Spelling Regulatory Reform: Restructuring Our Alphabet Soup of Financial Regulators

Introduction

The current financial regulatory landscape is littered with a veritable New Deal lexicon of regulatory agencies, which is ironic given that their collective failure failed to prevent the worst financial crisis since the Great Depression. From OTS and OCC, to FDIC and SEC, our regulatory landscape is fragmented amongst institutions overseeing their own bits and pieces of our financial system, in some instances overlapping their authority, while in others leaving gaping holes. Ultimately, this balkanized alphabet soup of regulators has spelled disaster.

These regulatory failures were part of a larger puzzle, and crystallized the need for system-wide and fundamental regulatory reform in an effort to prevent the occurrence of another financial crisis of similar magnitude and duration. Ultimately, the goals of any reform process should be to formulate a regulatory system that is more accountable, employs greater expertise, and closes gaps in regulatory coverage, all while maintaining the flexibility necessary to keep pace with industry growth and innovation.

This piece will examine the current efforts to restructure the financial regulatory system in order to make it more efficient, transparent and stable. It is structured as follows: a discussion of regulation by objective, whereby different regulators take responsibility for different objectives; an exploration of the optimal structure for achieving these desirable objectives; and conclusions, noting that structural reform is necessary but not sufficient to avoid another crisis. Strong regulatory performance and complementary fundamental reforms are essential to complete the picture.

The objectives approach to regulation

Objectives-based regulation, which has been implemented successfully in other economies, has three important elements: safety and soundness regulation, systemic risk oversight, and consumer/investor protection. While multiple ideas have surfaced with regard to reorganizing the regulatory structure, key to reform success are increased effectiveness and accountability, and an independent Fed.

Objectives of Regulation

The Blueprint for financial reform prepared by the Paulson Treasury proposed a system of objectives-based regulation, an approach that is the basis for successful regulation in Australia and other countries overseas. The White Paper prepared by the Geithner Treasury did not use the same terminology, but it is clear from the structure of the paper that their framework is an objectives-based one, as they lay out the different elements of regulatory reform that should be covered.

There are three major objectives of regulation:

• First is the micro-prudential objective of making sure that individual institutions are safe and sound. That requires the traditional kind of regulation and supervision – albeit of improved quality.
• Second is the macro-prudential objective of making sure that the whole financial sector retains its balance and does not become unstable. That means someone has to warn about the build-up of risk across several institutions, and take regulatory actions to restrain lending used to purchase assets whose prices are creating a speculative bubble.
• Third is the conduct of business objective. That means watching out for the interests of consumers and investors, whether they are small shareholders in public companies or households deciding whether to take out a mortgage or use a credit card.

An objectives-based approach to regulation assigns responsibilities for these three objectives to different agencies. The result is clear accountability, concentration of expertise, and no gaps in coverage of the financial services industry – even as its structure changes and new products, processes and institutional types emerge. No other way of organizing regulation meets these important criteria while avoiding an undue concentration of power that a single overarching financial services regulator would involve.

It is important to remember that how we organize regulation is not an end in itself. Our plan must meet the three objectives efficiently and effectively, while avoiding over-regulation. In addition for objectives-based regulation to work, it is essential to use the power of the market to enhance stability. Many of the problems behind the recent crisis – executive and trader compensation, excessive risk-taking, obscure transaction terms, poor methodologies and conflicts of interest – could have been caught by the market with clearer, more timely and more complete disclosures. It will never be possible to have enough smart regulators in place that can outwit private sector participants who really want to get around regulations. An essential part of improving regulation is to improve transparency, so the market can exert its discipline effectively.

The independence of the Federal Reserve

In applying this approach, it is vital for both the economy and the financial sector that the Federal Reserve has independence as it makes monetary policy. Experience in the US and around the world supports the view that an independent central bank results in better macroeconomic performance and restrains inflationary expectations. An independent Fed setting monetary policy is essential.

What structure best meets the objectives of financial regulation?

In order to prevent overlapping jurisdiction, as well as regulatory gaps, a single micro-prudential regulator is needed to effectively manage the regulatory system as the financial sector evolves over time. In the macro-prudential sphere, the Fed is best positioned to monitor and respond to systemic risk.

Regulatory performance must be improved regardless of where it is done .

Under the current regulatory system, financial institutions are regulated primarily based on the specific legal forms they choose for their various divisions. Those legal forms, in turn, are determined by what institutions think will work best to achieve their strategic goals given the tax, regulatory and legal environment. The result has been a thriving market of regulatory competition. While competition in the private sector is the lifeblood of our economy, driving innovation, growth and consumer choice, it is unclear that regulatory competition is beneficial. It can, as we have seen, result in a de facto race to the bottom as financial institutions seek out the most lenient regulator that will allow them to engage in the riskiest behaviors that they desire, ultimately with other people’s money. Not everyone agrees that institutions’ ability to choose their regulatory leads to regulatory arbitrage. In recent Congressional testimony, Acting Head of the OTS John Bowman argued that institutions large and small change regulators for a number of legitimate business reasons.[1] That may be so, but our costly experience with AIG seems rationale enough to limit the opportunities. [2]

Regardless of who is doing it, there must be improved performance in the supervision and regulation of financial institutions There were rooms full of regulators sitting in all of the large regulated financial institutions prior to the crisis, and they failed to stop the crisis. This means there should be more accountability for regulators, so that they are censured or removed if they do not perform the role they were hired to do. It means they should be better paid. It seems paradoxical to reward a group that did not do so well historically, but if we want better regulators, then they must receive salaries that make these jobs attractive to high quality people: those who can understand complex institutions and products, and who may have the option of earning high incomes in the private sector. Adequate training must be available. Better quality regulation is a “must-have” of financial reform and must be part of the legislation now being considered. A lot of improvement can be made even under existing legislation if regulators have the incentives and abilities to do their jobs.

Some people argue that regulation has been the cause of the problem, and that if the government were removed from the equation then the financial sector would regulate itself, with weak companies failing and the strong companies surviving. Overall, I am a strong supporter of letting markets work and letting companies fail if they cannot be efficient or innovative. This includes financial institutions that should be allowed to fail if they do make bad decisions and fail to meet the market test. The financial sector has unique features that make it different from most other industries, however. Failure in one institution can spill over to others and problems in the financial sector can rock the whole economy, as we have seen in this crisis.

The case for a consolidated micro-prudential regulator for the financial sector

Because most of the large financial institutions participate in several lines of business, they are at present regulated by more than one agency. In such a system it’s easy to see how regulators would have a difficult time keeping track of the safety and soundness of a financial institution as a whole, given their narrow focus on a particular division. And it is even easier to see how some divisions, or even entire institutions, might escape regulation altogether. Even if the agencies themselves were well staffed and funded – a fact widely disproven by our experience with this crisis – the fragmentation of the overall regulatory system would remain a severe and potentially fatal flaw.

With a single micro-prudential regulator this would no longer be the case -- it would absorb the majority of the myriad of acronyms (regulators from OTS, OCC, SEC, and even the Fed). Dispensing with the OTS and OCC entirely, the FDIC would maintain responsibilities limited to the deposit insurance program. The SEC would continue to have a very important role as a protector of the interests of shareholders, a bulwark against insider trading, market manipulation, mis-selling and other practices that can undermine our capital markets. There is a case for giving the SEC additional authority to provide consumers protection against financial products that are deceptive or fraudulent; thus the SEC would consolidate its operations to function as the conduct of business regulator, ideally assuming the responsibilities of the Consumer Financial Protection Agency (CFPA) outlined by the Treasury Department.

The financial sector does not stand still. It evolves and innovates, and new institutions and products are born. A single prudential regulator with the necessary staff and skills would be best positioned to evolve along with the industry and adapt regulation to a changing world. Having a single prudential regulator would make it much easier to avoid gaps in regulation and discourage the kind of regulatory evasion that contributed to the crisis. It would also reduce the regulatory burden on financial institutions because it would avoid much of the duplication that now exists.

A single prudential regulator would supervise and regulate institutions large and small, and be able to maintain a level playing field for competition. It would be able to examine all of the activities of the large global banks and make sure they were not accumulating excessive risks through a combination of activities in different parts of their business.

An effective single prudential regulator acting as a cop on the beat could actually increase the level of effective competition among private companies in the financial sector, thus making the private market work better. In addition, it would be very important that the mandate of the single prudential regulator include the promotion of innovation and economic growth. The US financial sector has been one of the strongest in the world and has been one of our major exporters. Prior to the crisis there was great concern that the New York financial markets were losing their global competitive position—see, for example, the Bloomberg-Schumer report. The goal of sustaining a dynamic and competitive sector remains vital.

There are, no doubt, lessons to be learned from consolidation efforts in other economies. Australia’s twin peaks approach, with effective prudential and consumer-protection regulators, enabled its economy to weather the financial crisis better than many other developed countries. Likewise, Canada’s system of strong prudential regulation is considered to be efficient, independent, and well-functioning. On the other hand, the UK consolidated system, instituted in haste in an effort for broad reform, remains plagued by its failure to institute comprehensive structural integration. The thoughtful process of reform followed in Australia and Canada was bypassed during the hurried UK transition, leaving UK’s economy vulnerable during the financial crisis.[3]

The Federal Reserve as systemic risk monitor or regulator

Another advantage of creating a single federal prudential regulator is that it would enhance the independence of the Federal Reserve in making monetary policy. It gets the Fed out of the regulatory business and lets it concentrate on its main tasks. Chairman of the Federal Reserve Ben Bernanke has testified that he would like to see this micro-prudential authority for the systemically important institutions within the Fed. The record of the Fed as a regulator of bank holding companies is not very good, however. Several of the bank holding companies under Fed supervision faced severe problems in the crisis – its micro-prudential regulation was ineffective. In the past, bank regulation has existed as something of a poor relation at the Fed compared to the making of monetary policy. The Fed’s institutional focus is rightly on monetary policy, and micro-prudential responsibility would ultimately serve only as a distraction.

Instead the Fed is in a unique position to take on the macro side of prudential regulation, that of the systemic risk regulator, a responsibility that would well suit its purview of the overall stability and performance of the macro economy. The strong performance of the Fed in managing this crisis strongly suggests that this institution should be the primary systemic risk monitor/regulator. Moreover, this role is a natural extension of monetary policy, which can be thought of as the monitoring of, and response to, macro-economic developments. It fits with the dominant culture of economists and the Fed’s strong tradition of independence, which are both needed for systemic risk management to be effective.

For monitoring the economy and for making monetary policy the Fed needs, among other things, quick access to a broad base of financial information. Currently, the regulatory reporting is primitive. More complete, relevant and real time data should be available to all federal financial regulators.

To respond to specific systemic risks, the Fed needs another instrument in addition to its control over short-term interest rates. I suggest that Congress should grant the Fed the power to adjust minimum capital, leverage, collateral, and margin requirements generally in response to changing systemic risks, in addition to the specific power it has had to adjust margin requirements in stock trading since the Great Depression. The micro-prudential regulator would set basic minimum standards. The Fed would adjust a “multiplier” up or down as systemic circumstances required. This additional power should be used rarely and in small increments; recall how the Volcker-Carter credit restrictions stopped the US economy on a dime in 1980.

Conclusions

A single strong agency would meet the objective of micro prudential regulation of all financial institutions that were subject to regulation and supervision. It would work with state regulators, especially to make sure that the abuses that contributed to the crisis could not be repeated. It would work closely with the conduct of business regulators (the SEC and the CFPA) and the Federal Reserve to ensure that consumer protection is adequate, that monetary policymakers are well informed, and that all these institutions and the Treasury would work together effectively to deal with a new crisis should it occur in the future.

The Federal Reserve has shown its mettle in managing the crisis and should be given the role of principle systemic regulator or monitor. It should have the power to adjust borrowing rules prudently if it sees a bubble developing driven by excessive leverage.

The SEC is the natural institution to become the conduct of business regulator with a mandate to protect small and minority shareholders and, with a CFPA division, to protect consumers in financial markets. A single prudential regulator plus a single conduct of business regulator would constitute the so-called twin peaks approach to regulation that many experts around the world see as the best regulatory structure.

Though a necessary undertaking, it is important to bear in mind that structural reform is not a panacea. The experience of the UK with their single regulator, the FSA, should teach us that superficial restructuring can mask fundamental problems rather than address them outright. In the US, steps also need to be taken to toughen accountability, allowing for the censure or removal of regulators who do not perform. Regulators must also be provided with better compensation, a prospect difficult to stomach given regulators’ recent performance, but a step that should attract high-quality individuals who understand the complexity of modern financial institutions and products. Consolidated prudential regulators, coupled with conduct of business regulators in Canada and Australia, prove that the structure that I am proposing can be highly effective if undertaken thoughtfully and in combination with complementary fundamental reforms.

Many of the problems behind the recent crisis could have ultimately been caught by the market with clearer, more timely and more complete disclosures. Thus, an essential part of improving regulation is to improve transparency so that the market can exert its discipline effectively, together with a more effective system of regulation. It is time to bid good-bye to the alphabet soup of regulators that contributed to this financial crisis, and instead spell out a regulatory structure up to the task of describing the dynamism and complexity of the US financial system.

[1] Statement of John E. Bowman, Acting Director, Office of Thrift Supervision. http://www.house.gov/apps/list/hearing/financialsvcs_dem/bowman_-_ots.pdf

[2] Phil Mattingly, “Financial Regulations: Running the Risk,” CQ Weekly, June 8, 2009. http://www.cq.com/display.do?dockey=/cqonline/prod/data/docs/html/weeklyreport/111/weeklyreport111-000003136740.html@allnews&metapub=CQ-WEEKLYREPORT&searchIndex=1&seqNum=1

[3] Adriane Fresh and Martin Baily, “What does international experience tell us about regulatory consolidation?” Pew Financial Reform Project Briefing Paper # 6

http://www.pewfr.org/admin/task_force_reports/files/Fresh-Baily-International-FINAL.pdf