The White Paper on Financial Market Regulation

The White House today announced the publication of the long-awaited Treasury Department White Paper on Financial Regulation. Here's the summary, with commentary in red:

(1) Promote robust supervision and regulation of financial firms. Financial institutions that are critical to market functioning should be subject to strong oversight. No financial firm that poses a significant risk to the financial system should be unregulated or weakly regulated. We need clear accountability in financial oversight and supervision. We propose:

• A new Financial Services Oversight Council of financial regulators to identify emerging systemic risks and improve interagency cooperation.

• • Instead of consolidating financial regulators, so as to eliminate forum-shopping, duplication, inconsistent regulation, and all the other problems associated with the regulatory alphabet soup, we're going to create a new regulatory body and an additional layer of regulatory hierarchy. We're making the system more rather than less complex.

• New authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability, even those that do not own banks.

• • A massive expansion of Fed power and a massive expansion of government power to regulate the economy. Also dubious, because the Fed's expertise does not extend to regulation of non-banking industries.

  • In the long run, it may threaten the fed's independence. Query whether Congress will tolerate the Fed meddling in industries of local importance to powerful committee chairs.

• Stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms.

• A new National Bank Supervisor to supervise all federally chartered banks.

• Elimination of the federal thrift charter and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve.

• The registration of advisers of hedge funds and other private pools of capital with the SEC.

• •  There is no evidence that hedge funds contributed to the financial crisis nor that regulation of them would have prevented or even mitigated the crisis.

  • Because hedge funds benefit the economy by bearing risks that others will not, engaging in transactions that tend to make securities more liquid, and ferreting out market inefficiencies, stricter regulation of hedge funds could do more harm than good. See Shadab on The Challenge of Hedge Fund Regulation.

  • Bear in mind that Bernie Madoff was a registered investment adviser, much good that did.

(2) Establish comprehensive supervision of financial markets. Our major financial markets must be strong enough to withstand both system-wide stress and the failure of one or more large institutions. We propose:

• Enhanced regulation of securitization markets, including new requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that issuers and originators retain a financial interest in securitized loans.

  •  The whole idea of securitization is to enable firms to diversify by shedding originated loans. The problem was that the Lehmans of the world retained too many of their toxic assets. So the last element of this bullet is likely to do more harm than good.

• Comprehensive regulation of all over-the-counter derivatives.

• New authority for the Federal Reserve to oversee payment, clearing, and settlement systems.

(3) Protect consumers and investors from financial abuse. To rebuild trust in our markets, we need strong and consistent regulation and supervision of consumer financial services and investment markets. We should base this oversight not on speculation or abstract models, but on actual data about how people make financial decisions. We must promote transparency, simplicity, fairness, accountability, and access. We propose:

• A new Consumer Financial Protection Agency to protect consumers across the financial sector from unfair, deceptive, and abusive practices.

  • The federal government has long eschewed merit regulation of securities, in large part because it threatens to restrict and constrain innovation. I worry that the new agency will have that impact.

• Stronger regulations to improve the transparency, fairness, and appropriateness of consumer and investor products and services.

• A level playing field and higher standards for providers of consumer financial products and services, whether or not they are part of a bank.

(4) Provide the government with the tools it needs to manage financial crises. We need to be sure that the government has the tools it needs to manage crises, if and when they arise, so that we are not left with untenable choices between bailouts and financial collapse. We propose:

• A new regime to resolve nonbank financial institutions whose failure could have serious systemic effects.

  •   We've got to get away from the moral hazard problem and the probelm of de facto federal guarantees. Making clear that these problems will be resolved in the future via the bankruptcy process would be far more preferable.

• Revisions to the Federal Reserve’s emergency lending authority to improve accountability.

(5) Raise international regulatory standards and improve international cooperation. The challenges we face are not just American challenges, they are global challenges. So, as we work to set high regulatory standards here in the United States, we must ask the world to do the same. We propose:

• International reforms to support our efforts at home, including strengthening the capital framework; improving oversight of global financial markets; coordinating supervision of internationally active firms; and enhancing crisis management tools.

In addition to substantive reforms of the authorities and practices of regulation and supervision, the proposals contained in this report entail a significant restructuring of our regulatory system. We propose the creation of a Financial Services Oversight Council, chaired by Treasury and including the heads of the principal federal financial regulators as members. We also propose the creation of two new agencies. We propose the creation of the Consumer Financial Protection Agency, which will be an independent entity dedicated to consumer protection in credit, savings, and payments markets. We also propose the creation of the National Bank Supervisor, which will be a single agency with separate status in Treasury with responsibility for federally chartered depository institutions. To promote national coordination in the insurance sector, we propose the creation of an Office of National Insurance within Treasury.

Under our proposal, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) would maintain their respective roles in the supervision and regulation of state-chartered banks, and the National Credit Union Administration (NCUA) would maintain its authorities with regard to credit unions. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) would maintain their current responsibilities and authorities as market regulators, though we propose to harmonize the statutory and regulatory frameworks for futures and securities.

What's striking about this last paragraph is the regulatory cowardice it exhibits. It makes no sense for the SEC and CFTC to remain separate, for example. The only reason they do so is because the SEC is regulated by the Senate Banking and House Financial Services Committee, while the CFTC is regulated by the House and Senate Agriculture Committees. An agency merger would have deprived one of these committees of jurisdiction. The Obama administration was unwilling to challenge the old bulls that run those committees.