The Obama Financial Regulation Reform Proposal: The Good and the Not-So-Good

Given the financial debacle of the past two years -- and the macroeconomic trauma that has accompanied it -- a comprehensive financial regulation reform proposal from the Obama Administration was inevitable. To paraphrase Rahm Emanuel, "Never let a financial debacle go to waste."

In that respect, the proposal that was released in mid-June did not disappoint. Its 88 pages address a broad spectrum of financial regulatory issues.

No commentary can do full justice to those 88 pages, and I will not try. Instead, I will focus on a few of the major pieces of the proposal.

The proposal gets some major things right (including admirable restraint in not proposing a few measures that have been widely discussed in the financial press and on Capitol Hill). But, alas, it also gets some major things wrong. It is "two steps forward -- and one and a half steps back." Overall, the proposal probably would yield a net gain. But that net gain is a great deal smaller than it needed to be.

I'll start with the good things in the proposal (including those admirable absences), and then turn to the clinkers.

The Good

1. A prudential regulatory regime for large, systemically important financial institutions. This is surely the most important feature of the Obama proposal. If we (U.S. taxpayers) are going to continue to "throw" large sums of money at fragile financial institutions, so as to avoid the systemic consequences of their failure, then we must regulate them so as to greatly reduce the likelihoods that they will (again) take the risks that would yield the sizable losses that would (again) require large sums from taxpayers.

This prudential regulation -- which already exists for banks and other depository institutions and for insurance companies, and which is different in form, substance, and spirit from (say) consumer safety regulation or from regulatory limits on pricing -- must include the following elements:

a) Risk-related capital requirements (with capital measured through the use of market-value accounting), and prompt corrective action when those requirements are breached;

b) Limitations on the activities that these institutions can undertake;

c) Managerial competence requirements;

d) Tight monitoring of the financial flows between the regulated entity and its parent (and affiliates, customers, suppliers, friends, etc., of its parent);

e) Adequate numbers of well-trained, well-paid, and well-supported regulatory personnel to enforce the regulation; and

f) A receivership regime for insolvent institutions (more about this below).

The regulatory requirements must be rigorous and even onerous. After all, if the covered entities are going to present a potential claim on the public treasury, their regulation should not only reduce the likelihood of this occurring but also make the financial institutions reluctant to place themselves in this regime in the first place. Equivalently, the systemic risk of a financial institution is a negative externality vis-a-vis the rest of society -- comparable to industrial pollution. A tax on pollution is a well understood method of dealing with negative externalities; a tax, or its regulatory equivalent, on systemic risk is equally appropriate.

This prudential regulatory regime should apply to all large financial institutions unless they are already covered by an effective prudential regime. Thus, large bank holding companies, insurance holding companies, investment banks, finance companies, hedge funds, and mutual funds should be covered. Exactly what size and degree of interconnectedness (i.e., systemic-ness) will qualify a financial institution for inclusion should be decided by the regulator.

And who should that regulator be? The Obama proposal nominated the Federal Reserve, which would also receive advice from a "Financial Services Oversight Council." However, piling more financial regulatory responsibilities on the Fed, which has not handled its current prudential oversight of bank holding companies especially well, would be a mistake. A new agency, which should be embedded in the Treasury, so as to retain Executive Branch authority and responsibility, would be a better choice.

2. Establish a receivership regime for these large, systemically important financial institutions. This proposal ranks a close second. Among the things that have made public actions so difficult with respect to the large troubled financial institutions is that only a bankruptcy process was available for many of them -- and the Lehman Brothers bankruptcy in September 2008 showed how ugly that procedure could be. The contrast of the disruption caused by the Lehman bankruptcy with the far smoother transfer of Washington Mutual -- a large thrift institution on which the Federal Deposit Insurance Corporation could use its receivership powers -- into the arms of JPMorgan Chase ten days after the Lehman bankruptcy, is striking.

Why are receivership powers important? Because of the more controlled environment. Rather than subjecting the resolution of a large, complex, insolvent financial institution to the vagaries of a bankruptcy judge, a receivership places the insolvent institution under the aegis of a regulatory agency (currently the FDIC, which is the best candidate for this expanded authority) with well developed and well understood procedures. Also, unlike a bankruptcy procedure, where the debtor organization's owners and management continue to have important representational rights, a receivership washes away the owners and almost always the senior management as well -- as is appropriate for an insolvent institution where the public treasury may well be asked to make up the shortfall.

To drive this point home, consider the public policy dilemma of dealing with Citigroup. As a first approximation, Citi is a $1.1 trillion (in assets) bank, on top of which sits a $700 billion holding company. The FDIC could probably execute a receivership of the bank -- but then the holding company would have to declare bankruptcy (since there currently is no receivership regime for bank holding companies). Given the fallout from the Lehman bankruptcy, hardly anyone wants to see what the bankruptcy of the $700 billion Citi holding company would look like; and thus any FDIC receivership of Citibank is currently out of the question.

3. Modest reorganization of the financial regulatory agencies. The Obama proposal wisely avoids any widespread organizational restructuring of the financial landscape. The proposal limits itself to the elimination of the Office of Thrift Supervision and the consolidation of the OTS's regulation of thrift institutions with the Office of the Comptroller of the Currency's regulation of commercial banks into a new National Bank Supervisor.

The current regulatory structure is a near-indescribable tangle of overlapping and duplicative federal and state agencies and functions. There are overlapping responsibilities and jurisdictional disputes galore. Indeed, any attempt to diagram the multiple agencies and their responsibilities would look far more complicated than a 1930s radio wiring diagram. The duplication and delays of this arrangement certainly add to both private and public sector costs. The temptations to propose far greater consolidation must have been great.

Restraint was wise, however, for at least three reasons: First, multiple agencies mean that there are multiple places where someone with a new idea -- a financial innovation -- can go for approval. Despite the regulatory failings of the past few years, including the failure to deal more forcefully with the downside of some recent financial innovations (such as the sub-prime residential mortgage-backed securities), financial innovation is generally a positive and productive force and should be encouraged. Having multiple regulators to which an innovator can turn -- so that a single regulatory "no" need not mean a lost innovation -- is an important safety valve. Monopoly in the public sector has its drawbacks, just as does monopoly in the private sector.

Second, although the current regulatory structure surely would not arise if a "clean sheet" regulatory structure were being designed, deliberate duplication and redundancy are often designed into complex systems, such as a modern passenger jet aircraft. Since a modern financial system may well be as complex as a modern jet, the duplication and redundancy ought to be recognized as having value.

Third, even if a major reorganization had merit, there would inevitably be bureaucratic confusion and possibly even chaos in its implementation. Now is not a good time for regulatory confusion.

4. No return to Glass-Steagall. Again, the proposal shows wise restraint in avoiding a call to resurrect the barrier between commercial banking and investment banking that the Glass-Steagall Act of 1933 had erected and that the Gramm-Leach-Bliley Act of 1999 had finally (after three decades of erosion by Federal Reserve decisions) eliminated. Almost all of the damage and mistakes by financial institutions of various kinds could have (and would have) happened even if GLBA had not become law.

The Not-So-Good

1. More regulation of the credit rating agencies. The three large U.S.-based credit rating agencies -- Moody's, Standard & Poor's, and Fitch -- and their excessively optimistic ratings of subprime residential mortgage-backed securities -- played a central role in the financial debacle. The Obama proposal calls for greater regulatory efforts to deal with the agencies' conflicts of interest (as exemplified by their "issuer pays" revenue model) and to increase the transparency of their ratings and of the methodologies underlying the ratings. The Securities and Exchange Commission has already been moving in this direction and will likely do more, regardless of the fate of the Obama proposal.

This effort figuratively to grab the three agencies by the lapels, shake them, and shout "Do a better job!" is understandable. But it is misguided. The heightened regulation of the agencies is likely to discourage entry, rigidify existing procedures, and discourage innovation in new technologies, methodologies, and models (including new business models) -- and may well not achieve the goal of inducing better ratings from the agencies.

There is a better route. That route starts with the recognition that the centrality of the three major rating agencies for the bond information process was mandated by decades of prudential financial regulation that stretch back to the 1930s. In that decade, bank regulators specified that banks could not hold "speculative" bonds -- that the only bonds in which they could invest had to be "investment grade" -- as determined by the rating agencies. In essence, the judgments of these third-party debt raters as to the creditworthiness of debt obligations had acquired the force of law!

Over the following decades, other financial regulators -- e.g., state insurance regulators, federal pension fund regulators, and the SEC -- followed with similar requirements that their regulated financial institutions must heed the agencies' ratings, thus strengthening the force-of-law attributes of those ratings. The SEC compounded the problem in 1975 by becoming a major barrier to entry into the rating business.

It should thus come as no surprise that when these (literally) handful of rating firms stumbled badly in their excessively optimistic ratings of the subprime RMBS, the consequences were serious.

But, rather than trying to force them by fiat to improve, a better route would be to bring market forces directly to bear. That route must start with the elimination of the force of law from agencies' ratings. Although the regulatory requirements for banks (and insurance companies, pension funds, money market mutual funds, etc.) to have safe bond portfolios should remain in place, the burden for demonstrating the safety of those portfolios should be placed directly on those financial institutions (just as it is currently, for example, with respect to banks' loan portfolios). Since financial institutions could then call upon a wider array of sources of advice on the safety of their portfolios (as well as doing the appropriate research themselves), the bond information market would be opened to innovation and entry in ways that have not been possible since the 1930s.

2. Eliminate the industrial loan company charter. The ILC charter, which exists in a few states (most notably Utah), allows a commercial or industrial company to own a bank. The Obama proposal calls for the elimination of the ILC charter, even though ILCs were not involved in the debacle.

The ILCs are a beneficial exception to federal policy, which (for the past 50 years) has insisted that a bank holding company can engage only in finance-related activities. The idea is to separate "finance" from "commerce." However, there is no such barrier when individuals own a bank. Thus, it is legal for the local car dealer to own a bank; but it is illegal for AutoNation, Inc. (a publicly traded company that owns multiple car dealerships) to own a bank.

There is nothing inherently wrong with the concept of an industrial or commercial company owning a bank. The potential problems -- those of self-dealing, whereby the bank favors the owner (or the customers or suppliers or friends of the owner) -- are no more serious if AutoNation, Inc. owns a bank than if the local car dealer owns a bank.

U.S. bank regulators already understand the self-dealing problem and have rules in place to forestall it. Those rules would be equally effective against large owners as well as small.

Instead of eliminating the ILC charter, a far better path would be to expand it and make it the presumptive federal model. With an expansion of the ILC charter, more competition -- the good kind -- could enter banking. The array of financial services that would be offered to low- and moderate-income households would likely expand if Wal-Mart -- which tried to enter banking through an ILC charter a few years ago, but was rebuffed by the FDIC -- could bring its business model to banking.

Also, by expanding the ILC charter, the FDIC would have more parties to whom it could turn when offloading costly insolvent banks -- of which there have been 53 so far this year, and dozens (or perhaps hundreds) more to come.

3. No recommendation as to the future of Fannie Mae and Freddie Mac. The hybrid public/private model that these two large companies embodied for the secondary mortgage market has clearly proved to be a failure. They were put into conservatorships in September and have been the insolvent wards of the Federal Housing Finance Agency ever since.

The Obama proposal only describes an array of future possibilities for these two enterprises, promising a specific recommendation next February. It is disappointing that the proposal didn't advocate true privatization of the two companies, combined with a modest program of on-budget targeted subsidies (and financial counseling) for first-time home buyers among low- and moderate-income households.

4. Failure to propose a federal insurance charter. Insurance chartering and regulation are the responsibilities of the 50 states. By creating a federal chartering and regulatory option for the insurance industry, a dual system for insurance that would roughly track the dual system that has been in place for banking since the 1860s, would be possible. The Obama proposal mentions a federal charter as a possibility but disappointingly doesn't advocate it.

5. Create a Consumer Financial Protection Agency. The proposed CFPA has the possibility of protecting "widows and orphans" households from financial products that they don't understand and that can "explode" and injure them (financially). Some of this clearly has happened during the debacle of the past few years, although these types of "accidents" were not the major fuel for the debacle. Further, since the "compliance" regulatory function (which encompasses this kind of consumer protection regulation) is usually a "second-class citizen" within the existing bank regulatory agencies (which focus much more on prudential regulation), there is some logic to separating these efforts in a separate agency.

However, there are some major drawbacks to the creation of a CFPA. First, there is the great risk that it will squelch -- or at least retard -- financial innovation. Second, in the interests of promoting simplified financial products, more complex products that can be appropriate for some households may be neglected. Third, the separation of compliance from prudential regulation runs the risk that the former could undercut the latter.

On balance, a better route than a CFPA would be an increased emphasis on simplified disclosure, fiduciary obligations, suitability requirements, and financial counseling, coupled with an enhanced status for the compliance function within the regulatory agencies.

A Summing Up

On balance, the pluses in the Obama proposal do outweigh the minuses; but that is a far closer call than it needed to be.

Lawrence J. White is the Arthur E. Imperatore Professor of Economics at the Stern School of Business, New York University, and Deputy Chair of Stern's Economics Department. He has taken leave from NYU to serve in the U.S. Government three times: During 1986-1989 he was a Board Member on the Federal Home Loan Bank Board; during 1982-1983 he was the Chief Economist of the Antitrust Division of the U.S. Department of Justice; and in 1978-1979 he was a Senior Staff Economist on the President's Council of Economic Advisers. Among his publications is The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation (Oxford University Press, 1991); and he is the co-editor (with John E. Kwoka, Jr.) of The Antitrust Revolution: Economics, Competition and Policy, 5th edition. (Oxford University Press, 2009).