More on the Volcker Alliance Financial Regulatory Proposals

In my previous post, I criticized the Volcker Alliance report, “Reshaping the Financial Regulatory System,” for essentially being the opening salvo in a turf fight between the Fed and the Treasury. Since I agree with the report authors that the financial regulatory system should be reformed, I was disappointed with some of their specific recommendations and the seeming underlying assumption that the Federal Reserve is the best regulatory agency around and should essentially be the lead agency except when there is a financial crisis and more political entities, such as Treasury need to get involved.

There are some other comments I have on the report’s recommendations that did not fit into the main theme of the previous post.

First, the report’s recommendation that the SEC and the CFTC be merged is one with which most disinterested observers have agreed for a long time. It has long been obvious that a mistake was made when the CFTC was created in the mid-1970s from its predecessor agency, the Commodity Exchange Authority, which was part of the Agriculture Department. The advent of futures on foreign currencies and subsequently other financial instruments, which were not covered by the Commodity Exchange Act (“CEA”) at that time, made some sort of change necessary. But rather than transferring authority for futures and “commodity” options to the SEC, the CEA was modified so that the definition of “commodity” encompassed potentially almost everything imaginable (with the amusing exception of onions), including securities and indices of all sorts, while leaving the definition of “futures contract” undefined. This first led to jurisdictional issues with the SEC, which were initially papered over with the Shad-Johnson Accord in December 1981 (named after the then chairmen of the SEC and the CFTC). I remember discussing the Shad-Johnson Accord with my boss at Treasury at the time. We concluded that it resolved some existing, troubling jurisdictional issues, but that it did not solve the jurisdictional problems due to the way the CEA could be interpreted and the overlapping interests of the two agencies. We were right. (Most significantly, the lack of definition of futures contracts led to a large public debate among the CFTC and other financial regulators about whether OTC swaps were covered by the CEA. This was never resolved and has been overtaken by various amendments to the statutes which the CFTC, the SEC, and the bank regulators administer. Another provision of the CEA, known as “the Treasury Amendment” led to a dispute between the Treasury and the CFTC about it jurisdiction over OTC foreign currency options. An aspect of that dispute went to the Supreme Court in a 1997 case in which Treasury was not a party. The CFTC lost, nine to zero.)

Given that most of the contracts the CFTC now regulates are financial, it has long made sense that the SEC and the CFTC be merged. For example, it makes no sense that stock index futures and options on stock index futures are regulated by the CFTC, while option on the same stock indices are regulated by the SEC. The political problem is that the CFTC falls under the jurisdiction of the Congressional agriculture committees, which do not want to cede their authority over the CFTC.

However, while the report is right in calling for a SEC/CFTC merger, the recommendation that some of the authority that now exists with these agencies should be transferred to a new regulator is more problematic. The report recommends that a new prudential supervisory authority (“PSA”) be “responsible for supervising broker-dealers, swap dealers, FCMs [futures commission merchants], and MMFs [money market mutual funds].” (p. 36) The new SEC-CFTC merged agency would have “the current rulemaking authority of the SEC and the CFTC with respect to matters of investor protection, the structure of securities and derivatives markets, and the integrity of those markets.” (p. 36) The report is silent about whether the SEC-CFTC agency would have any examination authority.

This structure looks like one asking for turf fights. Dividing the responsibility for the structure of markets, their integrity, and investor protection from responsibility for overseeing the principle market makers and conduit to the marketplaces is unlikely to work very well. One wonders why the authors of this report, after correctly identifying that merger of the SEC and the CFTC would improve the regulatory structure, then go on to weaken the combined agency and create other problems.

Another weakness of the report is the failure to address the insurance industry and the mortgage markets. The report specifically states that regulation of the insurance industry and the mortgage markets “are beyond the scope of [the] report.” (p. 5) Perhaps, the authors were perplexed about what to do in this area, because there has no decision about Fannie Mae and Freddie Mac and reforms to insurance regulation means taking on state regulatory agencies. Nevertheless, this is a significant weakness in the report since both the mortgage market and an insurance holding company were heavily involved in the 2008 financial crisis. The involvement of the mortgage market does not require any elucidation here. With respect to insurance, an affiliate of AIG took on more risk than it can handle from other financial institution through the use of credit default swaps. This turned out to be a major problem during the financial crisis. AIG was nominally regulated by the Office of Thrift Supervision (“OTS”) as a savings and loan holding company because it owned a savings and loan, but OTS did not (and probably did not have the capacity) to do much supervision of AIG. The Dodd-Frank legislation abolished OTS and merged it with the OCC. The savings and loan holding company responsibilities were transferred to the Fed. An insurance company could fall under some federal oversight under Dodd-Frank if it is deemed to be a systemically important financial institution even if it does not own a thrift institution, but, given the large role insurance companies play in the financial system, the report’s omission of any discussion or recommendations of how they should be regulated is significant.

Another important omission of the report is the lack of any discussion of the too-big-to-fail issue, which has arguably gotten worse after the financial crisis. The report also does not discuss whether the contention that the resolution procedures of Dodd-Frank would work, especially for large, complex, international financial institutions subject to the courts and differing legal systems of multiple jurisdictions.

Finally, fewer regulatory agencies, as this report recommends (though in a flawed manner), may mitigate the regulatory capture problem but will not eliminate it. For example, of all the regulatory agencies, the Fed is the most powerful and the most able to withstand both political and industry pressure, but the evidence suggests that it is not immune from regulatory capture. (The Carmen Segarra tapes are one example; the decision to pay AIG swap counterparties in full is possibly another.)  Paul Volcker is someone ideally situated to think about and make recommendations about what to do about regulatory capture. I hope he will.

As it is, though, the Volcker Alliance is going to have to do better to contribute meaningfully to consideration of changes in the U.S. financial regulatory structure. The current report is, unfortunately, disappointing.