Comments on Financial Regulatory Reform

The financial regulatory reform bill that will be going to conference is a bit of a muddle.  Some aspects of it are necessary and others not so much; some provisions are oversold; and some needed reforms are not included.

Consumer Protection

On the plus side of the ledger, setting up a consumer financial protection agency, whether nominally housed in the Fed or fully “independent,” is an important provision.  The financial crisis began with a housing bubble, which would not have happened to the extent it did without inappropriate mortgages being offered to prospective house buyers.  The Federal Reserve failed in its consumer protection role, and other regulatory agencies did not get at this problem from the other side, safety and soundness.  In the absence of consolidating the regulatory agencies, this new agency should both serve to protect consumers and help to reduce systemic risk by preventing the large scale offering of loans individuals cannot afford unless everything goes right.  That is, it will do this if it is not overrun by the other regulatory agencies in the turf wars the new legislation is likely to encourage.  Also, for political reasons, it seems consumers will be less protected when it comes to auto loans offered by dealers.

Derivatives

Some of the derivatives provisions seem to be unnecessary and how meritorious they are can be debated.  They do broaden the turf of the CFTC and the SEC, which may be a good thing but could turn out badly if vicious turf wars develop.

Among the likely legislative outcomes is forcing standardized derivatives, such as interest rate swaps, to be traded on a central platform of some sort and to be submitted to a clearinghouse.  More complicated, customized derivatives, such as credit default swaps on particular securities, will probably not be subject to these requirements, since their lack of liquidity and customization make it too difficult to impose such requirements without in effect making these types of contracts illegal (which is probably the agenda of some participants in the debate).  The CFTC and the SEC will have new authority, though, to regulate customized derivatives, which will probably put these agencies in conflict with the bank regulators and perhaps with each other in cases where the jurisdictional lines between the two agencies is less than clear.

It is peculiar that the likely outcome is to impose more regulation on the plain vanilla derivatives, which have not been a source of major problems, than on more complicated, customized derivatives, which in the case of credit default swaps exacerbated the financial crisis.  The trading platform requirement for standardized derivatives may serve to improve transparency, though price information is available to those with the appropriate terminals, such as provided by Bloomberg.  One can argue both ways the merits of concentrating risk in a clearinghouse.  As for a provision that the U.S. government will never, ever bailout a derivatives clearinghouse, this lacks credibility for large, systemically important ones.  In a crisis, the government will find a way, if necessary by passing statutes, to do what it believes necessary.  Our recent experience demonstrates that.

It is also strange that the Treasury is apparently acquiescing in having the CFTC have a role in the OTC market for foreign exchange, including apparently options, unless the Secretary of the Treasury formally exempts them in writing.  It is not clear how regulation would work in an international market.  Moreover, dating back to the 1973 legislation creating the CFTC, the Treasury has consistently opposed the CFTC applying the Commodity Exchange Act ("CEA") to the wholesale OTC foreign exchange market, including options, and was able to get a provision in the 1973 statute known as the “Treasury Amendment” to attempt to attempt to accomplish this.  (In 1997, the Supreme Court decided in the Dunn case that the Treasury Amendment exclusion from the CEA included FX options.)

Resolution Authority

With respect to resolution authority for systemically important financial institutions, this is a useful authority for the government to have.  As it stands, the Bankruptcy Code process in certain situations is not ideal.  In the Long-Term Capital Management situation, the New York Fed successfully persuaded major Wall Street firms to fund a workout outside of bankruptcy in order to provide for an orderly wind down of the fund.  The Lehman bankruptcy caused market panic.  The provisions for close-out netting for certain types of financial contracts, including “swaps,” which provide an exemption from the Code’s automatic stay, were supposed to mitigate systemic risk.  In certain situations, though, these provisions may exacerbate it.  The problem is that, if a large institution fails, its counterparties may all rush to sell the underlying collateral for eligible contracts at the same time, thus causing a market problem.

It is, however, not clear how the resolution authority would work for large institutions which are failing and which have significant foreign operations subject to the laws and regulations of different countries.  It is also not clear in a financial crisis with more than one failing institution how long it would take for the FDIC to staff up sufficiently to handle multiple “resolutions.”  Improvisation, as we have witnessed, may be resorted to once again.

Whether improvisation is a “bail-out” depend on what one means by this inexact term.  Stockholders would almost certainly be wiped out, as they, to a large extent, have been for some of the large financial institutions, such as Citigroup.  Some uninsured creditors would likely fare better than others.  What happens to existing management is also a question.  It is not, though, credible to say that the government will never step in with funds or guarantees in a financial crisis.

What the legislation does not do is address the problem of regulatory capture and turf wars.  This is a serious problem about which I will have more to say.