Financial Industry Regulatory Framework Pending

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The Congressional Financial Industry Rescue Panel led by Harvard Law Professor Elizabeth Warren is supposed to monitor the disbursement of the $700 billion in bailout money, but it is also required by law to provide Congress with recommendations for reforms to the financial regulatory structure, a report that she said it would deliver by Jan. 20.[i]  What kind of regulatory structure should be considered?

To prevent a recurrence of the problems that led to this current financial crisis, the United States and indeed the entire world need a new rigorously enforced regulatory structure for the financial services industry.  In the United States, legislation is needed to establish a streamlined framework for regulating the equity, debt, commodity and derivatives markets.  The functions of the SEC and CFTC, as well as functions undertaken by the Fed and the Treasury on an ad hoc basis, should be transferred to this new regulatory agency.[ii]

The federal government needs to regulate all aspects of the financial services industry.  As Barack Obama said in his speech on March 27, 2008, “We need to regulate financial institutions for what they do, not what they are.”[iii] The basic principles should be based on asking what role the financial institution plays in the economy.  If it is accepting and keeping retail and commercial deposits, with FDIC insurance, it should be regulated as a commercial bank.  If it invests the shareholder capital in risky assets, using leverage to increase its returns, it should be regulated as an investment bank.  Some 21st Century version of Glass-Steagall is necessary to protect taxpayers from the need to bail out investment banks.

With Elizabeth Warren as chairman of the Financial Industry Rescue Panel, we can expect a strong consumer protection element in the recommendations.  She has recently proposed that mortgage products should be examined and tested for safety.    She and her daughter Amelia Warren Tyagi wrote “Of all the borrowers who were sold subprime mortgages in the past five years, nearly 60 percent would have qualified for prime mortgages if brokers had offered them; the subprime mortgages carried so many rate escalators, prepayment penalties, and other traps that even would-be prime borrowers defaulted.”[iv]  When actual costs and unfavorable terms are regularly concealed, the regulatory authority should order those products removed from the market.  Warren and Tyagi have proposed a Financial Product Safety Commission, which would require that companies reveal the true cost of credit.  This is a good idea, and should be included in the recommendations, but it is a small part of the reforms needed to protect the 21st Century economy from another financial meltdown.

Leverage needs to be controlled for all financial institutions, whether they are called banks or insurance companies or hedge funds or commodity futures trading companies.  No company should be allowed to operate with so much leverage that its failure could threaten the entire global financial system, a situation in which we have found ourselves during the past two years.  To be more specific, leverage of 30:1 is outrageously too high.  Fines are not a sufficient deterrent to the greed of some people who will use high leverage whenever they think they have a chance to make a large fortune risking other people’s money.  Legislation needs to specify significant prison time for people who violate the rules of the new financial system. 

Now that we have mentioned hedge funds, the question is whether they have any redeeming social value.  Banks keep depositors money safe and put money to work by lending to households and businesses based on the lender’s assessment of their ability to pay the loans back.  Insurance companies spread risk among large groups of customers, sparing the focus of hardship on the unlucky few.  Financial advisers help people and businesses save and invest wisely.  Venture capitalists raise funds for entrepreneurs who create innovative products and services.  Hedge funds should not be allowed to exist just to gamble on giant returns by using greater leverage than is allowed of regulated financial institutions.  As a minimum, hedge funds should be regulated with regard to leverage and the transparency of their operations.  If hedge funds cannot find a contributing role in the real economy, they should be shut down.

The new financial order must ensure the independence of the financial rating companies.  We need to separate the funding of financial rating companies (like Moodys, Standard & Poors, and Fitch) from the financial engineers who came to them for ratings.  We have suffered from a system under which bond issuers paid the ratings companies to rate their bonds, and the ratings companies sold consulting services to tell the issuers how to tweak the composition of their Collateralized Debt Obligations to get AAA ratings. The federal government needs to police conflicts of interest like that.

Transparency is a key issue.  New Deal legislation sought to increase transparency in the interstate offering and sale of securities.  The Securities Act of 1933 requires every U.S. public company to register new securities (with the SEC after 1934) and to offer (interstate) securities only through a truthful prospectus giving basic financial information as well as stating the risk involved in investing in the offered securities.  Corporations were also required to issue audited annual reports on the status of the business.  The Securities Exchange Act of 1934 focused on the sale of securities in secondary markets, creating the Securities and Exchange Commission (SEC) to monitor and enforce corporate reporting, ensure conformance with regulations, as well as to detect and punish accounting fraud, false information distribution, insider trading or other violations of the securities law.[v]  Unfortunately, despite additional legislation (e.g., the Investment Company Act of 1940, the Investment Advisors Act of 1940, and the Sarbanes-Oxley of 2002), federal laws have not kept up with the pace of financial chicanery (described in the industry as innovation).

There needs to be more transparency of all kinds of financial instruments, including the kind of mortgage-backed securities, collateralized debt obligations and credit default swaps that have created the multi-trillion dollar financial meltdown we have experienced over the past eighteen months.  For example, standardized credit default swaps should be traded through a CDS clearinghouse (something that Tim Geithner has been encouraging in recent months). Legislation is needed to establish a streamlined framework for regulating the equity, debt, commodity and derivatives markets.  The functions of the SEC and CFTC, as well as functions undertaken by the Fed and the Treasury on an ad hoc basis, should be transferred to this new regulatory agency.[vi]

Size is also an issue.  No financial institution should be allowed to grow into a company that it is too big to fail.  Sandy Weill was right when he predicted the repeal of the Glass-Steagall Act after he created Citigroup, but he was also right in what he implied, which was that he had created an institution that had an inherent advantage over its rivals because it was too big to fail.  Citigroup must be broken up.  If the Citigroup management does not spin off parts of its business voluntarily, then antitrust litigation should be used to break up the company.  Furthermore, we need to reverse the trend during the Paulson era of turning to the biggest banks to absorb other big banks that get into trouble.  We must ensure that there are no more Citigroups in the future.

We hope that that the Warren Panel will lay out a framework by January 20 and then work with the new Economic Recovery Advisory Board to be chaired by Paul Volker to address in more detail the proposed financial system regulatory framework.

 


 

[i] http://www.nytimes.com/2008/12/02/business/02tarp.html?_r=1

[ii] https://westonpolicy.wordpress.com

[iii]http://www.prospect.org/cs/articles?article=seven_deadly_sins_of_deregulation_and_three_necessary_reforms

[iv] http://www.law.harvard.edu/news/2008/10/23_warren.html

[v] http://en.wikipedia.org/wiki/U.S._Securities_and_Exchange_Commission

[vi] https://westonpolicy.wordpress.com

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