Background
The financial crisis that has prevailed over the past two years brought to light several gaps and weaknesses in the supervision and regulation of financial firms. The urgent need to reform the financial regulatory system and put the economy on track to a sustainable recovery was the reason for the Obama administration’s financial reform proposals.
The root of the financial crisis, that has left Americans struggling with unemployment, failing businesses, falling home prices, and declining savings, has many causes. Among them is the complacency that built up among financial intermediaries and investors due to a long stretch without a serious economic recession, and the government’s inabilities to monitor, prevent, or address risks as they built up in the system.
Obama said, as he revealed his proposals for regulatory reform, "It is an indisputable fact that one of the most significant contributors to our economic downturn was an unraveling of major financial institutions and the lack of adequate regulatory structures to prevent abuse and excess. A culture of irresponsibility took root from Wall Street to Washington to Main Street. And a regulatory regime basically crafted in the wake of a 20th century economic crisis—the Great Depression—was overwhelmed by the speed, scope, and sophistication of a 21st century global economy."
Summary
The Obama administration’s plans to overhaul the financial regulatory system were revealed in the document entitled “Financial Regulatory Reform - A New Foundation: Rebuilding Financial Supervision and Regulation”. The administration has urged Congress and regulators to adopt sweeping changes to financial regulation and oversight, while giving an increased role to the federal government in all aspects of the financial markets. Both new and substantive authorities and practices in government regulation and supervision have been proposed. The administration also proposes to restructure the regulatory system, including creating new federal agencies, offices and councils.
The administration has proposed reforms to meet five key objectives:
- Promote robust supervision and regulation of financial firms;
- Establish comprehensive supervision of financial markets;
- Protect consumers and investors from financial abuse;
- Provide the government with the tools it needs to manage financial crises; and
- Raise international regulatory standards and improve international cooperation.
Promote Robust Supervision and Regulation of Financial Markets
The plan proposes an increased focus on financial institutions that pose systemic risks to the market. The administration has urged that these institutions are critical to the functioning of the financial markets, and should therefore be subject to strong oversight. There is also a need for clear accountability in financial supervision and oversight.
In order to increase oversight of systemic risk and financial regulation, the administration has proposed the establishment of a new Financial Services Oversight Council (FSOC). The FSOC will facilitate coordination of policy and resolution of disputes, and identify emerging risks in firms and market activities. It will include the heads of the principal federal financial regulators and will be headed by the Treasury. The FSOC will facilitate information sharing and coordination among the principal federal financial regulatory agencies regarding policy development, rulemakings, examinations, reporting requirements, and enforcement actions.
The plan also aims to provide for robust and accountable regulation of large, interconnected financial firms (termed as Tier 1 Financial Holding Companies or Tier 1 FHCs). Under the plan, all financial firms that are found to pose a threat to our economy’s financial stability based on their size, leverage, and interconnectedness to the financial system will be subjected to strong consolidated supervision and regulation. These Tier 1 FHCs will be subject to consolidated supervision and regulation regardless of whether they own insured depository institutions and will be subject to the nonfinancial activities restrictions of the BHC Act. The Federal Reserve has been given expanded authority and accountability over these Tier 1 FHCs.
The plan proposes that Congress should establish criteria that the Federal Reserve must consider for identifying large and interconnected firms as Tier 1 FHCs. The Federal Reserve will take on authority and accountability for consolidated supervision of all Tier 1 FHCs. Tier 1 FHCs will be subjected to stricter and more conservative prudential standards than those that apply to other bank holding companies – including higher standards on capital, liquidity and risk management.
Additionally, the plan also proposes higher standards for all financial firms. All financial holding companies, including Tier 1 FHCs, will be required to be “well capitalized” and “well managed” on a consolidated basis to engage in the broad set of financial activities permitted under the Gramm-Leach-Bliley Act. To achieve this, the plan also proposes reassessment of the existing regulatory capital requirements, reassessment of executive compensation standards, strengthening of firewalls between banks and their affiliates, and a review of the accounting standards for financial firms.
To complement these proposals, the administration has asked for a more sensible and efficient regulatory system. One of the proposals is to create a new National Bank Supervisor that will conduct prudential supervision and regulation of federally chartered depository institutions and federal branches and agencies of foreign banks. Additionally, due to the fragility of thrifts that became apparent during the crisis, the plan proposes to eliminate the thrift charter. The plan also tries to eliminate loopholes in the Bank Holding Company Act by proposing the regulation and supervision at the federal level by the Federal Reserve of all companies that control an insured depository institution.
These proposals aim to overhaul the current regime that is based on an outdated concept of financial risk - focusing on the safety and soundness of individual institutions, but not on the interconnections among firms or the stability of the system as a whole. To complement these proposals, the administration has proposed its second key objective – establish comprehensive supervision of financial markets.
Establish Comprehensive Supervision of Financial markets
There was dramatic growth in financial activity, outside the traditional banking system, in the recent years. Markets for mortgage-backed and other asset-backed securities, credit default swaps, repurchase agreements and securities lending became critical elements of our financial system. But regulation has not kept pace with financial innovation. As a result, regulators were unable to track or prevent the massive buildup of risk in these markets, which played a central role in producing this crisis.
Under the President’s plan, the supervision of securitization markets will be strengthened. The SEC will continue its efforts to increase the transparency and standardization of securitization markets, and be given clear authority to require robust reporting by issuers of asset-backed securities. The originator of a securitized loan or the sponsor of a securitization will retain 5 percent of the credit risk of securitized exposures.
The plan also proposes to bring comprehensive regulation to the market for all over-the-counter derivatives, including credit default swaps. The comprehensive regulation will include:
- transparency for all OTC derivative trades and positions, through recordkeeping and reporting requirements;
- market regulators to take vigorous enforcement action against fraud, market manipulation, and other market abuses;
- conservative regulation of all OTC derivative dealers and all other major participants in the OTC derivatives markets;
- standardized OTC derivatives to be centrally cleared and executed on exchanges and other transparent trading venues; and
- higher capital charges for customized OTC derivatives.
The administration has also proposed new authority for the Federal Reserve to oversee payment, clearing, and settlement systems. The Federal Reserve will be required to consult with the Financial Services Oversight Council to identify systemically important systems and in setting standards for those systems.
Protect Consumers and Investors from Financial Abuse
Financial products are complex, and it is often difficult for even the most financially astute consumers to recognize the risks financial products can present. The financial crisis, in turn, revealed inadequacies in consumer and investor protection across a wide range of financial products and markets.
To help ensure consumer protection and representation, the plan proposes the creation of a new Consumer Financial Protection Agency (CFPA). The agency will have broad authority to protect consumers of credit, savings, payment, and other consumer financial products and services, and to regulate all providers of such products and services. The CFPA will be responsible for:
- promoting concise and clear information for consumers; and protecting consumers from unfair and deceptive practices;
- promoting fair, efficient, and innovative financial services markets for consumers; and
- improving access to financial services.
The CFPA will be structured to be independent and accountable. It will introduce stronger regulations to improve transparency, fairness, and appropriateness of consumer and investor products and services.
Provide the Government with the Tools it needs to Manage Financial Crisis
The financial crisis over the last two years brought to light the federal government’s inabilities. One of these was the lack of a statutory framework for avoiding the disorderly failure of a non-bank financial firm. The failure or near failure of the largest and most interconnected financial firms threatened the entire financial system.
To reduce the likelihood and impact of failures of the largest and most interconnected financial firms (Tier 1 FHCs), the administration proposes establishment of a resolution authority to ensure that the federal government does not have to choose between bailouts and financial collapse. Tier 1 FHCs will be subject to more stringent capital, activities, and liquidity standards, and more exacting prudential supervision. They will also be subject to a prompt corrective action regime that would require the firm and its supervisor to take corrective actions as the firm’s regulatory capital levels decline. This regime will mirror the prompt corrective action regime for insured depository institutions established under the Federal Deposit Insurance Corporation Improvement Act (FDICIA).
Additionally, the plan gives the federal government the authority necessary to avoid the disorderly resolution of large, interconnected firms when the stability of the financial system is threatened. The proposed resolution authority would supplement (rather than replace) and be modeled on the existing resolution regime for insured depository institutions under the Federal Deposit Insurance Act. The aim is to provide for a regulatory regime that can adequately respond to a financial crisis.
Raise International Regulatory Standards and Improve International Cooperation
In today’s economy, a financial crisis knows no national boundaries. Problems in any country’s financial system can quickly spread throughout the global financial system, as we witnessed during the current crisis. In these circumstances, it is imperative to achieve international cooperation for consistent high quality regulation.
The administration’s plan proposes to subject foreign financial firms operating within the U.S. to the same standards as U.S. firms. The plan also proposes to strengthen the international capital framework with coordination from the Basel Committee on Banking Supervision. International measures have also been urged that will improve oversight of global financial markets, reform crisis management and prevention authorities and procedures, and enhance supervision of internationally active financial firms.
In concluding his speech, as he revealed the proposals, Obama said, “We are called upon to put in place those reforms that allow our best qualities to flourish – while keeping those worst traits in check. We are called upon to recognize that the free market is the most powerful generative force for our prosperity – but it is not a free license to ignore the consequences of our actions.”
References
http://www.whitehouse.gov/the_press_office/Remarks-of-the-President-on-Regulatory-Reform/
http://www.financialstability.gov/docs/regs/FinalReport_web.pdf
http://www.fdic.gov/news/news/speeches/chairman/spjuly2409.html
