Since there are five key objectives in this proposal (which is 87 pages long), I'll do this in a series that will include
- Supervision and Regulation of Financial Firms
- Regulation of Financial Markets
- Consumer and Investor Protection
- Government Tools to Meet Objectives
- International Standards and Regulation.
We'll start with the first two - Supervision and Regulation of Financial Firms and Regulation of Financial Markets. Please feel free to comment on this, and all subsequent articles.
Supervision and Regulation of Financial Firms
To fix a problem, it must first be properly defined. The proposal notes that leverage, or borrowing, by consumers and financial institutions alike, expanded dramatically during the housing bubble. This is an inarguable fact. People were borrowing more and more money against houses with prices that were rising at an unsustainable pace. Lenders were lending more and more money against these (and other) assets, with declining lending standards. Neither consumers nor lenders were prepared for the inevitable fall in prices. The root problem, however, was that no regulatory body had sufficient jurisdiction (or power) to address these problems.
The specific problems were:
- Capital and liquidity standards were too low
- The widespread effect that financial institutions would have on the entire financial system if they failed
- Splintered, fragmented regulatory bodies, none of which had responsibility or authority for the overall system
- Insufficient oversight for investment bankers (brokerage firms)
Capital standards are the required amount of money that must be put aside, and are based on assets. At its worst, some investment banks were leveraged 47:1. That means for every $47 dollars it had in loans, swaps, etc., it had $1 in actual cash. In other words, that would be like putting $8500 down on a $400,000 house, and thinking you had a sufficient down payment.
The second issue is"too big to fail," which basically means that, if that particular financial institution failed, it would severely damage the entire financial system. This type of systemic risk was present in AIG, a mammoth insurance company. Because of the number of credit default swaps (unregulated inter-financial institution agreements to cover loan amounts, if the borrower defaulted) and other risks assumed by the company, had the government allowed it to fail, the result would likely be catastrophic for, not only the US, but the world-wide financial markets.
Regulatory oversight for financial institutions was very like the issue that arose after 9/11, when the CIA, FBI and local law enforcement agencies in total may have had the intelligence to prevent the attacks, but had no inter-communication, and in some cases competing and proprietary interests. Insurance companies are state regulated, and every state is different. Banks are regulated by the either the Comptroller of the Currency or FDIC and the Federal Reserve Bank, thrifts, by the OTC, and investment bankers, by the SEC. There's no coordination. So, when investment bankers went into the mortgage business, the OTC had no jurisdiction.
And, speaking of the investment bankers, they were convinced that, since the overall housing market hadn't fallen for 50 years, it followed that a geographically diverse portfolio of mortgages would be safe no matter how little the down payment, whether income was verified, etc., etc. After all, an overall rising market would protect investors. They even convinced the rating agencies that reviewed their portfolios that they were right. The fact that this business needs more oversight could not be more apparent in hindsight.
So, the Administration proposes seeks to put the Treasury Department in charge. They'll be the "big boss" over all the other agencies, and have the authority to stop these problems before they become systemic. A Financial Oversight Council, consisting of the heads of supervisory agencies, will be established to identify such risks before the problems become too large, and agencies will be consolidated in order that responsibilities not overlap or compete, with the Fed responsible for implementing more stringent standards for the operation of these companies.
All financial institutions will have more stringent capital requirements and executive compensation standards. Capital requirements for reserves covering potential loan losses will be set by both accounting standards boards and the SEC.
Regulation of Financial Markets
The problem having been defined, the Administration seeks to address these issues through the following regulatory reforms.
- Strengthening of "firewalls" between banks and their affiliates to curtail conflicts of interest
- Closing loopholes in bank regulation (to prevent financial institutions from changing their charter from one type of bank to another to enable certain practices)
- Eliminating the thrift (the old "savings and loan") charter and unifying those institutions under the supervision of commercial banks
- Hedge funds will no longer be unregulated
- Insurance companies will be regulated on the federal, instead of state level
- The future of Federal "agencies" (Like Fannie Mae and Freddie Mac) will be considered
- Regulating "over-the-counter" instruments, like credit default swaps, derivatives and commodities
- Strengthen regulation of securitization markets (like "asset backed securities" that consist of mortgages)
- Tie compensation with long term performance
- Provide means to eliminate conflict of interest by the Rating Agencies
That's a synopsis of the proposals. So, where is the "doom and gloom?"
Too Powerful Treasury
First, many people feel that this proposal gives the Treasury too much power. I agree that the "regulator's regulator" is a powerful position. But, I have heard no one provide an alternative. In reading this objection by many authors, I have noticed a common thread. Generally, the objectors seemed more concerned about the current Treasury Secretary than the fact that Treasury is the agency in charge. After all, what is the alternative? The Fed? Another agency? I agree that, as with all complex issues, often the key players are more important than the structure in which they operate. But, that argument is fallacious in criticizing the structure.
Reinstate Glass-Steagall
Many feel that strengthening firewalls between banks and their affiliates is an inadequate solution, and want the Glass-Steagall Act, repealed under the Clinton Administration, to be reinstated. While that may or may not be a valid point, the fact is that those who recommend this action do not say how it will be accomplished. Since most investment bankers now operate under a commercial bank charter, would you require that the banks divest themselves of the investment banking portion of their operation? This would require a new board of directors, management team, central operation, etc. Who would pay for the additional expense this would require?
Government Has No Business in the Compensation Business
Many object to "capping" executive pay. I am one of these people. However, close reading of the proposals does no such thing. It ties compensation with long term, as compared with short term objectives. While I concur that this will be difficult, allow me a bit of pontificating. Short term financial goals can be achieved by taking action that is not necessarily in the best long term interests of a company.
As an example, lax underwriting standards for mortgages may allow people who really can't afford a home to qualify to buy one. When one significantly increases the demand for something, many more people are bidding on that thing, and the price goes up. That is called demand-push, and that pushes up prices. At some point, demand will level off. During the "push" prices - and profits - increase. If "everybody's doing it," and you are the company that is NOT, your profits are lower, and your stock is less valuable. However, your decision not to participate (if you survived), was in the long term interests of your company, your stockholders and the economy.
It's not going to be easy to change the short term profit motive, but it's worth a try.
Banks, Especially Multi-National Banks, Will Be Less Profitable
With stricter capitalization requirements, this is undoubtedly true. After all, if you're putting more money aside to cover potential problems, that money will not be earning what it would if it were invested. But, the profitability that was derived from participation in the unsustainable rise in housing prices cannot be considered "the norm." To compare properly regulated bank profits with those derived during the housing bubble is inappropriate when considering that the goal is long term sustainablility as compared with short term profitability.
These are the major objections I've seen raised and what I believe to be an appropriate response. Feel free, as mentioned before, to comment, and I'll do my best to answer.
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