IN-DEPTH ANALYSIS
Treasury Releases White Paper Proposing Significant Financial Regulatory Reform
INTRODUCTION:
On June 17, 2009 the Treasury released a white paper entitled "Financial Regulatory Reform - A New Foundation: Rebuilding Financial Supervision and Regulation" (the "Proposal") which outlined the Obama Administration's ambitious plan to reform extensively the U.S. financial regulatory system. If adopted in its entirety, the Proposal will result in wide-ranging changes that will affect every corner of the financial markets and the financial regulatory landscape. For example, the Proposal would alter or eliminate several of the more significant recent legislative initiatives including the "functional regulation" regime of the Gramm-Leach-Bliley Act of 1999 (the "GLBA") and the interstate branching approval process of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the "Riegle-Neal Act"). The Obama Administration hopes to sign legislation enacting the provisions of the Proposal by the end of 2009. Rep. Barney Frank, Chairman of the House Financial Services Committee, has set regulatory reform hearings for the next several weeks and has indicated that he wishes to pass legislation in the August congressional recess. Senator Chris Dodd, Chairman of the Senate Banking Committee, has indicated that he does not want to take up any legislation until the fall in order to prioritize health care legislation. Given this legislative timeline, the deadlines for many of the reports called for in the Proposal may be difficult to achieve.
This edition of the Alert examines each section of the Proposal in depth and discusses significant provisions that may not appear in more abbreviated summaries. Section I through IV also provide commentary on some of the initial reactions to the Proposal by members of Congress and the financial services industry.
I. FINANCIAL REGULATORY AGENCY AND OVERSIGHT REFORM
Background. Currently, there are four federal bank regulatory agencies: OCC (national banks), FRB (bank holding companies ("BHCs") and state member banks), OTS (thrifts) and FDIC (state nonmember banks and back-up regulator of insured banks). A few weeks ago, Treasury Secretary Geithner suggested that the Proposal might consolidate this federal bank regulatory oversight into a single new agency, and extend its reach into other significant nonbank financial services firms.
In part because of Congressional and other criticism, the Proposal does not go quite that far, but still arguably proposes the most significant change to the federal oversight of financial services firms since the Great Depression. To provide context to these proposed changes, the Proposal first describes the four principal shortcomings in the current regulatory regime that the Obama Administration believes were at the core of the financial crisis: (1) regulators imposed insufficient capital and liquidity requirements, particularly as to off-balance sheet and trading assets; (2) in their oversight, regulators did not take into account the harm that the failure of a large, complex financial institution could have on the economy; (3) because of the division of supervision of large firms among many agencies and the number of bank charter types available, firms had fragmented, uncoordinated oversight and could "shop" for the ideal regulatory supervision; and (4) there was insufficient or no oversight over significant non-bank focused financial enterprises such as investment banks, money market funds, hedge funds and other private pools of capital. To address these perceived shortcomings, as described in more detail below, the Proposal would create a new umbrella oversight council, expand the FRB's authority over banking firms and significant nonbank financial institutions, increase the capital and supervision of the largest financial firms, and eliminate the OTS.
A. Creation Of Financial Services Oversight Council
To address the need for coordinated agency oversight and identification of emerging risks, the Proposal would create the Financial Services Oversight Council (the "Council"). The Secretary of Treasury would serve as the Council's Chairman, and membership would also include representatives of a broad range of agencies, including the SEC, the CFTC, the FHFA, and the new federal banking and consumer protection agencies described in Sections I.D and III.A. below, respectively.
Role Of The Council. The Council (with a broader membership than the FFIEC, which only includes bank and credit union regulators) is emblematic of the Administration's focus on identifying and overseeing activities and interrelationships across the financial services industry. The Council's mandate also reflects this mission, as it is intended to: (1) facilitate coordination of administrative actions and information sharing across agencies; (2) facilitate the evaluation of cross-industry products and trends; and (3) identify gaps in regulation and emerging risks in the economy. In addition, the Council will assist the FRB in connection with the FRB's identification and prescription of regulations applicable to the most systemically important financial institutions ("Tier 1 FHCs", as discussed further in Section I.B. below) and with the FRB's identification of firms where resolution may be appropriate. The Council does not, however, have any enforcement powers or direct authority over financial institutions and other regulators.
Council Information Gathering Authority. To enable it to fulfill its role, the Proposal would provide the Council with broad information gathering authority. The Council would be permitted to require reports from any U.S. financial services firm, although the Proposal is careful to note that the Council would obtain information only to determine if a particular activity or market in which the firm participates poses a threat to financial stability.
B. Increased Supervision And Regulation Of Large Financial Firms
The Proposal clearly places a lot of the blame for the current crisis around the sudden failures of large U.S. firms (e.g., AIG) that "were large, highly leveraged, and had significant financial connections to the other major players in our financial system, yet ... they were ineffectively supervised and regulated."
Tier 1 FHC Identification. To address this issue, the Proposal advocates sweeping new authority for the oversight (principally, via the FRB) and regulation of "any firm whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed" (a so-called "Tier 1 Financial Holding Company" or "Tier 1 FHC"). Notably, by its terms the Proposal does not limit Tier 1 FHCs to institutions that own banking enterprises, or to domestic financial institutions (as discussed in Section V.B. below).
Although not detailing specific criteria, the Proposal states the following factors should be relevant to determining Tier 1 FHCs: (1) the impact the firm's failure would have on the economy; (2) the firm's size, leverage and reliance on short term funding; and (3) the firm's importance as a source of credit for businesses, government and households, and as a source of liquidity for the financial system. However, unlike, for example, Basel II (which has defined criteria for "core banks"), the Proposal wants the FRB to have the discretionary power to designate firms as Tier 1 FHCs, so that an enterprise cannot avoid the designation by adjusting its balance sheet or operations. The Proposal suggests that the FRB should conduct stress tests in analyzing whether a firm qualifies as a Tier 1 FHC.
Though the Council would have the ability to recommend that certain firms be designated as Tier 1 FHCs, the final determination rests solely with the FRB. As part of its responsibility to identify Tier 1 FHCs, the Proposal recommends that the FRB have the ability to conduct limited examinations of any U.S. financial firm that meets a certain minimum size threshold and cannot otherwise be determined to be a Tier 1 FHC.
Justification Of The FRB Role. As discussed above, the Proposal provides the FRB with broad authority to identify and oversee Tier 1 FHCs. Recognizing that many in Congress, including Senator Dodd, have questioned the ability and/or desirability of having the FRB serve in that role rather than a council of regulators (such as the Council, described above), the Proposal devotes considerable attention to explaining why "ultimate responsibility for prudential standard-setting and supervision for Tier 1 FHCs must rest with a single regulator." The FRB was selected because it "has by far the most experience and resources to handle consolidated supervision and regulation of Tier 1 FHCs." Moreover, the Proposal likely creates, and provides a coordinating role to, the Council to assuage Congressional critics of an "FRB-only" approach.
The Proposal calls for the FRB to fundamentally adjust its current holding company supervisory framework in order to effectively regulate Tier 1 FHCs. The FRB would need to expand its focus and regulations beyond the safety and soundness of banking subsidiaries to address the activities of the organization as whole and the risks the organization presents to the financial system. The Proposal asks that the FRB, in consultation with the Treasury, propose recommendations by October 1, 2009, to align its structure and governance with the authority contemplated by the Proposal.
Prudential Standards For Tier 1 FHCs. The Proposal demands heightened supervision and regulation of Tier 1 FHCs. The FRB would develop prudential standards for Tier 1 FHCs, in consultation with the Council. At a minimum, these standards would be equal to those necessary for a firm to maintain financial holding company status (which would be strengthened under the Proposal as discussed in Section I.C. below) and include heightened capital requirements, liquidity standards, risk management standards and public disclosures. Tier 1 FHCs that do not control a depository institution would be subject to all of the prudential regulations and guidance applicable to BHCs, including those requiring the separation from commercial activities. Those Tier 1 FHCs that were not previously subject to the Bank Holding Company Act of 1956, as amended ("BHC Act"), would have five years to conform to these activity restrictions. All Tier 1 FHCs would be subject to a prompt corrective action regime and would need to maintain a rapid resolution plan.
Consolidated Supervision. The Proposal would give the FRB the authority to supervise and examine a Tier 1 FHC and all of its subsidiaries, including those that have another primary regulator. The Proposal thus aims for a significant re-direction from the "functional regulation" at the heart of the GLBA. Under the Proposal, the supervision of Tier 1 FHCs would not focus solely on the safety and soundness of individual enterprises, but also on the impact of the failure of a Tier 1 FHC on the entire financial system. Accordingly, the Proposal would require each Tier 1 FHC to regularly report the nature and extent to which other major financial firms are exposed to it. The FRB would also be tasked with monitoring the concentration of risk with all Tier 1 FHCs as a group, even if no single institution appears to be at risk.
C. Strengthened Capital And Prudential Standards For Banks And Bank Holding Companies
Reviews Of Current Regulatory Standards. The Proposal calls for the Treasury to establish a working group to review the capital requirements for banks and BHCs, including Tier 1 FHCs, and issue a report by December 31, 2009. This review would include changes to reduce procyclicality, a cost/benefit analysis of allowing banks and BHCs to issue contingent capital instruments to satisfy regulatory capital requirements (such as convertible debt triggered by economic circumstances), increases in regulatory capital requirements on investments and other high-risk exposures (including trading positions, equity investments, low-quality credit exposures, asset-backed securities, mortgage-backed securities, exposures to off-balance sheet exposures and OTC derivatives which are not centrally cleared), and more transparent measures of leverage. The Proposal does not discuss the affect of this proposal on the relatively recently completed Basel II capital rules (or proposed Basel IA). In addition to the working group that would review capital requirements, the Treasury would lead a separate working group that would conduct a fundamental reassessment of the supervision of banks and BHCs. This working group would issue a report by October 1, 2009 that would address key problems and gaps in the current regulatory framework.
Executive Compensation Reforms. The Administration has advocated executive compensation reforms and proposed new standards and guidelines intended to align executive compensation with long-term shareholder value and prohibit incentives for risk taking. For additional discussion of these executive compensation reforms, see the June 16, 2009 Alert. The Proposal reiterates the call for such standards and also expresses support for "say on pay" legislation requiring non-binding shareholder resolutions on executive compensation.
Consolidated Capital And Management Requirements. Currently, subsidiary depository institutions of financial holding companies are required to be well-capitalized and well-managed in order for a holding company to maintain financial holding company status. The Proposal would extend these requirements to financial holding companies on a consolidated basis (current FRB regulations include the concept of a "well-capitalized" BHC, but do not mandate it for FHC status).
Review Of Accounting Standards. The Proposal calls for the Financial Accounting Standards Board, International Accounting Standards Board and the SEC to review accounting standards and adopt more forward-looking loan loss provisioning practices. Such forward-looking practices would be designed to result in higher loan loss provisions earlier in the credit cycle and reduce procyclical tendencies. The Proposal also call for a review of fair value accounting rules to identify changes that could provide users of financial reports with both fair value information and greater transparency regarding the cash flows that management expects to receive by holding investments.
Additional Affiliate Transaction Restrictions. The Proposal also would increase the existing affiliate transaction restrictions of Sections 23A and 23B of the Federal Reserve Act by placing more constraints on OTC derivates and securities financing transactions with affiliates. Covered transactions would be required to be fully collateralized throughout the life of the transaction. Transactions between banks and private investment vehicles sponsored or advised by the banks would be considered covered transactions.
D. Creation Of National Bank Supervisor, Elimination Of The Thrift Charter And Bank Holding Company Act Revisions
Creation Of The National Bank Supervisor. The Proposal also creates a new National Bank Supervisor ("NBS"). The NBS would have the sole authority with respect to federally charter banks and would thereby assume the prudential supervision and regulation responsibilities currently held by the OCC and the OTS. The FRB and FDIC would retain their respective oversight of state member and non-member banks and the NCUA would continue to charter and supervise federal credit unions.
Elimination Of The Thrift Charter. The Proposal eliminates the thrift charter. Citing the convergence of thrift and bank powers and changes in the markets for mortgage financing, the Proposal concludes that a strong rationale for the thrift charter no longer exists. Existing thrifts would be subject to "reasonable transition arrangements," which could include conversion to a national or state bank charter.
The elimination of the thrift charter is also intended to reduce the risk of regulatory arbitrage. To this end, the Proposal calls for a reduction in the differences between the regulations applicable to federally- and state-chartered banks and for restrictions on the ability of a troubled bank to switch charters.
Interstate Branching. The Proposal disposes of the interstate branching framework of the Reigle-Neal Act by giving national and state-chartered banks the unrestricted ability to branch across state lines that is currently held only by federal thrifts. States would no longer be allowed to prevent de novo branching or impose a minimum age requirement for an in-state bank to be acquired by an out-of-state bank. The Proposal would, however, retain all consumer protection and deposit concentration caps related to interstate banking.
BHC Act Revisions. The BHC Act does not currently apply to companies which own certain types of depository institutions (thrifts, industrial loan companies, credit card banks, sole-purpose trust companies, and grandfathered "nonbank" banks). With the elimination of the thrift charter, all savings and loan holding companies would become BHCs subject to the BHC Act. The Proposal would amend the BHC Act to include holding companies of industrial loan companies, credit card banks, trust companies and grandfathered "nonbank" banks, thus effectively eliminating most of these institutions. However, when discussing trust companies the Proposal specifically refers to FDIC-insured depository institutions, which would suggest that holding companies of non-depository trust companies (at least state-chartered trust companies) would continue to fall outside the BHC Act.
E. Eliminate SEC's Programs For Consolidated Supervision
The Proposal calls for the elimination of the SEC's two supervision regimes for companies that own SEC-registered securities broker-dealers – the regime for consolidated supervised entities ("CSEs") and the regime for supervised investment bank holding companies ("SIBHCs"). These regimes were established pursuant to a provision of the GLBA requiring consolidated supervision for investment bank holding companies. Most major stand-alone investment banks opted into either the CSE or SIBHC regime in order to demonstrate to European regulators that they were subject to consolidated supervision by a U.S. federal regulator (several large commercial banking organizations also opted in to either the CSE or SIBHC regime). The failure or acquisition of Bear Stearns, Lehman Brothers and Merrill Lynch last year, and the subsequent conversion of Goldman Sachs and Morgan Stanley into BHCs, lead the SEC to abandon the voluntary CSE regime in the fall of 2008. Currently, only one entity is subject to supervision under the SIBHC regime. Accordingly, the Proposal recommends that the CSE and SIBHC regimes be eliminated and any investment banking firm seeking consolidated supervision by a U.S. regulator should be subject to comprehensive supervision and regulation by the FRB.
F. Require Registration Of Advisers To, And Regulatory Reporting By, Private Pools Of Capital Including Hedge Funds, Private Equity And Venture Capital Funds
Under the Proposal, all advisers to private pools of capital, including hedge funds, private equity funds and venture capital funds (collectively, "private funds"), whose assets under management exceed "some modest threshold" would be required to register with the SEC under the Investment Advisers Act of 1940. "All investment funds advised by an SEC-registered investment adviser" would be subject to (a) recordkeeping requirements, (b) requirements regarding disclosures to investors, creditors and counterparties and (c) regulatory reporting requirements, with the SEC able to vary the particular requirements depending on the type of fund. Funds would be subject to regular, periodic examinations by the SEC to monitor compliance with these requirements. Regulatory reporting would be on a confidential basis and would encompass (1) assets under management, (2) borrowings, (3) off-balance sheet exposures, and (4) other information deemed necessary to assess whether a fund or group of related funds is so large, highly leveraged, or interconnected that it poses a threat to financial stability. The SEC would share fund regulatory reports with the Federal Reserve, which would determine whether a fund or fund group meets the Tier 1 FHC criteria, in which case it would be supervised and regulated as such (see Section I.B. above).
Separate from the Proposal, three bills already have been introduced in Congress to address the issue of hedge fund regulation – S. 344, which would effectively require any private fund with more than $50 million to register with the SEC as an investment company; HR. 711, which like the Proposal seeks to register private fund advisers by eliminating the registration exemption for advisers that do not hold themselves out to the public as investment advisers and who have fewer than 15 clients (the "private adviser exemption"); and S.1276, which also seeks to register private fund advisers (by narrowing the private adviser exemption to apply only to non-U.S. advisers with less than $25 million in assets) and enables the SEC to impose recordkeeping requirements on private funds similar to those contemplated by the Proposal. HR. 711 has received industry support from the Managed Funds Association and Alternative Investment Management Association. The Managed Funds Association has also expressed broad support for the Proposal and its private fund adviser registration and reporting component in particular, as has the Private Equity Council. The National Venture Capital Association has opposed the application of the private fund adviser registration and reporting element of the Proposal to venture capital firms because it believes they do not present significant risks to the financial system.
G. Money Market Fund Regulatory Reform
Citing the need to reduce the susceptibility of money market funds to "runs" by investors, the Proposal encourages the SEC to consider requiring all money market funds to: (a) maintain substantial liquidity buffers; (b) reduce the maximum weighted average maturity of their portfolios; (c) tighten their credit concentration limits; (d) improve their credit risk analysis and management of portfolio assets; and (e) empower their boards to suspend redemptions in extraordinary circumstances in order to protect the interests of fund shareholders. The Proposal also asks the President's Working Group on Financial Markets to prepare a report by September 15, 2009 to consider changes that would more directly address the systemic risks posed by money market funds, such as whether money market funds should be (1) permitted to maintain a stable net asset value per share or (2) required to obtain access to reliable emergency liquidity facilities from private sources.
Most of those proposals generally are consistent with some of the recommendations made by the money market working group of the Investment Company Institute (the "ICI") (discussed in the April 28, 2009 Alert). The SEC's Chairman recently has hinted that the SEC staff is working on proposals similar to those put forth by the ICI. Neither the SEC nor the ICI, however, has proposed that money market funds no longer be permitted to maintain stable net asset values, a change likely to face stiff industry opposition.
The Proposal addresses unregulated unregistered and offshore funds that participate in the U.S. money markets in a very limited manner; it only directs the SEC to consider ways to mitigate the adverse effect of investor flight to unregulated or less regulated money market investment vehicles in response to increased registered money market fund regulation. Notably, the Proposal does not suggest, as the Group of 30 did in January 2009, that money market funds be required to reorganize as special purpose banks.
H. Creation Of Office Of National Insurance Within Treasury
Significantly broadening the currently limited federal mandate with respect to insurance, the Proposal would establish the Office of National Insurance (the "ONI").
- The ONI would be responsible for monitoring all aspects of the insurance industry, in particular to identify emerging problems or gaps in regulation that could contribute to a future crisis and to identify to the Federal Reserve any insurance companies that should be considered for supervision as Tier 1 FHCs.
- The ONI would also carry out the federal government's current responsibilities under certain existing programs, such as the Terrorism Risk Insurance Act.
- On the international level, the ONI would be empowered to work with other nations and within the International Association of Insurance Supervisors (the "IAIS") to represent U.S. interests at the national level and would have the authority to enter into international agreements. The creation of the ONI would also address compliance with recent European Union legislation that will require a foreign insurance company operating in EU member states to be subject to supervision in the company's home country comparable to the supervision required in the EU.
Although the Proposal calls for increased national uniformity as one of its six principles of insurance regulation, it stops short of calling for an optional federal charter. Instead, the Proposal calls for increased uniformity through either "a federal charter or through effective action by the states." The Proposal notes that although some steps have been taken to increase uniformity, they have been insufficient.
Interested groups will continue to weigh in on the best way to achieve uniformity. For example, the American Council of Life Insurers issued a statement strongly supporting an optional federal charter as the only way to achieve the Treasury's objectives. The National Association of Insurance Commissioners issued a statement commending the President and the Treasury for proposing a plan that preserves the role of states as regulators of insurance.
The Proposal identifies the following additional principles that would guide the Treasury's approach to insurance regulation:
- Effective regulation of the systemic risks posed to the financial system by the insurance industry
- Strong capital standards and an appropriate match between capital allocation and liabilities for all insurance companies (including the management of liquidity and duration risk)
- Meaningful and consistent consumer protection for insurance products and practices (citing a wide variance in the protections currently provided by the states)
- Improvement in, and broadening of, the regulation of insurance companies and affiliates on a consolidated basis, including those affiliates outside of the traditional insurance business
- International coordination
I. Future Of Government Sponsored Enterprises
The Proposal includes an initiative to develop recommendations on the future of Fannie Mae and Freddie Mac. The Treasury and the Department of Housing and Urban Development ("HUD") are called on to solicit input from other government agencies and the public on possible options. Options range from conducting business as usual to eliminating Fannie Mae and Freddie Mac altogether. Options specifically mentioned in the Proposal include: (1) returning both entities to their previous status of pursuing the paired interests of maximizing shareholder returns and promoting home ownership; (2) winding down the entities' operations and liquidating assets; (3) incorporating Fannie Mae's and Freddie Mac's functions into a federal agency; (4) transitioning their operating model to a "public utility model" where the government regulates the entities' profit margin and fee structure, and backs their commitments; or (5) splitting Fannie Mae and Freddie Mac into many smaller companies. The Treasury and HUD will report back to Congress on viable options at the time the President's 2011 budget is released.
J. Some Initial Reactions
Almost every element of Section I of the Proposal received both favorable and unfavorable reactions and comments. One aspect that raised a great deal of concern from Congressmen and others was the dramatically increased authority that would be granted to the FRB under the Proposal. Some stated that the performance of the FRB over the past few years did not warrant the grant of a broadened regulatory role. In addition, FDIC Chairman Sheila Bair stated that having the FRB handle monetary policy while regulating systemic risk could lead to situations in which there were significant conflicts of interest. In response, the FRB and others noted that, under the Proposal, the FRB would not only be gaining authority, it would be ceding its authority to regulate BHCs' and banks' consumer products and services. Moreover, some commentators argued that the Council should be able to do more than merely advise the FRB of its views. Others question whether the Proposal, and specifically the increased role of Treasury, have the undesirable consequence of weakening the independence of the FRB.
A number of Congressmen and others stated that even if the OTS is mingled into another regulatory agency, there may be merit in preserving the thrift charter. In addition, there was a mixed reaction to the Proposal's failure to reduce the total number of federal banking agencies. Furthermore, there appeared to be a general recognition that the Proposal's increased capital requirements and heightened level of regulation would tend to reduce profitability in the banking industry.
II. COMPREHENSIVE REGULATION OF FINANCIAL MARKETS
A. Securitization Market Reforms
Risk Retention By Loan Originators/ABS Sponsors. In order to provide sufficient incentives for lenders and sponsors of asset backed securities ("ABS") to consider the performance of the underlying loans after ABS are issued, the Proposal calls on federal banking agencies to promulgate regulations that would require loan originators or sponsors of ABS to retain 5% of the credit risk of the underlying instruments and prohibit originators from directly or indirectly hedging or otherwise transferring the required risk retention. The federal banking agencies should have the ability to specify the permissible forms of required risk retention (e.g., first loss position or pro rata vertical slice) and the minimum duration of the required risk retention, as well as the ability to grant exceptions or adjustments to those requirements.
Aligning Compensation Of ABS Market Participants With Underlying Loans' Longer Term Performance. The Proposal urges measures to link the compensation of market participants to the longer-term performance of the securitized assets, rather than only to the production, creation or inception of those products. Appropriate measures cited in the proposal include:
- Accounting changes already under consideration that would require originators to recognize income over time in lieu of an immediate recognition of gain at the inception of a securitization transaction, which would also have the effect of requiring many securitizations to be consolidated on the originator's balance sheet and their asset performance to be reflected in the originator's consolidated financial statements.
- Requiring that the fees and commissions received by loan brokers and loan officers be disbursed over time and reduced in the event of underwriting or asset quality problems.
- Requiring sponsors of securitizations to make standardized representations and warranties regarding the risk associated with the origination and underwriting practices for the securitized loans underlying ABS.
Increased Transparency And Standardization Of ABS Markets And More Robust Reporting By ABS Issuers. Under the Proposal, the SEC would increase the reporting requirements applicable to ABS issuers to expand the availability to investors and credit rating agencies of information that would enable them to assess the credit quality of the assets underlying a securitization transaction at inception and over the life of the transaction, as well as the information necessary to assess the credit, market, liquidity, and other risks of ABS. Specifically, the Proposal would require disclosure of loan-level data (broken down by loan broker or originator) and the nature and extent of broker, originator and sponsor compensation and risk retention for each securitization. The Proposal also urges standardization of legal documentation for securitization transactions, which should include uniform rules for servicers to modify home mortgage loans under appropriate circumstances, if such modifications would benefit the securitization trust as a whole. Trade reporting for ABS should be added to FINRA's TRACE reporting system for corporate bond transactions.
Additional Regulation Of Credit Rating Agencies. The Proposal urges the SEC to adopt additional regulations applicable to credit rating agencies to require (1)(a) better management and disclosure of conflicts of interest, (b) better differentiation of ratings applied to structured debt from those applied to unstructured debt, (c) disclosure of credit rating performance measures and the types of risk credit ratings they are designed to assess, and (d) disclosure of methodologies used to assign ratings to structured debt, and (2) reporting by credit rating agencies of any unpublished rating agency data and methodologies to the SEC. The SEC has already undertaken rulemaking initiatives with respect to credit rating agencies that address some of the Proposal's recommendations in this area (as discussed in the December 9, 2008 Alert).
Reducing Reliance On Credit Ratings In Regulations And Supervisory Practices. Consistent with its recommendations with respect to other aspects of aspects of the securitized products markets, the Proposal would have regulators modify regulations and supervisory practices to better recognize the potential differences in performance between structured and unstructured credit products with the same credit rating, particularly in risk-based regulatory capital requirements. In this regard, the Proposal urges attention to the concentrated systematic risk of senior tranches and re-securitizations and the risk of exposures held in highly leveraged off-balance sheet vehicles, and calls for regulatory capital requirements to minimize opportunities for firms to use securitization to reduce their regulatory capital requirements without a commensurate reduction in risk.
B. Comprehensive Regulation Of All OTC Derivatives, Including Credit Default Swaps (CDS)
The Proposal advocates comprehensive regulation of the OTC derivatives markets, including CDS markets, to achieve the following four objectives: (1) containing the systemic risk posed by those markets; (2) promoting their efficiency and transparency; (3) preventing market manipulation, fraud, and other market abuses; and (4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.
Containing Systemic Risk. Under the Proposal, the Commodities Exchange Act (the "CEA") and the securities laws would be amended to require clearing of all standardized OTC derivatives through regulated central counterparties ("CCPs"). CCPs would be required to impose robust margin requirements and other risk controls. Mechanisms would be implemented to ensure that customized OTC derivatives cannot be used solely as a means to avoid using a CCP, for example, by creating a presumption that an OTC derivative accepted for clearing by one or more fully regulated CCPs is a standardized contract that must be cleared. OTC derivatives dealers and other firms whose activities in the OTC derivatives markets create large exposures to counterparties should be subject to conservative capital requirements (more conservative than the existing bank regulatory capital requirements for OTC derivatives), business conduct standards, reporting requirements, conservative requirements relating to initial margins on counterparty credit exposures and prohibitions addressing unacceptable counterparty risks associated with customized bilateral OTC derivatives transactions. As noted elsewhere in the Proposal, part of this regulatory regime would include increasing regulatory capital requirements for all banks and BHCs on OTC derivatives that are not centrally cleared.
Transparency And Efficiency. The Proposal would increase the transparency of the OTC derivatives markets by amending the CEA and the securities laws to authorize the CFTC and the SEC to impose recordkeeping and reporting requirements (including an audit trail) on all OTC derivatives. Proposed changes would also include public reporting of aggregate data on open positions and trading volumes and the availability of data on any individual counterparty's trades and positions on a confidential basis to the CFTC, SEC and the institution's primary regulators. The trading of standardized OTC derivatives would be moved onto regulated exchanges where they would be subject to regulated transparent electronic trade execution systems and timely reporting of trades and prompt dissemination of prices and other trade information. Regulated financial institutions would be encouraged to make greater use of regulated exchange-traded derivatives.
Market Integrity. Under the Proposal, the CEA and the securities laws would be amended to ensure that the CFTC and the SEC, consistent with their respective missions, have clear, unimpeded authority to police and prevent fraud, market manipulation, and other market abuses involving all OTC derivatives. The CFTC would also have authority to set position limits on OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets.
Protecting Unsophisticated Parties. Upon completion of reviews currently being conducted by the CFTC and SEC regarding participation limits, the Proposal recommends that the CEA and the securities laws be amended to tighten the limits or to impose additional disclosure requirements or standards of care with respect to the marketing of derivatives to less sophisticated counterparties such as small municipalities.
C. Harmonization Of Futures And Securities Regulation
The Proposal focuses principally on achieving consistent regulatory treatment of economically equivalent instruments regardless of whether they are subject to SEC, CFTC or combined jurisdiction. Unlike many prior recommendations for regulatory reform, the Proposal does not call for the consolidation of the SEC and the CFTC. The proposed harmonization instead would include an agreement by the SEC and the CFTC on precise core principles of regulation. Consistent procedures would be developed for reviewing and approving proposals for new products and rulemaking proposals by self-regulatory organizations.
The Proposal recommends that the SEC and CFTC complete a report to Congress, by September 30, 2009, that (1) identifies all existing conflicts in statutes and regulations related to similar types of financial instruments and (2) provides either proposed changes to reconcile the differences or explanations justifying them. If the SEC and CFTC do not reach agreement by September 30, 2009, the Proposal calls for the Council (described in Section I.A., above) to address the differences and make recommendations within six months of its formation.
D. Oversight And Functioning Of Systemically Important Payment, Clearing, And Settlement Systems And Activities
The Proposal identifies the strength of the systems for settling payment obligations and financial transactions among institutions as a key determinant of the risks posed by the interconnectedness of financial institutions. According to the Proposal, where such systems are weak, they can spread financial contagion. For this reason, the Proposal seeks to strengthen oversight of systematically important payment, clearing, and settlement systems ("covered systems") and systematically important payment, clearing, and settlement activities of financial firms ("covered activities").
The Proposal would give the FRB authority to identify covered systems and covered activities and to establish risk-management standards for their operations. The FRB also would possess authority to collect information from any payment, clearing, or settlement system or financial firm engaged in payment, clearing, or settlement activity for the purpose of assessing their systematic importance.
Systematically important systems would be subject to "rigorous on-site safety and soundness" examinations and prior reviews of changes to their rules and operations. Such reviews would conducted by a principal market regulator (e.g., the CFTC or SEC), if one exists, but the FRB would have the right to participate in the exams. The FRB also would have enforcement authority and the right to receive reports from systematically important systems. In instances where there is a principal market regulator, the FRB's enforcement authority and power to require reports would be shared with that regulator, but the FRB would have the reserve authority to take actions if it disagrees with the positions of the principal market regulator.
The FRB would be granted similar authority over covered activities at financial firms. Compliance with standards for covered activities would enforced by the firm's primary federal regulator (if applicable) with the FRB having back-up examination and enforcement authority. The FRB would be able to require reports on the conduct of covered activities from firms engaging in such activities.
E. Settlement Capabilities And Liquidity Resources Of Systemically Important Payment, Clearing, And Settlement Systems
In addition to the enhanced oversight of covered systems discussed in Section II.D. above, the Proposal would grant covered systems access to the discount window and FRB accounts and financial services. Access to the discount window would be reserved for emergency purposes, to prevent liquidity crises.
F. Some Initial Reactions
Both Congressmen and other commentators have been supportive of the Proposal's focus on increased regulation of derivatives transactions; however, a number of commentators have stressed that it is the "customized" derivatives and not the plain vanilla derivatives that damaged the financial system and that, under the Proposal, it will be only the plain vanilla derivatives that will be required to be traded on an exchange.
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