U.S. Administration Provides Blueprint for a Brave New World of Financial Regulation

Financial regulation is expanded in a number of dimensions, including:

• Creation of an umbrella "Financial Services Oversight Council" chaired by the Treasury.
• New "National Bank Supervisor" for all federally chartered depository institutions.
• New "Consumer Financial Protection Agency."
• Federal Reserve will have general oversight responsibility for financial market infrastructure, including securitization and over-the-counter markets.
• Creation of an "Office of National Insurance" within the Treasury to enhance oversight of the insurance sector.

Financial regulation is also deepened in several critical areas:

• Supervisory responsibility for all bank and nonbank firms that pose systemic risks is assigned to the Federal Reserve, and these firms will be subject to bolstered capital and liquidity requirements.
• Registration of hedge funds and other private pools of capital with the SEC.
• Tighter regulation of securitization markets, including higher loan retention requirements and stronger regulation of credit rating agencies.
• Increased regulation of over-the-counter derivatives, including regulated, centralized clearing.
• New authorities for addressing the "too big to fail" flaw in the current system to allow for the orderly resolution of large bank holding companies when the stability of the financial system is at risk.

The federal thrift charter will be eliminated, and the Federal Reserve and FDIC will retain responsibility for regulation of state-chartered banks, while the National Credit Union Administration retains authorities for credit unions. With respect to the future role of government-sponsored enterprises (GSEs), the Treasury and Department of Housing and Urban Development will develop recommendations for Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.

Outlook

The blueprint for expanding and deepening the financial regulatory apparatus is sweeping and ambitious. It attempts to address a myriad of flaws in the legacy system that became all too apparent in the financial crisis that started in 2007, ultimately leading to a meltdown in the functioning of U.S. and international financial markets.

There are some easy "scores" in the blueprint, including assigning responsibility for supervision of systemically risky large banks and nonbanks to the Federal Reserve, and stiffening the capital and liquidity requirements for these firms. This just codifies what the Federal Reserve has been doing on a de facto basis since the bailout of Bear Stearns and AIG. Registration of hedge funds and other private capital pools is also an easy hit.

Enhanced regulation of securitization, over-the-counter markets, and credit-rating agencies moves up the scale in terms of degree of difficulty. These are areas that need significant attention, but processes of financial innovation have been able to skillfully elude numerous attempts to tighten regulatory oversight in the past. The Securities and Exchange Commission is the primary regulator of these markets, but the Fed now has general oversight of market infrastructure, so it is not clear where the buck stops in these areas under the new framework.

Creation of a consumer financial protection agency, while having obvious political resonance, risks increasing the regulatory burden without a major benefit in terms of increased efficiency or stability of the system overall. However, there is significant room to improve the education of the general public on the complexities of the modern financial system and financial products, an area that has been seriously neglected by the legacy regulatory and supervisory agencies.

But the really tough issues related to the "too big to fail" dilemma, increased concentration and barriers to entry in the sector, and the future role of the GSEs did not benefit from any new, creative thinking in the blueprint.

Since the financial system as a whole has become even more concentrated as a result of the crisis, these are two areas that cry out for more much more definition in terms of the direction the administration wants to take. Overall, this is a major initiative that has the potential to change the shape of financial regulation, and the structure of U.S. financial markets for years to come. But there is no discussion of the long-term structural and systemic issues related to even higher levels of concentration that has been created in certain parts of the industry, or the use of a critical "cost-benefit" benchmark on additional regulations.

The financial markets play too important a role in supporting the funding of new products, processes, and technologies for these key questions to be neglected.