Saturday, June 20, 2009

Obama's financial market regulation plan

In order to redress and turn back "a culture of irresponsibility (that) took root from Wall Street to Washington to Main Street", the Obama administration has finally unveiled the draft of its much awaited financial market regulation plan that would broadly expand the scope (to include "other large firms that pose a risk to the entire economy in the event of failure") of the Federal Reserve to regulate financial risk. The draft plan includes proposals for raising the amount of the financial cushion that institutions must hold against losses, setting new conflict of interest rules for credit rating agencies, imposing new requirements that banks hold on their own books a percentage of the mortgages they issue to discourage the marketing of abusive or ill-suited loans, besides a new institutional framework.

The plan identifies many regulatory failures - capital and liquidity requirements did not require firms to hold sufficient capital to cover trading assets, high-risk loans, and off-balance sheet commitments, or to hold increased capital during good times to prepare for bad times; regulators did not take into account the harm that large, interconnected, and highly leveraged institutions could inflict on the financial system and on the economy if they failed; the responsibility for supervising the consolidated operations of large financial firms was split among various federal agencies, and even allowed owners of banks and other insured depository institutions to shop for the regulator of their choice; investment banks operated with insufficient government oversight, money market mutual funds were vulnerable to runs, and hedge funds and other private pools of capital operated completely outside of the supervisory framework.

It therefore proposes five key objectives (also here)

1. Promote robust supervision and regulation of financial firms. It is proposed to have a Financial Services Oversight Council of financial regulators to identify emerging systemic risks and improve interagency cooperation; authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability, even those that do not own banks; stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms; National Bank Supervisor to supervise all federally chartered banks; elimination of the federal thrift charter and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve; registration of advisers of hedge funds and other private pools of capital with the SEC.

2. Establish comprehensive supervision of financial markets to withstand both system-wide stress and the failure of one or more large institutions. It is proposed to have enhanced regulation of securitization markets (which supply roughly two-thirds of the credit in the economy, with banks providing the rest, through loans), including new requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that issuers and originators retain a financial interest (amounting to atleast 5% of loans packaged) in securitized loans; comprehensive regulation of all over-the-counter derivatives; a new authority for the Federal Reserve to oversee payment, clearing, and settlement systems.

3. Protect consumers and investors from financial abuse. It is proposed to have a new Consumer Financial Protection Agency to protect consumers across the financial sector from unfair, deceptive, and abusive practices; stronger regulations to improve the transparency, fairness, and appropriateness of consumer and investor products and services; a level playing field and higher standards for providers of consumer financial products and services, whether or not they are part of a bank.

4. Provide the government with the tools it needs to manage financial crises. It is proposed to have a new regime to resolve non-bank financial institutions whose failure could have serious systemic effects; revisions to the Federal Reserve’s emergency lending authority to improve accountability.

5. Raise international regulatory standards and improve international cooperation. It is proposed to promote international reforms to support our efforts at home, including strengthening the capital framework; improving oversight of global financial markets; coordinating supervision of internationally active firms; and enhancing crisis management tools.

However, the plan does not contain any proposals for drastic overhaul of rating agencies, whose conflicts of interest were at the heart of the financial market crisis. It does not alter the issuer-pay model, whereby the companies selling securities pay to have them rated, nor does it encourage competitors to enter the industry, which many regard as an oligopoly. The reforms proposed are restricted to regulators relying on more independent analysis, and calls on them to reduce their reliance on agency ratings when deciding whether structured investments are safe enough for banks, insurance companies, pension funds and money market mutual fund investors. The plan is also silent on what steps are required to better align executive compensation practices of financial firms with long-term shareholder value.

Apart from imposing the 5% retention of loans (the adequacy of which is itself questionable) on the issuers balance sheet for securitization of assets and setting up a clearinghouse for "bespoke" derivatives (customized, one-of-a-kind products that generated enormous profits for institutions), so that their price and trading activity can be more readily seen, the plan does not contain anything aimed at specific categories of derivative assets like CDS or CDOs. In the absence of standardization, and atleast some form of homogenity, customized (and thereby illiquid products with opacity in price discovery, irrespective of what clearinghouse prices indicate) products will continue to play a major role in the financial markets, with all their attendant risk quantification problems.

The highest risk, "too big to fail" financial institutions, labeled "Tier 1 Financial Holding Companies" in the draft plan, will continue to exist and grow. Only, they are proposed to be regulated more "robustly". There is little in the plan about "how the government will eliminate systemic risks posed by financial firms that aren’t allowed to fail because they’re simply too big or to interconnected to other important economic players here and abroad". As Eric Dash asks rhetorically, "If It’s Too Big to Fail, Is It Too Big to Exist?". But the Obama plan has answered in the negative and proposed greater oversight and regulation of such institutions. Quoting the work of Edward J. Kane, Gretchen Morgenson argues that such regulatory oversight only means "expanding the universe of companies eligible for taxpayer support if another mess arose".

Simon Johnson feels that intense lobbying by the finance industry has meant that the "reform process appears to be have been captured at an early stage". He writes that many of the proposals are mere re-iterations of the existing arrangements and inspire little confidence of success. Paul Krugman feels that the only redeeming feature of the draft plan is in bringing the shadow banking system under the regulatory architecture and giving the government the authority to seize such institutions if they appear insolvent.

Reactions to the draft plan are available here, here, and here. Though the plan is hosrt on details, as Joe Nocera rightly points out, there is nothing dramatic about the plan - "additional regulation on the margin, but nothing that amounts to a true overhaul".

Update 1
Thomas Frank critiques the Obama Plan on the grounds that it does not address the issue of regulatory capture. Mark Thoma argues that while most markets function well with minimal regulation, and that a hands off approach is generally best, financial markets are not among the markets for which this is true.

Martin Wolf drives home the importance of changing incentives so as to discourage traders and bankers from taking on too much risk and refers to the role of executive compensation in causing the crisis, as brought out by Lucian Bebchuk and Holger Spamann.

Update 2
On the controversial issue of regulating derivatives, the Plan proposes that complicated, illiquid derivatives should require higher margins from customers and that as much derivative trading as possible be pushed into standardized (instead of illiquid customized products), exchange-traded contracts.

Richard Bookstaber, one of the pioneers with financial engineering in the Wall Street, has described derivatives as providing "a means for obtaining a leveraged position without explicit financing or capital outlay and for taking risk off-balance sheet, where it is not as readily observed and monitored... Viewed in an uncharitable light, derivatives and swaps can be thought of as vehicles for gambling; they are, after all, side bets on the market". They let institutions dodge taxes and accounting rules and take side bets that could destabilize the markets.

Further, contrary to conventional wisdom that claimed derivatives as allowing risks to be transferred to those better able to bear them, experience had shown that "derivatives allow risk to be shifted from those who understand it a little to those who do not understand it at all" (the risks of bad mortgage loans were transferred from those who made the loans to those who bought troubled collateralized debt obligations).

Update 3
Simon Johnson too feels that "too big to fail" is "oo big to exist" and feels that the Obama Plan does little to alleviate this fear. Also see the Senate hearings video on "too big to fail" institutions.

Update 4
Douglas Elliot of the Brookings Institution reviews the Regulation proposals.

Update 5
Alan Blinder weighs in arguing that the Federal Reserve should be the systemic risk regulator, to serve as an early-warning-and-prevention system, on the prowl for looming risks that extend across traditional boundaries and are becoming large enough to have systemic consequences. Alice Rivlin and Mark Thoma too support much the same.

Update 6
Two excellent posts, here and here, in Baseline Scenario about financial market regulaiton.

Update 7
Alan Blinder points to five reasons for the inertia against financial market regulation. He also identifies three important financial market regulation proposals - a systemic risk monitor or regulator (and he favors Fed); a new mechanism to euthanize or rehabilitate giant financial institutions whose failure could threaten the whole system; and do something serious to tame, though not to destroy, the derivatives markets.

Mark Thoma too feels that as time passes the resolve to pass strong enough regulation proposals will fade away.

Update 8
The Obama Plan passes the House of Reps and moves to the Senate. The House Bill’s principal provisions establish a process for dismantling large, failing financial institutions; set up a council to identify and regulate firms that are so big, interconnected or risky that they need heightened supervision to keep them from bringing down the whole financial system; create a new consumer financial-protection agency to squelch unfair and abusive practices; and for the first time, regulate over-the-counter derivatives markets. The bill also contains provisions on executive pay, investor protection, credit ratings, hedge funds and insurance.

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