Briefing Report: Federal Financial Regulatory Reform

Wednesday, January 13, 2010

Overview

While the nation’s attention to Congress and the White House is largely focused upon the seemingly endless debate between House and Senate Democrats as to how best to seize control of Americans’ health care, in the shadows of that project, another significant policy debate over reforming the regulatory scheme for the nation’s financial system is underway. In many respects, that debate is more important, if not more so, to the economic competitiveness and well being of the nation and its citizens than that of health care. In 2008, the U.S. Gross Domestic Product ( GDP) was $14.44 trillion, with the financial sector accounting for nearly 8% of GDP.1 Although the nation’s financial sector is only half the size of its health sector, and economists and policy makers are debating its appropriate size (some think it is too large, too highly compensated, and too politically powerful), it is indisputably clear that much of the nation’s economic growth over the last 30 years has been financed by innovation in the financial sector resulting largely from deregulation. Finance is the oxygen for American economic innovation, competitiveness and growth – it is no accident the deepest recession since the Great Depression is accompanied by an ongoing credit crunch.

That is not to say deregulation is blameless for the current financial crisis. The policy disputes over assigning culpability may be unresolved for generations (e.g., see Amity Shlaes “The Forgotten Man: A New History of the Great Depression,” 2007, for an authoritative revision of the conventional understanding of the economic history of the Great Depression). In light of the massive economic dislocations and unprecedented taxpayer bailouts, there is general bipartisan consensus in Washington that reforms are necessary. The nature of those reforms, however, is hotly disputed by policy makers and the various industries subject to those reforms.

The nation’s banking and financial system, while much more complex than about to be described, can generally be understood as comprised of four major elements. These are the Federal Reserve System (which is the central bank, responsible for money supply); nationally and federally chartered banks; state chartered banks; and non-bank institutions such as mortgage companies, finance companies, insurance companies, credit agencies, credit unions, brokers and dealers in securities, investment bankers and hedge funds. As it relates to reform efforts in Washington, this last group is often characterized as the “shadow banking system”2 and is perceived by the President, Congressional and legislative Democrats as too lightly regulated, if at all. Many of them assign responsibility for the current crisis to these institutions: the larger investment banks for creating mortgage backed securities and credit default swaps which resulted in “systemic risk,” (which is broadly understood to mean, “risk to the entire market”)3 and the smaller mortgage and finance companies for aggressively selling inappropriate sub-prime mortgages to extremely poor credit risks.

The President’s Proposal and Congressional Action

On June 17, 2009, the President announced an aggressive and comprehensive proposal significantly expanding the scope of the government’s authority over the nation’s financial system since the Great Depression: Financial Regulatory Reform - A New Foundation: Rebuilding Financial Supervision and Regulation.4 The proposal effectively targets the nation’s entire financial system, except for state chartered institutions, to address the “shadow banking system” and to reduce “systemic risk;” seeks to expand supervision and regulation of financial firms; regulates financial markets comprehensively; enacts federal protections for consumers and investors; authorizes regulators to manage future financial crises; and initiates international regulation of financial systems and firms. The proposal would primarily do so by creating a “Financial Services Oversight Council,” authorize the Federal Reserve Board (the Fed) to supervise and regulate large firms whose failure would create “systemic risks” (i.e., the failure of any one such firm could have crippling effects in the nation and international financial markets), and to increase reserve requirements. The proposal would also increase regulation of securitization markets, expand regulation of credit rating agencies, and mandate issuers and originators retain a financial interest in securitized loans. It would create a new “Consumer Financial Protection Agency,” ostensibly to protect consumers from unfair and abusive practices; establishes a new, non-bankruptcy scheme for resolving non-bank financial institutions failures whose collapse could have systemic effects; and it promotes oversight of global financial markets and coordinating supervision of internationally active firms.

As the President released his proposals, both the House and Senate had been developing their own respective legislative packages. The House version, led by House Financial Services Committee Chairman Barney Frank (D-MA), is closest to the President’s proposal. Like the President’s proposal, the House bill most notably would establish a council of regulators to reduce systemic risks, begin oversight of the sizable derivatives market, create a new federal agency for consumer protection, and give the government power to wind down large, failing firms whose insolvency could harm the national and international financial system. This bill passed the House on Friday, December 11, 2009 without any House Republican votes.

Despite the House finishing its bill first, the Senate bill is the bill to watch. Interestingly, while the Senate bill, led by Senate Banking Chair Dodd (D-CT), seeks to address many of the same policy questions as the President’s proposal, and it seems to generally conform to the President’s goals (it seeks to provide authority to “resolve” failing institutions, create a Consumer Financial Protection Agency, regulate derivatives and regulate systemic risk), it does not mirror the President’s plan. Significantly, Sen. Dodd and Sen. Shelby, (R-AL), the Ranking Republican of the Banking Committee, are now working together in a reportedly sincere effort to develop a bipartisan reform bill (as Senate Rules generally require 60 votes for an item to move to the Senate Floor). Ironically, despite its more bipartisan character, the Senate bill appears to be more aggressive than the House bill, both in its focus upon realigning responsibilities and reorganizing the various federal regulatory agencies, and in its actual regulatory constraints upon financial institutions. It remains to be seen, however, if the Senate’s approach holds through the conference committee, or what effect Sen. Dodd’s retirement announcement in the first week of January will have.

So What Will it Mean?

Although the final bill is still unknown, Congress will most likely send a reform bill along the lines of the Senate version to the President later this Spring. Washington’s reform efforts may, in the near term, instill a sense of stability in the market, increasing overall confidence in the financial system among investors, lenders, borrowers and policy makers, thus freeing up capital for lending. Yet, in the longer term, serious issues will result.

The reform effort seeks to address systemic risk, regulate the shadow banking system, and expand the size and power of the nation’s regulatory agencies. Yet much of the reform effort expands upon underlying principles of the Troubled Asset Relief Program (TARP), which saw unprecedented taxpayer bailouts of firms “too big to fail,” (to save the system from systemic risk) and ensuing market concentration amongst the nation’s biggest banks. The reform effort ignores the nation’s bankruptcy laws (embedded in the Constitution5), instead focusing upon a taxpayer funded resolution process (not too dissimilar from the process used for AIG); creates moral hazard by statutorily recognizing firms as “too big to fail” will not be allowed to fail, thus eliminating the fear of failure as a self-regulating tool.

In short, the reform effort will very likely produce a financial system looking more like publicly regulated power companies than the innovative financial sector of the last 30 years. Market power concentration will be greater and the nexus between Washington regulators and politicians and Wall Street investment bankers will be tighter, with market behavior predicated upon political power and influence. Profits will be more greatly privatized and failure socialized than now. Innovation will be limited to regulators’ tolerance for risk or understanding of the new financing mechanism. Smaller firms competing for investors, employees and market share against larger firms with the imprimatur of the federal government; borrowers with connections to power will enjoy access to capital not available to those without connections. In short, an effort designed to “fix Wall Street to save Main Street,” will likely do neither.

 

1 http://sternfinance.blogspot.com/2008/10/future-of-financial-industry-thomas.html
2 https://en.wikipedia.org/wiki/Shadow_banking_system
3 http://www.investopedia.com/terms/s/systematicrisk.asp
4 http://www.financialstability.gov/docs/regs/FinalReport_web.pdf
5 http://www.law.cornell.edu/constitution/articlei

 

For more information on this report or other Banking, Finance & Insurance issues , contact Tim Conaghan, Senate Republican Office of Policy at 916/651-1501 or Tim.Conaghan@sen.ca.gov