A Plan for Regulatory Reform

On May 26, 2009, the Committee on Capital Markets Regulation (CCMR) released its report, “The Global Financial Crisis: A Plan for Regulatory Reform.” As stated in its press release, the plan presents its comprehensive approach “for reforming the U.S regulatory structure” as a result of the financial crises. The report presents 57 recommendations which address the flaws in the regulatory system which the crisis has exposed.

The Committee concludes that an effective regulatory system must achieve four objectives:
1. Reduced systemic risk
2. Increased disclosure to protect consumers and investors
3. A unified regulatory system with clear lines of accountability and improved transparency
4. International regulatory harmonization

(See “The Global Financial Crisis: A Plan for Regulatory Reform” link on the right)

On May 28th, the Wall Street Journal reported that Obama administration officials are close to recommending a single regulator to oversee the entire banking sector, a step which would effectively merge regulatory responsibilities of the Fed, the FDIC, the Office of the Comptroller and the Office of Thrift Supervision. The article also reported that the Fed would assume the role of a systemic regulator to oversee the entire financial sector, while the FDIC would assume powers to expand its ability to put any large financial company into receivership. Currently, no agency has explicit authority to monitor and manage systemic risks, and the FDIC only has authority to put banks into receivership. (See “Single-Regulator Plan for Banks Now Close” link.) These elements follow some of the recommendations contained in the CCMR report.

Following the Wall Street Journal story, Bloomberg News reported that House Financial Services Committee Chairman Barney Frank ruled out creating a single U.S. bank regulator. Congressman Frank stated that Congress would examine retaining the existing multi-regulator structure, while creating a new authority, which could be a combination of agencies, to deal with risks to the overall financial system. In contrast to the Administration’s thoughts, Congressman Frank’s statements appear to be precisely what the CCMR report recommended against. The consolidation of agencies and creation of a new authority would upset the existing oversight by various Congressional Committees, which would cause a reduction in power by some members of Congress who would lose oversight of existing government agencies. (“Frank Rules Out Creating Single U.S. Bank Regulator” link.)

CCMR Report: Shortcomings of the Current Market Environment and Regulatory Agencies

• While Credit Default Swaps are an important tool for measuring and diversifying credit risk, the current market significantly increased the potential for systemic risk with interconnected counter-party risk multiplying the effects of a chain reaction of defaults.
• The existing capital regime, which was established by the Basel Capital Accords, was inadequate to prevent financial distress of large financial institutions. The system also excluded other important financial institutions, which created moral hazard risk as the crisis developed.
• Regulatory agencies do not have sufficient tools to resolve the insolvency of all systemically important financial institutions. Its ability to manage insolvency is limited to banks and excludes its ability to address solvency issues of other financial institutions.
• The current securitization markets do not properly align the incentives of originators, investors and credit rating agencies involved in different aspects of the market.
• Disclosure requirements of existing SEC regulation AB do not require sufficient detail for securitized products to allow investors to independently value securities.
• Credit Rating Agencies failed to assess the risk of securitized issues accurately, had widespread conflicts of interest in the rating process, and did not provide sufficient transparency to the rating process. Investors placed excessive reliance on the ratings.
• Increased use of fair value accounting (FVA) may promote instability in financial markets, especially during periods of market distress. The approach required by FAS 157 combine three different valuation approaches into one number: market price, intrinsic value and replacement cost.
• U.S. financial market participants are regulated by a fragmented, sector-based model which does not reflect the complexity of the current market

CCMR Report: Selected Recommendations

• Mandate centralized clearing of Credit Default Swap (CDS) contracts to limit counterparty risk and improve liquidity.
• Adopt a CDS reporting system which requires volume and position data to be publicly available.
• Hold large financial institutions to higher solvency standards.
• Adopt counter-cyclical capital ratios.
• Establish a single insolvency regime applicable to all financial companies.
• Explore minimum risk retention by securitization product originators.
• Amend Regulation AB for securitized issues to increase loan-level disclosures.
• Increase disclosure of how credit ratings are determined for securitized products.
• Supplement FVA with a dual presentation of market values and intrinsic values.
• Replace the existing fragmented regulatory agencies with a new framework consisting of at most three agencies, while increasing the role of the Fed to become the systemic risk regulator. One agency should have total authority to regulate the financial industry, with that agency being either the Fed or a new U.S. Financial Services Authority.

About CCMR
(from its website at http://www.capmktsreg.org)

The Committee on Capital Markets Regulation is an independent and nonpartisan 501(c)(3) research organization that includes leaders in finance, business, academia, law, accounting, and the investor community from all across the political spectrum. The Committee provides policymakers with a nonpartisan, empirical foundation for public policy on capital markets regulation.

Bob Decker, CFA