In response to the recent financial crisis and the on-going world-wide recession, on June 17, 2009, President Obama announced the outline of a far-reaching plan to reform the regulation and oversight of the U.S. financial system (the Reform Plan), which, if implemented in its current form, would have significant ramifications on U.S. financial institutions of all types. In announcing the Reform Plan, the President asserted that, even though the financial crisis has had many causes, the government could have done more to prevent the crisis from threatening the overall economy. While this remains open to debate, what is clear is that the Reform Plan would fundamentally re-order the financial regulatory system and substantially expand the federal government's role in regulating firms providing financial services.
At this stage, the Reform Plan is merely a set of proposals which are not binding unless and until Congress passes legislation that is signed into law by the President. However, given the severity of the on-going recession and the political momentum in Washington for increased regulation and government intervention in the financial system, it is likely that many of the President's proposals set forth in the Reform Plan will become law sooner rather than later. That being said, it is vitally important for financial institutions to understand the proposals in the Reform Plan so that management can respond quickly and decisively to the changes in the regulatory environment at least some of which are sure to come. This alert summarizes the principal aspects of the Reform Plan as announced by the President on June 17.
I. OVERVIEW OF THE REFORM PLAN
The Reform Plan has five basic components: (1) requiring consolidated supervision and regulation of all financial firms that pose a significant risk to the overall financial system; (2) increasing the federal government's supervision over financial markets, including the securitization and derivatives markets; (3) creating a Consumer Financial Protection Agency to focus on protecting consumers in credit, savings, and payment markets; (4) providing the federal government with new tools to manage future financial crises so that we are not left with the choice between the bailout or financial collapse of systemically important firms; and (5) raising international regulatory standards and improving international coordination. Each of these components is summarized below.
A. Consolidated Supervision And Regulation Of Financial Firms
The Reform Plan calls for the creation of a new Financial Services Oversight Council within the Executive branch to identify emerging risks posed by firms whose failure could pose a systemic risk to the financial system (referred to as Tier 1 FHC's in the Reform Plan). The new council would also have the responsibility to improve cooperation, information sharing, and coordination among the various financial services regulatory agencies.
The Reform Plan also proposes new authority for the Federal Reserve to regulate and supervise all Tier 1 FHC's that could pose a threat to financial stability, including firms that do not own banks. The Federal Reserve would be required to apply certain criteria in identifying and supervising Tier 1 FHC's, including capital, liquidity, and risk management standards. In this regard, the Reform Plan proposes that each Tier 1 FHC should be subject to consolidated supervision by the Federal Reserve, extending to the parent company and to all of its subsidiaries (regulated and unregulated). However, functionally regulated and depository institution subsidiaries of a Tier 1 FHC will continue to be supervised primarily by their functional or bank regulator, as the case may be.
Also as part of the first component of the Reform Plan, the Treasury Department and federal regulators will be required to impose stronger capital and prudential standards on all financial firms, with even higher standards imposed on large, interconnected firms. In this regard, a working group headed by the Treasury Department will conduct a fundamental reassessment of the existing regulatory capital requirements for and supervision of banks and bank holding companies, which will issue its conclusions by Dec. 31, 2009. The Reform Plan also encourages federal regulators to issue guidelines for executive compensation practices of financial firms, and encourages legislation requiring all public companies to hold non-binding "say-on-pay" shareholder votes. It is also proposed that the accounting standards for loan-loss provisioning and fair value accounting be reviewed and strengthened by the agencies involved in setting accounting standards (i.e., the FASB, International Accounting Standards Board, and SEC).
In one of the more important aspects of the Reform Plan, the President is proposing the creation of a new National Bank Supervisor to regulate all federally-chartered depository institutions, and, in this connection, to eliminate the federal thrift charter. Moreover, the Reform Plan calls for the consolidated supervision by the Federal Reserve of all companies that control an insured depository institution, and to subject all of these institutions' non-banking activities to the restrictions of the Bank Holding Company Act of 1956, as amended.1 As a result of these proposals, all thrift holding companies, industrial loan companies, credit card banks, trust companies, and grandfathered "non-bank" banks would be subject to supervision by the Federal Reserve.
The Reform Plan also proposes changes to the regulation of hedge funds, private equity funds, venture capital funds, money market mutual funds, and insurance companies. Under the proposals, all advisers to hedge funds and other private capital pools (such as private equity and venture capital funds) whose assets under management exceed an as yet undetermined threshold will be required to register with the SEC under the Investment Advisers Act of 1940.2 This registration requirement presents a sea-change in the regulation and supervision of private capital vehicles and should be of substantial importance to all private capital managers. In this regard, the Reform Plan also calls for private advisers to report to the SEC information on the funds they manage in order to assess whether any fund poses a threat to financial stability.
With respect to money market mutual funds, the Reform Plan encourages strengthening the regulatory framework around these funds to reduce their credit and liquidity risk profiles and to make the industry as a whole less susceptible to runs. In the insurance sector, the Reform Plan proposes the creation of a new Office of National Insurance within the Treasury Department to gather information, develop expertise, negotiate international agreements, and coordinate policy within the insurance industry.
B. Increased Supervision Of Financial Markets
Under the second component of the Reform Plan, the President proposes enhanced regulation of securitization markets, credit rating agencies, and over-the-counter (OTC) derivatives. With respect to securitization markets, loan originators would be required to retain an economic interest in a material portion of the loans they securitize, and the SEC would be given increased authority to require "robust reporting" and disclosure by issuers of asset-backed securities. The Reform Plan also encourages the SEC to strengthen the regulation of credit rating agencies, including measures to manage and disclose conflicts of interest, differentiate between structured and other products, and generally strengthen the integrity of the ratings process.
Additionally, all OTC derivatives markets, including the market for credit default swaps, would be subject to comprehensive regulation under the Reform Plan, with the primary purpose of preventing activities in these markets from posing an overall risk to the financial system. The Reform Plan also calls for the harmonization of futures and securities regulation between the CFTC and SEC, and giving the Federal Reserve the authority to conduct oversight of systematically important payment, clearing, and settlement systems. As the legislative process moves forward, the details of the precise terms of these proposals will be filled-in.
C. Consumer Protection
The third component of the Reform Plan involves increasing the regulation and supervision of consumer financial products and services, including credit cards and mortgages. In this regard, the Reform Plan proposes the creation of a new Consumer Financial Protection Agency (the CFPA) to act as the single primary federal consumer protection supervisor to protect consumers from unfair, deceptive, and abusive practices and to regulate the providers of consumer financial products and services. Under the proposals, the CFPA would have sole rule-making authority with respect to consumer financial protection statutes, and also would have supervisory and enforcement authority over all persons covered by consumer protection statutes, including insured depository institutions. The CFPA also would be given a broad mandate to require stronger and more straightforward disclosures to consumers regarding offered financial products, it would be authorized to place tailored restrictions on product terms and financial institution practices with respect to consumer financial products and services, and it would be authorized to impose appropriate duties of care on financial intermediaries.
The Reform Plan also proposes the expansion of the SEC's authority to promote transparency in investor disclosures, including by establishing a fiduciary duty for broker-dealers offering investment advice and by harmonizing the regulation of investment advisers and broker-dealers. The proposals also would expand protections for whistleblowers, increase enforcement sanctions, and require non-binding "say-on-pay" shareholder votes on executive compensation.
D. New Tools To Manage Financial Crises
Under the fourth component of the Reform Plan, the President proposes the creation of a new resolution regime for failing bank holding companies and Tier 1 FHC's modeled after the existing resolution regime for insured depository institutions under the Federal Deposit Insurance Act (the FDIA). The new resolution regime would supplement, and not replace, the FDIA's current regime, but it would provide the federal government with expanded powers to address the potential failure of a bank holding company or other non-bank financial firm, such as AIG or Bear Stearns, when the failure of such a firm would place the stability of the financial system at risk. The details of this expanded resolution authority are uncertain at this time, but they are sure to become clearer as the legislative process moves forward.
In addition, the Reform Plan proposes the amendment of Section 13(3) of the Federal Reserve Act3 to require the Federal Reserve to obtain the prior written approval of the Secretary of the Treasury for any extensions of emergency credit to individuals, partnerships, or corporations under the Fed's "unusual and exigent circumstances" authority.
E. International Standards
Under the fifth component of the President's proposals, the Reform Plan proposes a variety of international reforms to strengthen the capital framework of financial institutions, improve oversight of global financial markets, coordinate the supervision of internationally active firms, and enhance cross-border crisis management tools. Many of these reforms will be coordinated through the G-20 group of industrialized nations and the Basel Committee on Banking Supervision. More specifically, the proposals will include (i) a recommendation that the Basel Committee modify and improve Basel II by refining the risk weights applicable to the trading book and securitized products, introducing a supplemental leverage ratio, and improving the definition of capital by the end of 2009; (ii) urging other countries to standardize and improve the oversight of credit derivative and other OTC derivative markets (in particular through the use of central counterparties); and (iii) enhance the supervision of internationally active financial firms through a variety of tools, including the establishment of international supervisory authorities, improvement of information sharing and other cross-border crisis management initiatives, promotion of aligned executive compensation standards, improve the consistency of fair value accounting standards across borders, and tighten the oversight of credit rating agencies.
II. CONCLUSION
While the Reform Plan is still in its nascent stages, it is very likely that the proposals contained in the plan will form the basis of comprehensive financial system reform legislation which will pass Congress and be signed into law by the President before the end of 2009. This legislation will present a sea-change in the regulatory system that most financial institutions have been accustomed for years, and the management teams of financial firms should be prepared for the coming changes.
Footnotes
1. 12 U.S.C. § 1841 et seq.
2. 15 U.S.C. § 80b-1 et seq.
3. 12 U.S.C. § 321 et seq.
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