Regulatory Responses to Failures in the Financial System: As Windows Open and Close

If recent events in the financial system are indications of inadequate corporate governance and risk management, do we know how and why the system failed? And perhaps most importantly, do we know what can be done to fix it?

Why did the system fail us? Have we really created a system that is too complex to manage and unable to adequately monitor and value the risk it undertakes? Is it really the case that nobody knows the real risks that are being created and undertaken in our capital markets and financial institutions? Is it true that even the guys at the very top (and maybe a woman or two) do not fully understand the implications of the highly complex products that their own employees are creating? Can this really be the case? Or is this just the easy response when the answer to a complex question is not immediately apparent? Is it really true that modern finance and laissez-faire capitalism is a chaotic, overly complex system of intricate parts where no one has either the mandate or even ability to know when we are bit-by-bit creating Frankenfinance?

There is a fair bit of evidence to give pause to even the most optimistic believers in laissez-faire capitalism and capital markets; a system which those of faith believe corrects its own errors guided by the twins gods of supply and demand. Some of these believers- like the Federal Reserve, the SEC and Congress- have come to the conclusion that there are problems with the current financial system and that a regulatory response is needed. Though it may not be much of a surprise that regulator and political vultures are circling those who have wandered out in the wilderness of risk and gotten lost, the vultures are indeed circling and the natural laws of politics are in full flight.

Treasury Secretary, Henry Paulson, has recently taken the lead with his reform proposal (Blueprint for Change) that was released March 31 and which calls for the creation of new regulatory agencies with broad powers over lending, the securities industry and business conduct. The key features of the proposed reform package include: more power to the Federal Reserve, combination of the Office of Comptroller of Currency (OCC) and the Office of Thrift Supervision (OTS) into a single banking overseer, and the merger of the SEC and the Commodity Futures Trading Commission. The recommendations more specifically call for the formation of a “Prudential Financial Regulator” to oversee financial institutions that have an explicit government guarantee such as deposit insurance. The Treasury is also calling for a “Business Conduct Regulator” to monitor disclosures, business practices, chartering and licensing. The proposals further call for a “Corporate Finance Regulator” with a mandate relating to corporate oversight in public securities markets.

The Blueprint for Reform also suggests turning the President’s Working Group- which has advised the President since 1987- into a government chartered interagency body to coordinate financial regulatory policy and that the composition of the group be expanded to include the heads of the OCC, FDIC and the OTS.

To address some of the problems more specifically related to the sub-prime crisis and mortgages, the report calls for the creation of a federal Mortgage Origination Commission. Some have viewed this proposal as a partial solution to suspect securitisation since the commission would have the mandate to evaluate and grade the underwriting of loans going into pools. Others, however, view the creation of the commission as another unwanted level of bureaucracy that would coexist with state regulators of mortgage brokers and select money lenders.

Another important part of the report is the proposal that the Federal Reserve become a market stability regulator which would give it powers over insurance companies and securities forms with federal charters. Once these regulatory reforms are completely implemented, there would be a new regulatory architecture consisting of three agencies: a Federal Reserve focused on market stability, a prudential regulator for banks and thrifts and a business-conduct agency which would include much of the SEC’s oversight of disclosure.

In its expanded role, the Federal Reserve would be mandated with systemic risk evaluation including the subterranean and intermingled world of hedge funds and investment banks. If investment banks are to receive emergency funding or other forms of support, such as Bearns Stearns did, there will have to be tighter regulation, both for political and financial management reasons. Though the plan does not deal with the regulation of Fannie Mae and Freddie Mac where many mortgage-backed securities have faltered, there is additional House of Representatives- initiated legislation being proposed and debated to deal with those institutions.

There are other proposals for reform, some of which differ from and compete with the Treasury Secretary’s proposals. Barney Frank who leads the House Financial Services Committee has been working on his own Congressional proposal. Shortly after the Treasury Secretary’s Report was released, Frank issued a statement claiming that the plan goes too far in reducing the role of the states and not far enough in providing adequate powers to the Federal Reserve over non-bank lenders. Frank would like to see investment banks be subjected to the same rules that commercial banks must abide by, particularly for capital reserves. Other critics, beyond Frank, say that the Treasury Secretary proposal will actually lead to less regulation rather than more and that the SEC- one of the few proactive regulators- will become less effective rather than moreso. More specifically, the Treasury Secretary proposal suggests that the SEC should regulate stock market exchanges less allowing them to self-regulate. Others critical of Paulson’s proposal argue that many of the proposed changes will do little to eliminate the types of practices that caused the current financial crisis in the first place.

For the moment, the future of financial regulation of investment banks will be debated in political corridors and in the media. Congress is set to begin hearings on July 10 on banking sector regulation. There will be, almost inevitably, some form of quid pro quo for investment banks continuing to avail themselves of the Federal Reserve’s overnight discount window. And although this window was supposed to close in September (six months after opening the window to Bear Stearns), it is unlikely that the window can now be closed. Other investment banks such as Lehman Brothers or Merrill Lynch may need to use this borrowing window. Closing the window now when many liquidity concerns still persist could create a further crisis of confidence in the market.

But in order for the window to remain open, regulators will insist on various forms of increased oversight. Regardless of which proposal for reform wins the day, there are pressing calls for reform of the financial system and capital markets. Common elements of the proposals include: subjecting investment banks to capital requirement similar to those that already exist for commercial banks, ensuring that investment banks eliminate their illiquid assets including mortgage-backed securities and private-equity holdings, the creation of an “aged inventory capital charge” which would discourage banks from holding paper inventory for long periods, and requirements that limit banks’ venture capital and hedge fund holdings.

In addition to reducing leverage and other balance-sheet concerns, regulators are working on creating mechanisms for winding down failing investment banks. As became evident during the problems with Bear Stearns, there is no “bridge bank” model which maintains key businesses while offloading other assets. This “bridge bank” model exists already for commercial banks and is currently being contemplated for investment banks.

Political battles will also be fought between regulators as evidenced by the Federal Reserve and Securities and Exchange Commission (SEC) current manoeuvring for position in the world of regulatory power politics. Though the Fed and SEC are currently working on an information sharing agreement, the power-sharing is most likely to evolve to create a double-headed regulatory regime where the Fed will regulate bank stability and the SEC will focus on investors concerns.

The Treasury Secretary’s Blueprint for Change, the Congressional hearings, the internal regulator reviews, all come at an opportune time, even if after the fact. The financial markets may be more willing to entertain some regulatory measures after the recent market meltdown and ongoing credit issues. Financial institutions in general, and investment banks in particular, are usually and understandably opposed to regulatory intervention. But current circumstances may give them little choice but to submit to a change in regulatory environment. In fact, some financial institutions may be increasingly open to regulatory proposals particularly if these proposals are promoted as changes that will make the system more stable, less prone to shock and more flexible. Commercial banks may welcome regulation as a way of leveling the playing field and ensuring that investment banks have to follow most of the rules commercial banks already have to abide by. It may also be easier for financial institutions to accept proposals coming from a long-time Wall Street resident who Wall Street trusts to have the best interests of flexible markets at heart. The fact that the original purpose of the Treasury Secretary’s Blueprint was to devise strategies for maintaining and enhancing the competitive position of US capital markers also situates these regulatory proposals within a broader objective of streamlining, rather than regulating, capital markets.

Though there has already been some profile endorsement of the Treasury’s Blueprint and some of the other proposals for regulatory reform, it is uncertain what the future holds for these proposals for change. There have been many attempts at financial sector reform since the Great Depression, most of which have ended up as casualties of entrenched political and financial interests in the status quo. Those forces are still present and powerful, and may not be particularly interested in considering the merits of any proposal that threatens to impose greater oversight, regardless of how those proposals are spun or how they may actually lead to greater long-term financial stability. And although Chairman of the SEC, Christopher Cox, calls for and predicts a “brave new world” for financial regulation, it will require a lot of bravery and political sophistication to increase oversight of markets and institutions that are exceptionally adept at navigating outside the regulator’s view.

By Robert Adamson, Executive Director, CIBC Centre for Corporate Governance and Risk Management
July 7, 2008