulation. 20 This proposal called
for a strengthened Federal Reserve and the consolidation of the numerous federal
regulatory agencies, including a recommendation to merge the SEC with the
Commodities Futures Trading Commission (CFTC).21 While the Blueprint introduced
many ideas that are currently being considered in connection with the today’s push for
regulatory reform, it was a highly political document introduced in an election year. As
such, little progress was made on the reform proposals.
The escalating failure of financial markets, which saw the late 2008 demise of
Lehman Brothers, the seemingly shot-gun merger of Merrill Lynch and Bank of
America,22 and the discovery of the Bernard Madoff’s $65 billion Ponzi scheme,
however, renewed interest in financial regulatory reform. The epic nature of the
economic crisis revealed that market regulators23 were not able (although some may
argue that they were unwilling) to keep pace with the rise in newly-introduced,
innovative financial products;24 the rise in trading volumes;25 the introduction of new
20
The Department of the Treasury, Blueprint For a Modernized Financial Regulatory Structure (March
2008), w.w.w.treasury.gov (“Blueprint”).
21
The Department of the Treasury, Blueprint For a Modernized Financial Regulatory Structure (March
2008), w.w.w.treasury.gov (“Blueprint”).
22
23
Describe and Cite
Defined as SEC, Fed, CFTC, Banking regulators, etc.
24
The 21st century ushered in even more complex financial products and terms like mortgage-backed
securities (MBS), collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), assetbacked commercial paper, auction rate securities, credit default swaps (CDS), financial insurers, and
structure investment vehicles (SIVs). Unfortunately, federal financial regulations and internal risk
management standards failed to keep pace with these new market products and vehicles.
25
The dollar value of average trading volume in the U.S. capital markets, which was approximately $87
billion a day in February 1999, sprang to $251 billion a day by February 2009. See SEC Chairman Mary L.
5
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market participants; the convergence of financial services and their providers, and the
continued globalization of the financial industry.26
The regulatory failings can be attributed to numerous shortcomings, including
regulatory turf wars, funding shortfalls, incomprehension of risk magnitudes, and the lack
of acknowledgement of the inter-connectedness of significant players in the financial
system, to name a few.27 The SEC, for example, had been hampered for years in its
efforts to “protect investors, facilitate capital formation and maintain fair, orderly, and
efficient markets.”28 This federal agency lacked the necessary leadership who embraced
the organization’s goals and mission;29 and has remained significantly under-funded,30
and understaffed31 despite market changes. Moreover, in light of the GLBA and the
Shapiro, Testimony Concerning Enhancing Investor Protection and Regulation of the Securities Markets
(March 26, 2009).
26
See Congressional Oversight Panel, Special Report on Regulatory Reform, submitted under Section
125(b)(2) of Title I of the Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-343 (January
2009). cite also to Congressional Hearings.
27
Some commentators will argue that the regulatory failings also can be attributed to regulatory apathy,
regulatory capture, or subordination to a deregulatory leadership. cite to instances.
28
U.S. Securities and Exchange Commission, Office of Inspector General, Semiannual Report to Congress,
October 1, 2008 –March 31, 2009 at p. 5, (noting SEC’s mission).
29
For the past eight years, the SEC was led by Commissioners, many of whom thought the SEC should
take a lighter touch in regulating and policing the capital markets. cite to speeches by Cox, Donaldson,
Paul Atkins, Nazareth etc.
The SEC’s operating budget has increased only incrementally during the period of 1999 through 2008,
from $341 million to $906 million. Frequently Requested FOIA Document: Budget History – BA vs.
Actual Obligations, available at http://www.sec.gov/foia/docs/budgetact.htm. Specifically, its budget for
the years 1999 through 2002 (the period preceding discovery of the wave of accounting scandals) was $341
million; $377 million; $423 million; $514 million, respectively; and only increased following calls for more
funding in 2002 to $716 million in 2003; $812 million in 2004; $887 million in 2005; $888 million in 2006;
$882 million in 2007 and $906 million in 2008. Id.
30
31
The SEC has a staff of 3,511 full time equivalents. These figures are actual values for fiscal year 2008.
U.S. Securities and Exchange Commission, FY 2010 Congressional Justification at p. 1 (May 2009). See
also Testimony of Linda Chatman, Former SEC Director of Division of Enforcement, Before the U.S.
Senate Committee on Banking, Housing and Urban Affairs Re: Maddoff Matter (January 27, 2009). There
are 80 fewer SEC staffers than at its 2005 fiscal year peak. Testimony of SEC Division Heads before
House Comm. on Financial Svces. Subcommittee. on Capital Markets (February 4, 2009). Nevertheless, it
regulated and oversaw the activities of approximately 5,600 broker-dealers, over 11,000 investment
6
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CFMA, the SEC neither had jurisdiction over many of the financial products, nor
regulatory authority over some of the market participants32 who traded in those products33
that most commentators attribute to the current credit crisis.
Inadequate regulatory schemes have greatly impacted the general public, who
continually rely on the capital markets in particular (and the financial markets in general)
to acquire wealth, fund higher education for their children, purchase residential property,
to engage in the entrepreneurial spirit and provide for retirement income. In fact, more
than 52 million U.S. households, or 45% of total households, owned mutual funds, and
had assets under mutual funds management totaling $9.4 trillion as of January 31, 2009.34
When the capital markets faltered and credit markets dried up, the losses were staggering
and their effects far-reaching.
Systemic risk35 had entered the American lexicon. The distaste for regulatory
reform slowly began to wane. Indeed, the Congressional Oversight Panel (convened in
advisors, 4,600 registered mutual funds, 12,000 public companies, 600 transfer agents, 11 stock and option
exchanges, over five clearing agencies and ten credit rating agencies, among other financial intermediaries,
through March 2009. See SEC Chairman Mary L. Shapiro, Testimony Concerning Enhancing Investor
Protection and Regulation of the Securities Markets (March 26, 2009); U.S. Securities and Exchange
Commission, Office of Inspector General, Semiannual Report to Congress, October 1, 2008 –March 31,
2009 at p. 5 (noting that the SEC also oversees the Public Company Accounting Oversight Board
(PCAOB), the Financial Industry Regulatory Authority (FINRA), and the Municipal Securities Rulemaking Board (MSRB)).
32
The SEC had no authority to regulate investment bank holding companies, hedge funds, or their
investment advisors.
33
The SEC had no jurisdiction over collateralized debt obligations, credit default swaps . . . Note: The
SEC did not oppose the CFMA. It had, however, begun filing amicus briefs in support of its
authority to bring Rule 10b-5 actions since the mid-1990s.
34
U.S. Securities and Exchange Commission, FY 2010 Congressional Justification at p. 7 (May 2009).
Institutions pose a “systemic risk” when the failure of one large private institution would damage the
entire U.S. financial system. In other words, most big financial institutions are so interlinked with one
another and other market participants that the failure of one counter-party to a transaction can drag down
other counter-parties around the world. See Allan Sloan, On the Brink of Disaster, Fortune at 82 (April 14,
35
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connection with the adoption of the Emergency Economic Stabilization Act of 2008)
noted in its January 2009 Special Report on Regulatory Reform that “the present
regulatory system has failed to effectively manage risk, require sufficient transparency
and ensure fair dealing.”36 Six months later, President Barack Obama released the
Administration’s proposal for reforming the regulatory structure that oversees the
financial services industry. The proposal, inter alia, reshuffles regulatory powers;
combines some regulatory agencies, while creating new ones; and extends federal
regulatory powers to products and firms that are not currently regulated at all. By most
accounts, the eagerly awaited proposal is sweeping in nature.
This article focuses specifically on the President’s proposal to address systemic
risk and analyzes (i) whether the Administration’s plan, if implemented, would have
significantly mitigated or prevented the current economic crisis; (ii) whether the
Administration’s plan, if implemented, would lessen or forestall future economic crises;
and (iii) whether the pending legislation would strengthen or weaken the
Administration’s financial regulatory reform proposal. Of course, the underlying
question is whether the public’s appetite for reform will diminish if too much time passes
while Congress attempts to formalize key aspects of the President’s proposals. The
central question for Congress, therefore, is whether the U.S. will finally heed the lessons
from the 1998 collapse of Long Term Capital Management, the behemoth hedge fund and
2008); Kathleen A. Scott, Addressing the Conditions Leading to “System Risk” on a Global Basis, NYLJ,
at 3 (Mar. 18, 2009).
36
Congressional Oversight Panel, Special Report on Regulatory Reform (January 2009) at 2, submitted
under Section 125(b)(2) of Title I of the Emergency Economic Stabilization Act of 2008, Pub. L. No. 110343.
8
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precursor to the current economic crisis,37 or is it doomed once again to experience the
near-destruction of its financial markets?
I.
ORIGINS OF ECONOMIC CRISIS – A SUMMARY
The global economic crisis resulted from the credit gridlocks sparked by capital
market participant paralysis –investors, businesses, banks and non-bank financial
institutions all were paralyzed by fear and the mounting losses from their constant
borrowing and lending and trading practices during the height of the boom markets.
From 2002 to 2006, the five largest investment banks – Goldman Sachs, Morgan Stanley,
Merrill Lynch, Lehman Brothers and Bear Stearns – earned more than $30 billion,
achieving an average return on equity38 of 22% at their peak.39 In recent years, the
business model on Wall Street changed as profit margins shrank in traditional businesses
(like merger and acquisition advising, securities underwriting and brokerage) causing
executives and shareholders to search for new avenues of profitability.40 This is
particularly true where investment banks found themselves competing with large
37
In 1998, the Federal Reserve orchestrated the bailout of the Long-Term Capital Management hedge fund
because it had amassed $1.25 trillion in transactions with other institutions. Allan Sloan, On the Brink of
Disaster, Fortune at 82 (April 14, 2008). For a detailed analysis of the rise and fall of Long-Term Capital
Management, see Roger Lowenstein, When Genius Failed, Random House (2000). See also discussion at
note 57, infra.
The “return on equity” is the amount of net income returned as a percentage of shareholders
equity. Stated differently, ROE measures a corporation's profitability by revealing how much profit a
company generates using the money shareholders have invested. The formula for calculating ROE is as
follows: ROE = Net Income divided by shareholder’s equity. In turn, shareholder equity is the owners'
interest on the assets of the firm (including both tangible and intangible items) after deducting all of the
firm’s liabilities.
38
39
Shawn Tully, What’s Wrong with Wall Street and How to Fix It, Fortune (April 14, 2008).
40
See Shawn Tully, What’s Wrong with Wall Street and How to Fix It, Fortune at 72 (April 14, 2008).
9
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commercial banks and private equity firms for such business.41 Their new business
models appear to have required using “towering leverage to make lottery-like” bets in the
seemingly long-running bull market.42 Reportedly, trading revenues accounted for 54%
of the profits at these investment banks during the period of 2000 to 2006, with a
majority of those revenues coming from proprietary trading.43 Moreover, the five firms’
average leverage ratio, measured by assets as a multiple of equity,44 jumped from 30:1 to
41:1 from 2002 through 2007.45 It is worth noting that the SEC had granted exemptions
to its net capital rules to these and other investment banks.46 Unfortunately, markets turn
and debts must be repaid. Liquidity quickly becomes a problem unless a sizeable cushion
was maintained. As Bear Stearns, Lehman and Merrill have subsequently illustrated,
when liquidity is questioned (as is similarly the case with trust), trading relationships end.
Rather than holding highly liquid assets (like Treasury bills or top rated corporate bonds),
however, many of these firms held the more exotic, complex financial products – which
were virtually illiquid when needed.
The liquidity crisis, which triggered the credit crisis, arguably resulted from the
bank and non-bank financial institutions’ over-dependence on risky trading ventures;
their unending embrace of dangerously high leverage levels; and pay schedules that tied
executive compensation to what amounted to short-term performance targets. This
41
CITE
42
See Shawn Tully, What’s Wrong with Wall Street and How to Fix It, Fortune at 72 (April 14, 2008).
43
See Shawn Tully, What’s Wrong with Wall Street and How to Fix It, Fortune (April 14, 2008).
44
For example, . . .
45
See Shawn Tully, What’s Wrong with Wall Street and How to Fix It, Fortune (April 14, 2008).
discuss the SEC’s Consolidated Supervised Entities Program and how it has responded to being
blamed for the demise of the biggest five investment banks.
46
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business model found comfort in the growing market for mortgage lending and
securitizations, spurred by the growth of the so-called “housing bubble.”
The reckless search for bigger payouts did not begin with investors speculating in
the housing market. It goes back at least a decade earlier. While many individuals and
entities made huge amounts of money trading and speculating in technology stocks
during the boom years of the 1990s, the lucrative technology bubble began to deflate
around the turn of the century and the stock market faltered.47 The events of 9/11 further
depressed capital market activity. To spur the economy and stimulate lending, the
Federal Reserve lowered the benchmark interest rate from 6.5% to 1% from 2002 through
2004.48 This action put more money – including foreign investor money – into the U.S.
economy, leading investors to search for and investment banks graciously to develop
newer investment options.
The U.S. was simultaneously experiencing a housing boom during which housing
prices increased, sometimes threefold. Consumers, lenders, and investors each assumed
that the housing prices would continue to go up. Many saw the value in mortgage
lending – consumers could obtain mortgage loans; lenders found an income stream; while
banks and non-bank financial institutions saw ways to profit off these loans.
In the early days of the housing boom, prime loans were packaged together or
securitized as asset-backed securities – specifically as mortgage backed securities and
sold to investors – including pension funds, and various nonprofit institutions. These
“prime loans” were so-called because they were seemingly less risky given that they
purportedly were supported by more credit-worthy homebuyers who had a lower risk of
47
Cite
48
cite
11
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default. Sales of these (asset-backed) derivative securities were made easier because
their issuers were able to secure favorable ratings from the credit-rating agencies. The
belief was that the risk dispersion occurred through the use of securitization. Some bank
and non-bank financial institutions saw this new avenue as a way to increase profits, and
provided incentives to loan originators to make more and more loans.
As the demand grew, the nature of the home loans that were repackaged changed.
They began to include some of the more risky loans from homebuyers with greater
perceived risks of default. These loans became known as “subprime loans.” Once again,
the initial mortgage-backed securities included a repackaged mix of prime and subprime
mortgages. Because of the increased risk, however, these derivatives could be offered for
a higher rate of return. The higher rates of return attracted even more investors –
including the banks and non-bank financial institutions (like hedge funds), corporations,
U.S. local municipalities, foreign nations, and individual foreign investors. Some of
these investors even used borrowed money to make even bigger investments, with many
eventually becoming over-leveraged. Once again, the issuers were aided by the credit
rating agencies who continued to provide unusually high ratings.
The growing demand for mortgage-backed securities led issuers to create even
more complex financial products – some only backed by subprime loans. To hedge the
risks associated with trading these and some of the earlier derivative securities, many of
investors simultaneously invested in credit default swaps (CDS). Some may even argue
that in lieu of adequate risk management systems, many firms (and individuals)
purchased investment insurance in the form of credit default swaps.
12
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This product was used early on by JPMorgan Chase in the 1990s, which had built
up a “swaps desk” in the mid-90s.49 Under the terms of a contract, as initially created, “a
third party would assume the risk of the debt going sour, and in exchange would receive
regular payments from the bank, similar to insurance premiums.”50 JPMorgan used these
products to remove the risky investments from its books and free up the bank reserves it
was required to maintain under federal law. By 1999, other commercial banks, as well as
insurance companies, like AIG, began issuing and trading CDS contracts.
Unfortunately, Congress, in its enactment of CFMA, determined to exclude credit
default swaps from regulatory oversight. Moreover, since these contracts are typically
privately negotiated between the parties, there is no central reporting mechanism to
determine their value, or for that matter whether the premiums paid will sufficiently
support the risks undertaken. This inadequacy was greatly revealed during the height of
the economic crisis when other market participants were unable to determine the value of
trillions of contracts. Indeed, trading in CDS contracts soared from 2004 through 2008,
when these instruments were used to hedge trades in mortgage-backed securities.51 Soon
companies like AIG (the insurance company rescued by the government) began writing,
and profiting from, such contracts. This continued until the bottom started falling out of
49
See Mathew Phillips, The Monster That Ate Wall Street, Newsweek (October 6, 2008).
50
Mathew Phillips, The Monster That Ate Wall Street, Newsweek (October 6, 2008). See also See Nelson
D. Schwartz and Julie Creswell, What Created This Monster, NY Times Sunday Business, p. 1 (March 23,
2008). In JPMorgan’s case, one of the earliest CDS deals involved the securitization, repackaging, and sale
of 300 loans that were made to various blue chip firms totaling $9.7 billion. When the riskiest 10 percent
of the tranches were sold, CDS were used to encourage investors to purchase those derivative securities.
See id.
51
See Mathew Phillips, The Monster That Ate Wall Street, Newsweek (October 6, 2008).
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the housing market, interest rates began to climb and homeownership rates began
reaching record levels. The new homebuyers market had begun to dry.
Moreover, housing prices also started to decline during the second half of 2006,
particularly in San Diego, California, a phenomenon that soon spread across the United
States. By early 2007, homebuyers began defaulting of their mortgages. As more and
more people stopped paying their mortgages and foreclosures rose during the summer of
2007, the value of the mortgage-backed securities began plummeting. Soon, the market
for mortgage-backed securities, especially those based on sub-prime loans, became toxic
and increasingly illiquid.
When mortgage-backed securities started going bad, issuers of CDS contracts had
to make good. Many were unable to do so. By the time AIG received its first
government bailout, it held CDS worth $440 billion, and had alone defaulted on $14
billion worth of credit default swaps that it had made to investment banks, insurance
companies and numerous other entities in the U.S. and around the world.52 Lehman,
itself, had issued more than $700 billion worth of swaps.53
Numerous bank and non-bank financial institutions had limited capital to absorb
losses in their investments in mortgage-backed securities, causing many to write down
billions of dollars of these assets (based on mark-to-market accounting rules). Unable to
raise additional capital, or to sell their illiquid asset-backed securities, many firms faced
hard choices – find a buyer or seek bankruptcy protection. This phenomenon spread
52
See Mathew Phillips, The Monster That Ate Wall Street, Newsweek (October 6, 2008).
53
See id.
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across the United States, and then globally, causing credit markets everywhere to seize
up.
By the end of 2008, the U.S. capital markets were changed forever. The world
had witnessed JPMorgan Chase’s “rescue” of Bear Stearns; the bankruptcy filing of
Lehman Brothers; the government bailouts of some of the country’s major banks and
non-bank financial institutions, including Citigroup, AIG, the governmental mortgage
buyers Fannie Mae and Freddie Mac, as well as other large corporations.54 We also
witnessed Bank of America’s purchase of Merrill Lynch and a thwarted governmentorchestrated sale of Wachovia Bank to Citigroup.55 Faced with an uncertain future, the
last two remaining independent investment banks – Morgan Stanley and Goldman Sachs
– voluntarily transformed themselves into bank holding companies.56
II.
“RULES OF THE ROAD” -- THE OBAMA ADMINISTRATION’S
PROPOSAL FOR REFORM OF THE U.S. FINANCIAL SERVICES
INDUSTRY
A little over a month after taking office, President Obama outlined his “core
principles” for reforming the current financial regulatory system with bipartisan leaders
of the House Financial Services and Senate Banking committees. According to the
President, “strong financial markets require clear rules of the road, not to hinder financial
institutions, but to protect consumers and investors, and ultimately to keep those financial
54
cite
55
See David Enrich & Dan Fitzpatrick, Wachovia Choose Wells Fargo, Spurns Citi, WSJ (October 4,
2008) (reporting that Citigroup Inc.’s takeover of Wachovia Corp. was torpedoed when Wells Fargo & Co
agreed to buy Wachovia without government assistance.)
56
See Ben White & Louise Story, Last Two Big Investment Banks Reinvent their Business, NY Times
(September 23, 2008).
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institutions strong.”57 He noted the need for greater accountability and transparency;
stricter oversight of financial institutions to prevent systemic risks; gap-filling regulatory
restructurings; and more uniform supervision and oversight of financial products
marketed to consumers and investors “based on actual data of how actual people make
financial decisions.” President Obama also acknowledged the need for greater
cooperation with global U.S.-counterparts.58
Although details of the Administration’s proposal would not be made publicly
available until many months later, Treasury Secretary Timothy Geithner repeated many
of these key regulatory reform principles while appearing before the House Financial
Services Committee on March 26, 2009.59 His congressional testimony coincided with
the upcoming G20 Leaders Meeting, scheduled to begin on April 2, 2009 in London.
While Secretary Geithner introduced four broad components of the Administration’s
financial regulatory reform proposals during his testimony – noting that comprehensive
regulatory reform must (i) address systemic risk, (ii) protect consumers and investors,
(iii) eliminate gaps in the current regulatory scheme, and (iv) foster international
coordination, the primary focus of his March 26 appearance concerned the manner in
which systemic risk could be addressed. Specifically, he called for the creation of a
systemic risk regulator, increased capital and risk management standards; the registration
of all hedge fund advisers who manage assets over a certain threshold; the comprehensive
regulation of the OTC derivatives market; and the strengthened regulation of money
57
Id.
58
See, White House Briefing Room, Blog, posted by Macon Phillips (February 25, 2009).
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy
Geithner’s Testimony before the House Financial Services Committee on Regulatory Reform (March 26,
2009).
59
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market funds. Perhaps most importantly, Secretary Geithner introduced the idea of
providing the government with “resolution authority” over systemically important60 nonbank financial institutions that fall outside the Federal Deposit Insurance Corporation’s
(FDIC) existing resolution regime.
The current economic crisis highlights three areas of particular concern:61 (i) the
business model for both bank and non-bank financial institutions involved profit-making
through proprietary trades in increasingly risky, complex financial products – sometimes
without any clear understanding of the inherent risks; (ii) many banks and non-bank
financial institutions relied of leveraging and short-term financings to fund their trading
strategies; (iii) reliance on credit rating agencies, computer models (that were either
backwards-looking or based upon a narrow set of assumptions), and credit default swaps
or some other insurance-type investment product – all of which proved to be imperfect
ways for firms and other investors to engage in risk management strategies. Many of
these areas of concern were revealed a decade ago when Long-Term Capital Management
nearly wrecked the capital markets.62 Coupled with regulatory gaps, these concerns and
the resulting lack of transparency in the markets for certain investment products or
Systemically important firms “would not be limited to banks or bank holding companies (BHCs), but
could include any financial institution that was deemed to be systemically important in accordance with
legislative requires. In defining such firms, the following characteristics should be taken into account: (1)
the financial system’s interdependence with the firm; (2) the firm’s size, leverage (including off-balance
sheet exposures), and degree of reliance on short-term funding and (3) the firm’s importance as a source of
credit for households and business, and governments and as a source of liquidity for the financial system.”
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy Geithner’s
Testimony before the House Financial Services Committee on Regulatory Reform (March 26, 2009).
60
61
See generally, Department of the Treasury, Blueprint For a Modernized Financial Regulatory Structure
(March 2008), w.w.w.treasury.gov (“Blueprint”); Congressional Oversight Panel, Special Report on
Regulatory Reform, submitted under Section 125(b)(2) of Title I of the Emergency Economic Stabilization
Act of 2008, Pub. L. No. 110-343, January 2009; Secretary Timothy Geithner’s Testimony before the
House Financial Services Committee on Regulatory Reform (March 26, 2009); Secretary Timothy
Geithner’s Testimony before Senate Committee on Banking, Housing and Urban Affairs.
62
Describe LTCM
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between and among those market participants and investors not only challenges price
discovery and internal risk management procedures, but also could continue to prevent
any meaningful attempt to limit systemic risks in the future. The rules of the road going
forward must change. The Administration’s proposals are well on their way to securing
that goal.
A.
“Rules of the Road”: A Closer Look at the Treasury
Department’s March 2009 Proposal to Address Systemic Risk
The six measures cited by the Treasury Secretary are believed to enable federal
regulators to contain systemic risk. Regulatory reform requires better monitoring of both
the financial activities and the financial markets in which these activities occur. The aim
is to pinpoint and warn against the build-up of risky behaviors that have the propensity to
devastate the entire capital market structure. What follows is a brief, but closer look at
these key elements of the Administration’s proposed regulatory reforms made public at
this juncture which should create a more stable and resilient financial system.
1.
The Systemic Risk Regulator
Critical to the Administration’s plan to arrest systemic risk is the ability to rely on
a single, independent entity with responsibility for ensuring systemic stability over
systematically important firms (“too big to fail” firms) and critical payment and
settlement systems. Nevertheless, when this idea was initially introduced in early 2009,
Secretary Geithner appeared reluctant to state with particularity who actually would be
the Systemic Risk Regulator, and who actually would be subject to its supervision.63
This led to much speculation and political jockeying for regulatory turf.64
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy
Geithner’s Testimony before the House Financial Services Committee on Regulatory Reform (March 26,
2009).
63
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At this point, the Treasury only described the characteristics65 of companies who
might be deemed to big to fail should the companies run into unfavorable financial
situations. Secretary Geithner also stated that since the focus should be on “what the
companies do” rather than “the form they take,” systematically important firms would not
be limited just to banks or bank holding companies.66 Commentators, however, worry
that the designation of a firm as “too big to fail” will create a moral hazard and enable
counter-parties to avoid engaging inadequate risk management in the belief that the
government will backstop any losses of the systemically important firm. (The
Administration addresses this issue in a more comprehensive proposal three months
later.)
Moreover, the Administration was silent on who would assume the role of
Systemic Risk Regulator when the idea was first introduced in March 2009. The Federal
Reserve was at the top of then-Secretary Paulson’s list given its traditional central bank
role of promoting overall macro-stability. Nevertheless, an early chorus of dissenters can
be heard decrying the Fed’s proposed selection in light of its role in the financial crisis.67
Rather, there were more favorable rumblings that the Systemic Risk Regulator should be
a council of federal regulatory agency heads. Indeed, Senator Susan Collins introduced
an early bill (S.664), calling for the establishment of a council of regulators, headed by an
64
See discussion, infra at ______.
65
See footnote 57, supra.
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy
Geithner’s Testimony before the House Financial Services Committee on Regulatory Reform (March 26,
2009) and footnote 57, supra.
66
67
cite to Congressional leaders who opposed placing the Fed in the position of systemic risk regulator
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independent chairperson.68 In any event, the Systemic Risk Regulator would have sole
supervisory and examination authority over covered firms and would be able to set
prudential requirements for them. Specific details of this aspect of the Administration’s
proposal would follow less than three months later.
2.
Higher Capital and Risk Management Standards
The call for higher capital and risk management standards reflects concern that
the current economic crisis was exacerbated by inadequate capital and liquidity cushions
needed by many financial institutions to withstand cyclical capital market contractions.
The Treasury Secretary floated the idea of enacting counter-cyclical capital buffers,
which would require higher capital retention during economic upturns to mitigate the
consequences of downturns.69 Moreover, the risk management standards would require
that firms be positioned to aggregate counter-party risk exposures on an enterprise-wide
basis within a matter of hours.”70 These requirements would apply to systemically
important firms, whether bank or nonbank financial institutions.
Absent from this outline of the proposal were details about what constitutes more
stringent capital requirements; whether there will be a series of acceptable capital ratios –
one for good economic times, and another for the bad; or even whether the U.S. intends
to negotiate for reformed international capital requirements.71
68
cite to Senator Collin’s March 23, 2009 bill
Secretary Timothy Geithner’s Testimony before the House Financial Services Committee on Regulatory
Reform (March 26, 2009).
69
70
Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009).
71
Basel I, an earlier standard, was the first major attempt to harmonize capital requirements among banks,
and has been used for all international activity since 1987. The latest standard is Basel II.
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3.
Hedge Fund Adviser Registration
As expected, the Treasury proposed that all advisers to hedge funds, private
equity funds and other private pools of capital be subject to the SEC’s registration and
reporting requirements if the assets under management reach a certain threshold.72 In
addition, all such funds also should be subject to investor and counter-party disclosure
and reporting requirements. Some of these reporting obligations will be subject to
confidential treatment by federal regulators – particularly as it relates to proprietary
trades and the identification of investors – when the funds provide information necessary
to determine whether the fund(s) are so large or highly leveraged as to pose a threat to the
financial stability of the capital markets.73 Such information would have been helpful to
know – especially in connection with regulating large hedge funds like LTCM.
4.
Regulation of the OTC Derivatives Market
The Treasury also proposed to regulate the currently unregulated market for CDS
contracts and OTC derivatives. The goal is to move all standardized74 OTC derivative
contracts to a central market where the transactions would be subject to comprehensive
settlement systems, supervision and oversight. 75 Disclosure of aggregate trading
volumes and positions would be required, while information about individual counter-
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy
Geithner’s Testimony before the House Financial Services Committee on Regulatory Reform (March 26,
2009).
72
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy
Geithner’s Testimony before the House Financial Services Committee on Regulatory Reform (March 26,
2009).
73
74
Non-standardized derivatives contracts must be reported to trade repositories which will examine all
transaction documentation and collateral and margin practices, as well as review settlementd. Id.
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy
Geithner’s Testimony before the House Financial Services Committee on Regulatory Reform (March 26,
2009).
75
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party trades and position would be provided to, and kept confidential by, appropriate
federal regulators.76 Finally, Treasury has proposed that all market participants be
subject to eligibility, registration and reporting requirements. Again, the specific details
were left to the Administration’s June 2009 white paper.
5.
Money Market Fund Regulations
Money market funds are essential to the short-term funding needs of financial
market participants. Consequently, the Treasury proposes that reform of the credit and
liquidity profiles will forestall future widespread withdrawals in the event of another
economic downturn. The flood of withdrawals during this crisis resulted in severe
liquidity pressures.77
6.
Resolution Authority
Lehman Brothers’ bankruptcy illustrated the problems associated with troubled
non-bank financial institutions. There was no governmental mechanism that would have
enabled an orderly liquidation of the firm. Moreover, the government failed to predict
the far reaching market impact of Lehman’s collapse. The Treasury, as a consequence,
now seeks that resolution authority over financial institutions that are not currently
subject to the FDIC’s authority, or that the Federal Housing Finance Agency has with
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy
Geithner’s Testimony before the House Financial Services Committee on Regulatory Reform (March 26,
2009).
76
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy
Geithner’s Testimony before the House Financial Services Committee on Regulatory Reform (March 26,
2009).
77
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regard to GSE’s like Freddie Mac.78 Under the proposed reform, the FDIC would have
the authority to place into conservatorship (with the aim of returning the firm to private
ownership) or under receivership (with the aim of winding down the firm) any bank and
thrift holding companies, holding companies that control broker-dealers, insurance
companies, futures commission merchants, or any other financial firm that could pose a
substantial risk to the economy.79 The Treasury’s proposal includes as a safeguard a
mechanism that provides for consultation between the President and Treasury Secretary,
upon recommendation by the Federal Reserve and the FDIC, that (i) the firm is in danger
of being insolvent; (ii) its insolvency would have serious adverse effects on the U.S.
economy; and (iii) such adverse consequences would be avoided or mitigated by the
government’s actions.80 Such authority and action plan would have certainly been
beneficial to the government at the start of the economic crisis – a clear plan, known by
the markets to be possessed by the government would have allowed for a faster
restoration of faith in the financial markets and would have contracted the impact of the
financial crisis.
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy
Geithner’s Testimony before the House Financial Services Committee on Regulatory Reform (March 26,
2009).
78
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy
Geithner’s Testimony before the House Financial Services Committee on Regulatory Reform (March 26,
2009).
79
See Treasury’s Regulatory Reform Proposal Press Release (March 26, 2009); Secretary Timothy
Geithner’s Testimony before the House Financial Services Committee on Regulatory Reform (March 26,
2009).
80
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B.
“Financial Regulatory Reform – A New Foundation”
Is the June 2009 Proposal a More Complete
Roadmap to Retarding Future Financial Meltdowns?
The Treasury Department on June 17, 2009 released a detailed white-paper of the
Obama administration’s recommendations for regulatory reform entitled, Financial
Regulatory Reform – A New Foundation: Rebuilding Financial Supervision and
Regulation.81 This proposal provides greater details and, in some cases, the legislative
language82 to support the regulatory reforms outlined by Treasury Secretary Geithner
almost three months earlier. Overall, the Administration’s proposal calls for a significant
restructuring of the federal regulatory system. Four new entities will be created: the
Financial Services Oversight Council, chaired by the Treasury and including the heads of
the principal federal regulators of the financial industry; the Consumer Financial
Protection Agency (“CFPA”), an independent agency; the Office of National Insurance,
to be housed within the Treasury; and the National Bank Supervisor, a single agency
(with status separate from the Treasury) responsible for all federally chartered depository
institutions and all federal branches and agencies of foreign banks. While the FDIC and
the National Credit Union Administration (“NCUA”) will continue with the former
supervising and regulating state-chartered banks and the latter, credit unions, the Office
of Thrift Supervision and the Office of Comptroller of the Currency will merge into a
new agency, the National Bank Supervisor.
Department of the Treasury Financial Regulatory Reform – A New Foundation: Rebuilding Financial
Supervision and Regulation (June 2009), www.financialstability.gov/docs/regs/FinalReport_web.pdf
(“New Foundation”).
81
82
See discussion of relevant provisions, infra.
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The expansive nature of the Administration’s proposals attempt to touch on
almost every corner of the capital markets. First, for example, existing regulation focuses
on the safety and soundness of individual institution rather than on the stability of the
entire financial system to the detriment of all. Consequently, the Administration
proposes to raise capital and liquidity requirements for all institutions, while enacting
even stricter standards for the largest, most interconnected firms. These systemically
important firms also will be subject to consolidated supervision by the Federal Reserve,
which will be aided by the Financial Services Oversight Council, a council of regulators
who will have broader coordinating and reporting responsibilities.
Second, in light of the increased activities in what has become the shadow
banking system,83 the Administration proposes more robust reporting requirements on
issuers of asset-backed securities; that investors and regulators reduce reliance on creditrating agencies; and that loan originators and securitization brokers retain a financial
interest in the performance of those products. The plan also calls for a harmonization of
regulations and goals of the SEC and the CFTC as well as greater safeguards on payment
and settlement systems and oversight in the OTC derivatives market.
Third, noting the levels and numerous accounts of consumer abuses particularly in
connection with subprime mortgage lending, the President has set forth a plan to provide
better protection for consumers and investors alike. A hallmark of that plan will be the
83
Over the last decade, there has been a growth in financial activity outside of the traditional banking
system, with more borrowing and lending and risk management occurring through securitizations. Initially,
this process was designed to reduce credit risk by spreading it more widely to those entities with better
resources to manage it. Unfortunately, the removal of the links between actual borrowers and lenders led to
an erosion in lending standards, which was greatly revealed when the housing boom dampened and housing
prices fell. See generally, Department of the Treasury Financial Regulatory Reform – A New Foundation:
Rebuilding Financial Supervision and Regulation (June 2009),
www.financialstability.gov/docs/regs/FinalReport_web.pdf (“New Foundation”).
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creation of the new Consumer Financial Protection Agency to protect consumers from
unfair, deceptive and abusive practices.84 The Administration also proposes to improve
the transparency, fairness and appropriateness of consumer and investor products and
services, as well as the establishment of higher standards for providers of consumer
financial products and services.85
Fourth, the Administration’s proposal also seeks more effective tools to allow the
government to prepare and respond to future financial crises. To that end, as outlined by
Treasury Secretary Geithner in March 2009, the Administration wants resolution
authority; a mechanism for unwinding large, interconnected non-bank financial
institutions such as AIG, whose failure might threaten the stability of the entire financial
system. Pursuant to this authority modeled on the existing resolution regime for insured
depository institutions that has been administered under the Federal Deposit Insurance
Act, the designated agency86 may serve either as a conservator or a receiver for the failing
financial institution, and perform an orderly resolution of that entity’s affairs.87 In
conjunction with this requested authority, the Administration’s proposal seeks authority
84
The CFPA will have full authority to write rules applicable to banks and non-bank financial institutions;
supervise and examine such institutions for compliance; enforce compliance through order, fines, and
penalties; and write rules that serve as minimum requirements (not the ceiling with respect to state laws)
while allowing states to enforce these laws. See id.
Transparency will be met by requiring that “all disclosures and other communications with consumers be
reasonable: balanced in their presentation of benefits, and clear and conspicuous in their identification of
costs, penalties and risks. Id. Unfair terms and provider practices generally will be banned, while
heightened duties of care that reflect consumer expectations will be imposed on financial intermediaries.
See id.
85
86
In general, the designated agency would be the FDIC, but the SEC may be appointed in certain cases.
See id.
Under the Administration’s plan, the Treasury Department can invoke this resolution authority only after
consulting with the President and upon the written recommendation of two-thirds of the members of the
Federal Reserve Board, and the FDIC or SEC as appropriate. Moreover, prior to invoking this authority,
the Treasury Department must show: (i) that the firm is in default or in danger of defaulting; (ii) that failure
of the firm would have serious adverse consequences on the financial system; and (iii) that the use of the
special resolution authority would avoid or mitigate these adverse effects. See id.
87
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to require large, interconnected firms to provide advance plans for their orderly
resolution. Specifically, the Federal Reserve will have authority to require each
systemically important firm to prepare and continuously update a credible plan for their
rapid resolution in the event of severe financial distress. Commentators refer to this plan
as the firm’s “living will.”
Finally, in recognition of the global interconnectedness of today’s financial
market, international regulatory standards and cooperation must be heightened if the U.S.
regulatory reforms are to have the desired effect. Specifically, the Administration’s
proposal seeks to (i) level the playing field by subjecting foreign financial firms operating
within the U.S. to the same standards as U.S. firms – including those applicable to
systemically important firms; (ii) improve oversight of credit derivatives and OTC
derivatives markets – in line with G-20 commitments; and most importantly (iii)
strengthen the international definition of regulatory capital.88 The Administration would
like the Basel Committee on Banking Supervision (“BCBS”) to develop simple, non-risk
based capital measures to limit the amount of leverage built up within the international
financial system. The Administration also noted that Basel II capital requirements are
insufficient to capture or offset the riskier assets such as securitized products or offbalance sheet items. Further, it believes that the definition of “regulatory capital” should
be improved to ensure the quality, quantity and consistency of the capital held by
financial firms.
Arguably, the Obama administration’s proposals rather successfully address the
causes of the current crisis, attempt to create a more stable financial system that is also
88
Id.
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fair to consumers and investors and will help prevent (or at least contain) potential crises
in the future. The two key recommendations that relate to these efforts – promote a more
robust supervision and regulation of financial firms and establish a more comprehensive
regulation of financial markets – deserve further examination.
1.
The Recommendation Promoting Robust
Supervision and Regulation of Financial Firms
The creation of the Financial Services Oversight Council is only one tool in the
proposed arsenal of reforms that are designed to “protect the integrity of the U.S.
financial system while encouraging growth and innovation.”89 Another powerful tool
will be the required consolidated supervision and regulation of all financial firms that
based on their size, leverage, and interconnectedness could pose a threat to the
economy’s stability. These systemically important firms (without regard to whether they
own insured depository institutions), now referred to as Tier 1 Financial Holding
Companies (“Tier 1 FHCs”), will be subject to the nonfinancial activities restrictions of
the Bank Holding Company Act of 195690 and will be supervised and regulated by the
Federal Reserve.91 The prudential standards, including risk-based capital, liquidity
requirements, leverage limits, and risk management standards, for the Tier 1 FHCs also
See Department of the Treasury Financial Regulatory Reform – A New Foundation: Rebuilding
Financial Supervision and Regulation (June 2009), available at
www.financialstability.gov/docs/regs/FinalReport_web.pdf (“New Foundation”). See also Treasury
Department Proposed Legislation, Title I – Financial Services Oversight Council, sent to Capital Hill (July
22, 2009).
89
See Treasury Department Proposed Legislation, Title II – Consolidated Supervision and Regulation of
Large, Interconnected Financial Firms, sent to Capital Hill (July 22, 2009). Discuss BHA in detail.
90
91
The Administration also seeks to have Congress remove the constraints that the Gramm-Leach-Bliley
Act imposed on the Federal Reserve’s ability to examine, impose reporting requirements or impose higher
prudential requirements. See Department of the Treasury Financial Regulatory Reform – A New
Foundation: Rebuilding Financial Supervision and Regulation (June 2009),
www.financialstability.gov/docs/regs/FinalReport_web.pdf (“New Foundation”).
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will be stricter and more conservative than those applicable to other financial firms based
on the nature of these firms’ risk profiles.
Treasury Secretary Geithner testified that since the Federal Reserve already has
regulatory responsibilities over bank holding companies, it is best suited to take on the
authority and accountability for supervising Tier 1 FHCs. Consequently, the Federal
Reserve alone has authority to assess risk and set higher standards for any Tier 1 FHC in
order to protect against excessive risk taking at any level.
Additionally, in connection with the requirement for higher standards of all
financial firms, the Administration’s regulatory reform will require that all financial
holding companies, including Tier 1 FHCs, be “well capitalized” and “well managed” on
a consolidated basis – at both the parent company and the subsidiary level – in order to
engage in the broad set of financial activities permitted under the Gramm-Leach-Bliley
Act. Firewalls between banks and their affiliate also must be strengthened to ensure that
the federal safety net that supports banks will not be used by these affiliates. To that end,
the Administration also proposes that all companies that control an insured depository
institution be subject to regulation by the Federal Reserve and to the limits on
nonfinancial activity contained in the Bank Holding Company Act.
Finally, the new Administration’s National Bank Supervisor, which will have
authority to conduct prudential supervision and regulation of federally-chartered
depository institutions and foreign bank branches or agencies, should support the Federal
Reserve.92
92
It is noteworthy that the Obama Administration believes it timely to have the accounting setters (the
FASB, the IASB and the SEC) consider changing the Fair value accounting rules. See 92 The
Administration also seeks to have Congress remove the constraints that the Gramm-Leach-Bliley Act
imposed on the Federal Reserve’s ability to examine, impose reporting requirements or impose higher
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2.
The Recommendation Establishing More
Comprehensive Regulation of Financial Markets
The proposals designed to strengthen the financial markets focus on either
establishing or increasing oversight of the securitization market and the markets for all
OTC derivatives. Recognizing that the markets for mortgage-backed and other assetbacked securities, credit default swaps, repurchase agreements, and securities lending
have become important elements of the U.S. financial system, the Administration seeks
to impose tighter controls on the market than seeks its elimination. Under the President’s
plan, originators or issuers must retain 5 percent of the credit risk of the securitized
products; issuer and transaction reporting obligations will be enhanced by the SEC; and
federal regulators will be required to reduce their reliance on the credit ratings when
regulating and supervising market activity. The SEC and CFTC also must harmonize the
regulation of futures and securities, including changes to the statutes and regulations.
Lastly, the Federal Reserve also will be given increased authority to oversee
systematically important payment, clearing, and settlement systems.
III.
LEGISLATIVE RESPONSE TO THE OBAMA ADMINISTRATION’S
PROPOSAL FOR REFORM OF THE U.S. FINANCIAL SERVICES
INDUSTRY
Legislative language to support the Obama administration proposed regulatory
overhaul was sent to Congress beginning in July 2009.93 Of course, many on Capital Hill
prudential requirements. See Department of the Treasury Financial Regulatory Reform – A New
Foundation: Rebuilding Financial Supervision and Regulation (June 2009),
www.financialstability.gov/docs/regs/FinalReport_web.pdf (“New Foundation”).
93
The House Financial Services Committee announced in June 2009 that it would tackle regulatory reform
of the financial system by considering a series of smaller, targeted bills rather than the more comprehensive
reform bill. cite On July 22, 2009, the Obama administration sent its proposed legislation under six
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had already begun to outline their own plans for reform. One of the Administration’s
chief proposal is to expand the Federal Reserve’s authority to enable it to regulate and
supervise the activities of all large, interconnected firms (the Tier 1 FHCs), regardless of
whether the firms own an insured depository bank. To be sure, the critiques began
coming from all corners when the Administration’s position was announced in March
2009. Senator Mark Warner who sits on the Banking Committee objects to this proposal
because it concentrates too much power in one entity. Senator Richard Shelby expressed
the concern that increasing the Fed’s governmental authority would reduce the Federal
Reserve’s independence and that it could be stretched too thin. The Administration’s
insertion of a Financial Services Oversight Council (“FSOC”) to identify emerging
systemic risks has been insufficient to tamp down on criticisms of its selection of the
Federal Reserve as what is akin to a prudential regulator.
Nevertheless, on October 27, 2009, the Treasury Department and the House
Financial Services Committee gave the public the first look at the proposed legislation to
address the issues of “too big to fail” and systemic risk.94 The draft of the proposed
separate titles: Title I – Financial Services Oversight Council (short title: “Financial Service Oversight
Council Act of 2009”); Title II – Consolidated Supervision and Regulation of Large, Interconnected
Financial Firms (short title: “Bank Holding Company Modernization Act of 2009”); Title VI – Further
Improvements to the Regulation of Bank Holding Companies and Depository Institutions (short title:
“Bank Holding Company and Depository Institution Regulatory Improvements Act of 2009”); Title V –
Office of National Insurance (short title: “Office of National Insurance Act of 2009”); Title XIII –
Additional Improvements for Financial Crisis Management; and Title IX – Additional Improvements to
Financial Market Regulation (short title: “Investor Protection Act of 2009”). In early August 2009, the
Administration sent Title VII – Improvements to the Regulation of Over-the-Counter Derivatives Market
(short title: Over-the-Counter Derivatives Market Act of 2009). All are available
www.financialstability.gov
94
cite. The House Financial Services Committee previously approved the Investor Protection Act (HR
3817) on November 4, 2009 by a vote of 41 to 28. Press Release, House Financial Services Committee.
The House Financial Services Committee also approved a bipartisan bill on credit rating agencies.
(November 4, 2009). The Accountability and Transparency in Rating Agencies Act, was approved on
October 28, 2009 by a vote of 49 to 14. Press Release, House Financial Services Committee (October 28,
2009). Both will be the subject of future articles. A competing bill, “Consumer Financial Protection
Agency Act of 2009” (HR3126) is still pending.
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legislation, Financial Stability Improvement Act, was recently hashed out by Chairman
Barney Frank of the House Financial Services Committee and the Treasury Department.
Like the Administration’s version, the Financial Stability Improvement Act also creates a
Financial Services Oversight Council. Under the proposal, the FSOC, would have
authority: (a) to advise Congress on banking legislation; (b) to identify companies and
activities that should be subject to more supervision; (c) to issue formal recommendations
that a council member adopt for firms it regulates; (d) to resolve disputes between
regulators; and to subject financial activity or practices to heightened rules and standards.
The key parts95 of the latest version of the proposed House Bill in addition to
creating a FOSC would: (i) give the Federal Reserve the authority to direct any large
financial holding company to shrink by selling or transferring assets or to stop certain
activities if it determines there could be a threat to the safety and soundness of such
company or to the financial stability of the United States; (ii) give the Federal Reserve
authority to set concentration limits for large financial holding companies, impacting the
firm’s ability to grow; (iii) give the Federal Reserve the authority to require any large
holding company it determines to be critically undercapitalized to enter bankruptcy; (iv)
authorize the FDIC, with approval from the Federal Reserve and the Treasury
Department, to make a loan or offer guarantees to a solvent company “predominantly
engaged in activities that are financial in nature” it this is necessary to prevent financial
instability during times of severe economic distress;” (v) provide that any losses incurred
by the FDIC would be paid by borrowed funds from Treasury, and later recouped by
95
Key Parts of Financial Stability Improvement Act WSJ (October 27, 2009); House Panel, Treasury
Department Offer Draft Bill Dealing with Too-Big-to-Fail Firms, Sec. Reg. L. Report (11/02/2009). See
Discussion Draft, Committee Print, Financial Stability Improvement Act (October 29, 2009), available at
www.financialservices.house.gov/key_issues/Financial_Regulatory_Reform/FinancialRegulatoryReform/D
iscussion_Drafts/Committee_Print_titleI102909.pdf.
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Discussion Draft. Please do not quote or circulate without permission.
All rights reserved
assessments on any financial company with more than $10 billion of asset; (vi) abolish
the Office of Thrift Supervision, and create a Division of Thrift Supervision (“OTS”)
within the Office of the Comptroller of the Currency; and (vii) place the Federal Reserve
Chairman or a Federal Reserve Governor on the FDIC’s five-member board, replacing
the extinguished OTS director.
Once again lawmakers voiced concern about expanding the role of the Federal
Reserve beyond its functions as central bank. They also noted a challenge against having
the Treasury Secretary serve as chair of the Financial Service Oversight Council.
Lawmakers also expressed concern about expanding the power of the executive branch
and the Federal Reserve in regulating and resolving systemic risk. Much exception was
taken with the notion that the Treasury and the Federal Reserve would be given new
federal authority to oversee and, if necessary, wind down large institutions that pose
systemic risks to the broader economy.96 According to Rep. Ben Sherman, the proposal
would provide “unprecedented powers for the executive to decide spending and taxes
without congressional approval, and depending on the desires of the executive branch
from time to time, the greatest transfer of money from the Treasury to Wall Street” could
occur.
IV.
CONCLUSION
There is still a lot of work yet to be concluded before a true assessment of whether
future crises can be averted. While the President has lobbed the ball to Congress, only
the House has responded, and then only through committee. There will be many
compromises. The fact that debates continue is a good sign that the parties will thrash
96
Mike Ferulio, Concerns Emerge About Unchecked Powers, Funding as Geithner Touts Systemic Risk
Plan, Sec. Reg. & L. Report (11/02/2009).
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Discussion Draft. Please do not quote or circulate without permission.
All rights reserved
out the positions of the various stakeholders. In the end, my hope is that investor
protection remains front and center during these debates. Nevertheless, taxpayers should
not be expected to finance the risky bets of bank and non-bank financial institutions.
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