Financial Services Regulation: Working Toward an Agenda for Reform

The financial turmoil that began last summer has impeded the ability of the financial system to perform its normal functions and has adversely affected the broader economy. Regulatory authorities have been actively considering the implications of the turmoil for regulatory policy and for private-sector practices.

Last year, the President's Working Group on Financial Markets (“PWG”) issued a report on their findings on the causes of recent market turmoil and recommended changes in the financial markets . At the international level, the Financial Stability Forum has also issued a report and recommendations.

Specific problem areas that have been identified in a number of reports over the last year include: mortgage lending practices and oversight; risk measurement and management by large financial institutions; capital, liquidity and leverage ratios; the performance of credit rating agencies; accounting and valuation issues; and issues relating to the clearing and settlement of financial transactions. Many of the recommendations in these reports are directed at regulators and the private sector and are already being addressed.

These reports complement the Blueprint for Regulatory Reform issued by the Treasury Department last year, which focused on broader questions of regulatory structure. Work is also ongoing to strengthen the framework for prudential oversight of financial institutions. Notably, events over the past year have led the Basel Committee on Banking Supervision to consider increasing capital charges for such items as complex-structured credit products, assets on banks' trading books, and liquidity guarantees provided to off-balance-sheet vehicles. Various reports have stressed the need for supervisors to insist on strong risk-measurement and risk-management practices that enable risk managers to assess the risks faced on a firm-wide basis.

The potential vulnerability of the financial system to the collapse of Bear Stearns was exacerbated by weaknesses in the infrastructure of the financial system, notably in the markets for over-the-counter (“OTC”) derivatives as well as in short-term funding markets. Much work is underway to address infrastructure issues as well. The financial turmoil is ongoing, and our efforts today are concentrated on helping the financial system return to more-normal functioning. It is not too soon, however, to think about steps that might be taken to reduce the incidence and severity of future crises.

Indeed, much is being written about regulatory restructuring, and I will spend the remainder of this report on this topic as recently addressed by the Government Accountability Office. In January 2009, the Government Accountability Office (“GAO”) published a report to Congress titled Financial Regulation: A framework for crafting and assessing proposals to modernize the outdated U.S. Financial Regulatory System. The GAO performed extensive research including discussions with federal and state supervisory authorities including self-regulatory organizations, associations representing the financial sector, and academic and industry experts.

For example, the GAO asked me to assemble the federal and state regulators as well as key self-recruiting organizations to provide the GAO team with our thoughts and feedback on their draft framework. A similar request was made to the American Bankers Association for the financial sector associations to provide the GAO with their views and thoughts on regulatory restructuring. The GAO report does not recommend a new regulatory structure but offers Congress a framework to evaluate restructuring proposals such as the Treasury blueprint. GAO identified five changes in the financial system highlighting limitations and gaps in the current regulatory system:

• First, regulators have struggled to mitigate the systemic risks posed by large and interconnected financial conglomerates to ensure that risks are adequately managed. The portion of firms operating as conglomerates crossing the financial sectors of banking, securities, and insurance has increased significantly in recent years, but none of the regulators are currently tasked with assessing the risks posed across the entire financial system.
• Second, regulators have had to address problems in financial markets resulting from the activities of less-regulated market participants—such as nonbank mortgage lenders, hedge funds, and credit rating agencies—some of which play significant roles in today’s financial markets.
• Third, the increasing prevalence of new and more complex investment products has challenged regulators and investors. In addition, consumers have faced difficulties understanding new and increasingly complex retail mortgage and credit products.
• Fourth, standard setters for accounting and financial regulators have faced growing challenges in ensuring that accounting and audit standards appropriately respond to financial market developments, and in addressing issues arising from the global convergence of accounting and auditing standards.
• Finally, despite the increasingly global aspects of financial markets, the current fragmented U.S. regulatory structure has complicated some efforts to coordinate internationally with other regulators. As I mentioned, GAO’s goal was to develop a framework that Congress could use to evaluate and, if necessary, craft regulatory reform proposals. The framework consists of nine characteristics that they believe should be reflected in a restructured regulatory system.

The characteristics include:

1. Clearly defined regulatory goals: Goals should be clearly articulated and relevant, so that regulators can effectively carry out their missions and be held accountable. Key issues include considering the benefits of re-examining the goals of financial regulation to gain needed consensus and making explicit a set of updated, comprehensive, and cohesive goals that reflect today’s financial environment.

2. Appropriately comprehensive: Financial regulations should cover all activities that pose risks or are otherwise important to meet regulatory goals. These regulations should also ensure that appropriate determinations are made regarding how extensive such regulations should be, considering that some activities may require less regulation than others. Key issues include identifying risk-based criteria, such as a product’s or instituion’s potential to create systemic problems for determining the appropriate level of oversight for financial activities and institutions, and closing gaps that have contributed to the current crisis.

3. Systemwide focus: Mechanisms should be included for identifying, monitoring, and managing risks to the financial system regardless of the source of the risk. Key issues include: Determining how to effectively monitor market developments to identify potential risks; The degree, if any, to which regulatory intervention might be required; and Who should hold such responsibilities.

4. Flexible and adaptable: A regulatory system that is flexible and forward looking allows regulators to readily adapt to market innovations and changes. Key issues include identifying and acting on emerging risks in a timely way without hindering innovation.

5. Efficient and effective: Efficient and effective oversight should be developed, including eliminating overlapping federal regulatory missions where appropriate, and minimizing regulatory burden without sacrificing effective oversight. Key issues include determining opportunities for consolidation given the number of overlapping regulators, identifying the appropriate role of states and self-regulation, and ensuring a smooth transition to any new system.

6. Consistent consumer and investor protection: Consumer and investor protection should be included as part of the regulatory mission to ensure that market participants receive consistently useful information, as well as legal protections for similar financial products and services—including disclosures, sales practice standards, and suitability requirements. Key issues include determining what amount, if any, of consolidation of responsibility may be necessary to streamline consumer protection activities across the financial services industry.

7. Regulators provided with independence, prominence, authority, and accountability: Regulators should have independence from inappropriate influence, as well as prominence and authority to carry out and enforce statutory missions, and be clearly accountable for meeting regulatory goals.