Thursday, January 29, 2009

Modernizing the American Financial Regulatory System

Yesterday, the Congressional Oversight Panel released it much anticipated report entitled, "Modernizing the American Financial Regulatory System." This report, required by the Emergency Economic Stabilization Act of 2008, discusses "how regulation would have averted the crisis that we are in today, and how the implementation of smart regulation will help the United States can prevent another financial crisis and determine our economic success in the years to come."

The report begins by discussing at some length the conditions that led us to, and the systematic causes of, the current economic crisis, but the bulk of the report lays out eight recommendations, summarized below:

1. Identify and Regulate Financial Institutions that Pose Systemic Risk

According to the Report, systematic risk is often not identified or regulated until a market crisis is imminent because there is no regulator with the authority to determine which financial institutions or products pose a systemic risk to the broader economy. The proposed solutiona are to:

  1. Mandate that a new or existing agency or an interagency task force regulate systemic risk within the financial system on an ongoing basis, and identify the degree of systemic risk posed by financial institutions, products, and markets during times of calmer market conditions, and regulate them according to their respective risk profiles. Providing proper risk adjusted oversight of such institutions, products, and markets "would help to prevent a crisis from striking in the first place, and it would put public officials in a much better position to deal with the consequences should a crisis occur."

  2. Impose heightened regulatory requirements, like more stringent capital and liquidity requirements, for systematically significant institutions to limit excessive risk taking, help ensure their safety, and reduce the risk of market-wide financial crisis.

  3. Establish a receivership and liquidation process, similar to the system for banks, rather than the current Bankruptcy Code regime, for systemically significant nonbank institutions.

2. Limit Excessive Leverage in American Financial Institutions

The report identifies overleveraging of financial institutions as a major risk factor that likely turned the intial subprime difficulties into a financial crisis requiring rapid deleveraging on a massive scale. The Report recommends the adption of one or more regulatory options to strengthen risk-based capital and curtail leverage. Among the options listed are:

  1. Capital requirements based on the basis of regulatory objectives (i.e., based on the level of risk) rather than on the type of institution.

  2. Stricter leverage restrictions to reduce the need for rapid deleveraging, or firesales, during economic downturns.

  3. Capital requirements that increase in times of rising asset prices, or countercyclical as opposed to the current procyclical capital requirements, that raise capital adequacy requirements "by a ratio linked to the growth of the value of bank‘s assets in order to tighten lending and build up reserves when times are good."

  4. Impose on certain institutions stronger requirements that they hold a greater proportion of liquid assets as well as a liquidity reserve that could be used in a crisis.

3. Modernize Supervision of Shadow Financial System

Unregulated OTC, off-balance sheet conduits and structured investment vehicles, and entities like private equity and hedge funds, have made it difficult for regulators and market participants to understand the full nature and scope of the risks in the bank credit markets and capital markets. The COP "urges Congress to consider shifting the focus of existing regulation toward a functional approach." This includes expanding the jurisdiction of the SEC to regulate all products that can function as securities, or economically substitute for securities, and in particular regulating hedge fund advisers. The report also suggests increasing the transparency of OTC markets by creating regulated OTC clearing houses, requiring OTC derivatives contracts to be traded on regulated derivatives markets, and requiring participants in the CDS market to participate in a regime of disclosure that would let regulators monitor them.

4. Ceate a New System for Federal and State Regulation of Mortgages and other Consumer Credit Products

The Panel finds that the method of regulating mortgages and other consumer credit products is Ineffective regulation of mortgages and has "produced unfair, and often abusive, treatment of consumers, which destabilizes both families and the financial institutions that trade in those products." The Panel recommends eliminating federal pre-emption of application of state consumer protection laws to national banks, and the cotroversial step of creating a single federal regulator for consumer credit products, similar to the Consumer Products Safety Commission.

5. Create Executive Pay Structures that Discourage Excessive Risk Taking

Because current executive compensation structures and methods provide incentives for excessive risktaking, the panel recommends:

  1. Creating tax incentives to encourage long-term–oriented pay packages.
  2. Encouraging financial regulators to guard against asymmetric pay packages in financial institutions, such as options combined with large severance packages.
  3. Regulators should consider requiring executive pay contracts to provide for clawbacks of bonus compensation for executives of failing institutions.
  4. Encouraging corporate governance structures with stronger board and long-term investor oversight of pay packages.

6. Reform the Credit Rating System

The credit rating agencies played a important role in placing the broader financial system at risk. The Panel finds that the system is "ineffective and plagued with conflicts of interest," and recommends that the SEC or another regulator should impose limits on or changes to the way the rating agencies generate revenue in order to eliminate these conflicts of interest in their business practices. The Panel also recommends creating a Credit Rating Review Board that would sign off on any rating before it takes on regulatory significance.

7. Make Establishing a Global Financial Regulatory Floor a U.S. Diplomatic Priority

Globalization of the financial markets has created regulatory challenges and exposed market participants to different and greater levels of risk. A global market and free movement of capital also creates incentives for market actors to seek permissive regulatory environments, and attracting these actors puts pressure on regulators. The Panel recommends creating global regulatory standards, and encourages "participation in international organizations that are designed to strengthen communication and cooperation among national regulators."

8. Plan for the Next Crisis

Tp help plan for, and perhaps minimize, future financial crises, the Panel recommends the creatin of a Financial Risk Council of outside experts to report to Congress and regulators on possible looming challenges.

Dissenters' Report

Panel members, Rep. Jeb Hensarling and former Senator John Sununu, disagreeing with the Panel's report, included their own report, offering the following rationale:

Building consensus over such a broad range of economic questions would be difficult in any event. The timing and process for preparing this document, unfortunately, made it more so. Given the differences that remain regarding our views of the systemic weaknesses that led to the crisis, and, more important, policy recommendations for reform, we have chosen not to support the Panel Report as presented. Instead, we provide here a more concise statement of the underlying causes of the current financial crisis and a series of recommendations for regulatory modernization. While there are several points in the Panel Report with which we agree, we also provide a summary of several areas where our disagreement led us to oppose the final product.

A summary of Hensarling and Sununu's alternative report is available at:

The full text of the Report and a video introduction by Elizabeth Warren, the Panel's chair, are available at: