After months of consultation with the President's Working Group on Financial Markets, Members of Congress and a range of constituent groups, the Obama administration has issued a proposal ("Proposal") that, if adopted, will result in a significant restructuring of the US financial regulatory system.1 In light of the numerous press reports over the last few days, many aspects of the Proposal are not surprising. Yet it is still ambitious in many respects. For example, it gives the Federal Reserve unprecedented powers over certain entities that had previously operated with little oversight. On the other hand, it stops short of calling for an optional federal charter for insurance or for a merger of the Securities and Exchange Commission ("SEC") with the Commodity Futures Trading Commission ("CFTC"). It remains to be seen whether the administration will be able to help forge a consensus of support around the proposal–among the affected industries and consumer groups and in the affected committees in the House and in the Senate–that will see it through to enactment in this session of Congress.
The Proposal creates four new federal entities: (i) a Financial Services Oversight Council ("Council"), chaired by Treasury and including the heads of the principal federal financial regulators; (ii) a Consumer Financial Protection Agency ("CFPA"); (iii) a National Bank Supervisor ("NBS"); and (iv) an Office of National Insurance ("ONI") within Treasury to "promote national coordination in the insurance sector."
The Proposal is designed to meet five main objectives. The administration will propose legislation where necessary to establish the new entities and accomplish the goals of:
- Promoting robust supervision and regulation of financial firms;
- Establishing comprehensive supervision and regulation of all financial markets;
- Protecting consumers and investors from financial abuse;
- Improving tools for managing financial crises; and
- Raising international regulatory standards and improve international cooperation.
This alert is organized by reference to each of these main objectives.
I. Robust Supervision and Regulation of Financial Firms
The Federal Reserve Board ("Fed") will be responsible for macro-prudential consolidated supervision over all firms that could pose a risk to the system as a whole. In addition, the new Council, comprised of the Secretary of the Treasury and the heads of all the relevant functional regulators, will monitor firms and markets for micro-prudential risk. Functional regulation will be strengthened, but will remain with the functional regulator, with some modifications.
A. Financial Services Oversight Council
A new Financial Services Oversight Council will be created as an independent agency to facilitate and coordinate information sharing, fill gaps in supervision, identify emerging micro-prudential risks and inform the Fed where such risks could pose a systemic threat, and provide a forum for jurisdictional disputes among regulators.
Proposed legislation will give the Council authority to gather information from any financial firm and the responsibility for referring emerging risks to the appropriate regulatory body for response.
The Council will be chaired by Treasury and will maintain a permanent staff at Treasury. Its membership will include: (i) the Secretary of the Treasury, who will serve as the Chair; (ii) the Chairman of the Fed; (iii) the Director of the new NBS; (iv) the Director of the new CFPA; (v) the Chairman of the SEC; (vi) the Chairman of the CFTC; (vii) the Chairman of the Federal Deposit Insurance Corporation ("FDIC"); and (viii) the Director of the Federal Housing Finance Agency ("FHFA"). Reporting to the Council will be a new Financial Consumer Coordinating Council ("FCCC") as well as the SEC's Investor Advisory Committee, which will be given permanent status.
B. Heightened Consolidated Supervision and Regulation for Tier 1 FHCs
All financial firms whose combination of size, leverage and interconnectedness could pose a systemic threat if they were to fail ("Tier 1 FHC") would be subject to the Fed's consolidated supervision and regulatory oversight, regardless of whether they own a depository institution.
The Fed will be required to follow new statutory guidelines for identification of Tier 1 FHCs. These guidelines would generally relate to size, leverage, and the importance of an entity as a source of credit for the public. The focus of such consolidated supervision would be macro-prudential, i.e., it would consider risk to the system as a whole.
The Gramm-Leach-Bliley Act ("GLB Act") currently limits the Fed's authority over functionally regulated subsidiaries of financial holding companies. These restraints will be removed and consolidated supervision of a Tier 1 FHC will extend to the parent company and to all of its subsidiaries, whether US or foreign and whether regulated or unregulated.
Tier 1 FHCs will be subject to higher capital, liquidity and risk management standards than other firms. All banks and bank holding companies, however, will be required to strengthen their capital and other prudential standards as well. Treasury will coordinate a working group to reassess regulatory capital requirements for all banks and BHCs, and will issue a report by the end of 2009.
Functionally regulated and depository subsidiaries of Tier 1 FHCs will continue to be regulated primarily by their functional or bank regulator, although the Fed will be permitted to require reports from, examine, and impose stricter prudential requirements or activity limitations on such subsidiaries. Treasury will coordinate a working group to reassess bank and BHC supervision and will issue a report by the end of the year.
The Fed will be required to propose recommendations to revise its structure in accordance with its new responsibilities by October 1, 2009.
C. Capital and Other Prudential Standards for all Banks and BHCs
In addition to enhanced regulatory capital requirements for all banks and BHCs, the Proposal requires all financial holding companies ("FHCs") to meet capital and management requirements on a consolidated basis. The SEC's Supervised Investment Bank Holding Company ("SIBHC") program will be eliminated. Investment banking firms that seek consolidated supervision by a US regulator will be subject to comprehensive supervision and regulation by the Fed.
The Proposal also requires new executive compensation standards and guidelines for all financial firms consistent with the proposal issued by Treasury last week.2
The Proposal makes various recommendations regarding accounting matters, including that by the end of 2009, US and international standard setters improve standards for loss-provisioning to mitigate procyclicality, and that they clarify and make consistent fair value accounting standards, including standards regarding impairment of financial instruments. "Substantial progress" should be made by the end of the year toward development of a single set of high quality global accounting standards.
As part of more rigorous prudential oversight, the Proposal calls for stronger firewalls between banks and their affiliates. It underscores the importance of the current limits and controls on certain transactions between a bank and its affiliates under Sections 23A and 23B of the Federal Reserve Act, and it proposes some specific additional restrictions.
In particular, it proposes (i) to add more constraints on bank's OTC derivatives and securities financing transactions with affiliates, (ii) to require full collateralization of covered transactions for the life of the transactions, and (iii) to expand the scope of the existing restrictions to transactions between a bank and all private investment vehicles sponsored or advised by the bank. It also limits the Fed's discretion to provide exemptions from firewall requirements and directs the Fed and banking regulators to consider additional regulation of potential conflicts of interest between banks and affiliated proprietary trading units and hedge funds.
D. Creation of a National Bank Supervisor
At present, there are four different federal agencies with some degree of jurisdiction and authority over depository institutions: the Office of the Comptroller of the Currency ("OCC") (national banks), the Office of Thrift Supervision ("OTS") (savings and loan associations), the Fed (member banks of the Federal Reserve System), and the FDIC (all insured depository institutions and state nonmember banks). The current arrangement permits a bank to select its regulator, and a particular regulatory scheme, by choosing to be governed by a particular charter, federal or state.
The Proposal creates a new federal banking agency, the National Bank Supervisor ("NBS"), which will have supervisory and regulatory authority over all federally-chartered depository institutions. In short, the National Bank Supervisor will succeed to the current responsibilities of the OCC and the OTS. The NBS will be an agency with separate status within Treasury, and will be led by a single executive–precisely the status of the OCC today. The Proposal will leave the Fed and the FDIC with exactly the same status that they have today. And the state banking charters and state bank regulatory agencies, the other half of the dual banking system that is unique to the US, will also retain their current status.
Federal Thrift Charter
The Proposal will eliminate the OTS and federal thrift charter in recognition of the fact that the business model for specialized lending institutions has proved to be vulnerable and fragile, and the need for the specialized lending institutions has decreased with the growth of securitization markets and the willingness of banks to engage in mortgage lending. The Proposal also will reduce the differences in substantive regulation and supervisory policies applicable to national banks, state-chartered banks, and state nonmember banks.
Unlike commercial banks, thrifts have always enjoyed the ability to branch across state lines. Commercial banks received the authority to engage in certain aspects of interstate banking through the Riegle-Neal Act. The Proposal now will eliminate all remaining restrictions on interstate banking by federal and state-chartered banks.
Separation of Commerce and Banking
The definition of "bank" in the Bank Holding Company Act, and the restrictions on permissible activities of a BHC or FHC, have kept entities that were not bank holding companies from owning and controlling a "bank." This is often referred to as the separation of commerce and banking. The Competitive Equality Banking Act of 1987 permitted the owner of an FDIC-insured thrift, an industrial loan company ("ILC"), a credit card bank, a non-depository trust company, or a grandfathered deposit institution to avoid registration with the Fed as a BHC. A bank holding company would be subject to consolidated supervision and regulation by the Fed, and would be subject to the restrictions on non-banking activities in the BHC Act. As a result, some investment banks, some insurance companies, finance companies, commercial companies, and other companies have been able to own depository institutions and thus to obtain access to the federal safety net through FDIC insurance while simultaneously engaging in commercial activities and avoiding any substantive regulation and supervision by the Fed. The Proposal will remove these exceptions to the definition of "bank" and require such owners to come into compliance with the restrictions on non-banking activities over a five-year period.
During the decade before the passage of the Gramm-Leach-Bliley Act in 1999, many companies seeking to own a depository institution also sought a state or federal thrift charter. A company that owned and controlled only one federal or state thrift was referred to as a unitary thrift holding company, and was lightly regulated by the OTS. Title IV of the GLB Act required the owners of unitary thrift holding companies to conform to the definition of "financial holding company" that that same legislation had added to the BHC Act, but grandfathered all of the non-financial unitary thrift holding companies that had been issued a charter before May 4, 1999. For many of the reasons set forth immediately above, unitary thrift holding companies will be required to become BHCs and will be fully regulated on a consolidated basis, as will the owners of ILCs, credit card banks, non-deposit trust companies, and "nonbank banks."
E. Registration of Hedge Fund Advisers
The investment advisers to hedge funds and other private pools of capital are usually able to avoid registration with the SEC under the Investment Advisers Act of 1940 in reliance on an exception to registration available to an investment adviser which has had fewer than 15 clients in the last twelve month period and does not hold itself out to the public as an investment adviser. The hedge fund itself, and other private pools of capital like a private equity fund or a venture capital fund, are usually able to avoid registration with the SEC as an investment company under the Investment Company Act of 1940 in reliance on one or more of the exclusions from the definition of "investment company" that except (a) an issuer which has fewer than 100 beneficial owners and has not made a public offering and (b) an issuer which is offered and sold only to qualified purchasers (which is itself a defined term) and has not made a public offering.
Under the Proposal, all advisers to hedge funds and other private pools of capital, including private equity and venture capital funds, over a de minimis amount, will be required to register with the SEC under the Investment Advisers Act. They will be subject to new recordkeeping, examination, disclosure and regulatory reporting requirements. They will also be required to provide enough information for a regulator to determine how a fund might be changing over time and whether it may have become so large, leveraged, or interconnected that it requires regulation for financial stability purposes.
The Proposal acknowledges that some of these requirements ought to vary across the different types of private pools, and that the regulatory reporting should be on a confidential basis.
F. Liquidity of Money Market Funds
A money market fund is a special type of mutual fund, one of whose characteristics is that it seeks to maintain a net asset value per share ("NAV") of $1.00 at all times by investing in a portfolio of very short-term money market instruments each of which is of very high quality. Money market funds are subject to Rule 2a-7 under the Investment Company Act of 1940, which imposes strict conditions to enforce the general themes that a money market fund is not expected to take any credit risks or have much volatility in its portfolio.
To make money market funds less susceptible to runs, the Proposal supports the SEC's efforts to strengthen the regulatory framework around money market funds. The SEC will consider requiring liquidity buffers; reducing maximum weighted average maturity of assets; tightening credit concentration limits; improving credit risk analysis and management of money market funds; and authorizing money market fund boards of directors to suspend redemptions in certain circumstances.
The President's Working Group is also tasked with preparing a report assessing whether further changes may be necessary, e.g., eliminating the use of a stable net asset value and requiring money market funds to access private emergency liquidity facilities.
G. Oversight of Insurance
For a long time insurance companies and those who sell insurance policies have been subject exclusively to regulation by the various state insurance commissioners. As recently as 1999, the GLB Act reiterated the federal policy that the business of insurance was the province of the states. State insurance laws address the safety and soundness of insurers, and state insurance laws provide for significant consumer protections for those who purchase life insurance, fixed and variable annuity contracts, property and casualty insurance, and health insurance. State insurance laws also create guarantee funds to provide a source of capital for the affected state insurance commissioner should an insurance company that is located and doing business in his state be unable to honor its obligations.
The Proposal will not create a federal insurance charter (optional or mandatory), which many in the industry had been hoping to see. Instead, the administration's proposed legislation will establish the Office of National Insurance ("ONI") within Treasury to monitor the insurance industry. The ONI will gather information and be responsible for identifying problems or regulatory gaps that could contribute to a future crisis. It will also identify to the Fed those insurance companies it believes should be supervised as Tier 1 FHCs.
Notwithstanding the administration's failure to include a federal insurance charter, Treasury nonetheless continues to support the following principles for insurance regulation: (i) effective systemic risk regulation of insurance; (ii) strong capital standards; (iii) meaningful consumer protection; (iv) increased national uniformity; (v) improved consolidated regulation of insurance companies and affiliates; and (vi) international coordination.
At the international level, the lack of a federal entity with supervisory responsibility and expertise in the insurance business has hindered the government's ability to engage with other nations on insurance issues. The Proposal will empower the ONI to represent the US those forums.
II. Comprehensive Supervision and Regulation of all Financial Markets
A. Oversight of Securitization Markets
The Proposal focuses on the incentive structure of market participants, the transparency of information regarding structured products, and the role of credit ratings.
Loan originators or sponsors will be required to retain five percent of the credit risk of securitized exposures. Originators will be prohibited from directly or indirectly hedging or transferring that risk. Bank regulators may specify the form of risk retention (e.g., first loss position) and the duration of the risk retention, and they may also increase or decrease the five percent threshold and provide exemptions from the bar on hedging. They may also impose similar risk retention requirement on securitization sponsors.
Accounting standards and other regulations will be changed to link the compensation of brokers, originators, sponsors, underwriters and other relevant parties with the longer term performance of securitized products. Originators may be required to recognize gains on sale over time rather than immediately upon sale, and loan brokers and officers may be required to structure their fees in a way that is tied to the performance of the securitization over time.
The SEC is charged with issuing new regulations to improve and standardize disclosure practices by originators, underwriters and credit ratings agencies. The SEC will also impose new disclosure requirements on credit ratings agencies, particularly with respect to their methodology for rating structured products.
The Proposal calls on regulators to reduce their use of credit ratings and to be mindful of the potential differences in performance between structured and unstructured products with the same rating. Such differences in performance and risk will be reflected in risk-based regulatory capital requirements. Finally, the securitization industry must improve the standardization and transparency of legal documentation of securitization and practices, such as home loan modifications where the loans have been securitized.
B. Regulation of OTC Derivatives
The Proposal will amend the Commodity Exchange Act ("CEA") and relevant securities laws to require clearing of all standardized OTC derivatives through regulated central counterparties ("CCPs").3 In addition, regulators will impose on CCPs robust margin requirements as well as other necessary risk controls. Customized OTC derivatives will not be permitted to be used solely to avoid using a CCP.
The CFTC and the SEC will be authorized through amendments to existing laws to impose recordkeeping and reporting requirements (including an audit trail) on all OTC derivatives. Certain of those requirements may be satisfied by either clearing standardized transactions through a CCP or by reporting customized transactions to a regulated trade repository. CCPs and trade repositories should be required, among other things, to make aggregate data on open positions and trading volumes available to the public and make data on any individual counterparty's trades and positions available on a confidential basis to the CFTC, SEC, and the institution's primary regulators.
All OTC derivatives dealers and all other firms whose activities in those markets create large exposures to counterparties will be subject to prudential supervision and regulation, including conservative capital requirements (more conservative than the existing bank regulatory capital requirements for OTC derivatives), business conduct standards, reporting requirements, and conservative requirements relating to initial margins on counterparty credit exposures. Regulatory capital requirements on OTC derivatives that are not centrally cleared also will be increased for all banks and BHCs.
Current law seeks to protect unsophisticated parties from entering into inappropriate derivatives transactions by limiting the types of counterparties that could participate in those markets. The CFTC and the SEC are reviewing the participation limits in current law to recommend how the CEA and the securities laws should 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. Roles of the SEC and the CFTC
Instead of merging the SEC and the CFTC, which many expected, the Proposal calls for those agencies to make recommendations to Congress for legislative changes that would harmonize the regulation of the products under their jurisdiction, namely futures and securities.
D. Systemically Important Payment and Clearing and Settlement Systems
The Fed will be given the responsibility and authority to oversee all systemically important payment, clearing and settlement systems, and activities of financial firms. Proposed legislation will lay out characteristics of systemically important systems (covered systems) and will establish objectives and principles for their oversight. The proposed legislation will also define certain systemically important activities. Covered systems will be required to have robust risk management systems and will be subject to examination by the Fed as well as reporting and recordkeeping requirements.
To the extent a covered system is subject to comprehensive regulation by the SEC or the CFTC, that market regulator will remain the primary regulator. The Fed will seek to obtain information it deems necessary from the primary regulator in the first instance. The primary regulator will also lead on-site examinations and reviews, although the Fed will have the right to participate in any such inspection.
Similarly, the primary regulator will be the first line of enforcement. However, the Fed will have emergency authority to take enforcement action if it disagrees with the SEC's or CFTC's conclusions, after consultation with the Council (which will attempt to mediate the agencies' differences).
The administration is requesting that Congress grant the Fed authority to provide covered systems access to Reserve Bank accounts and financial services as well as to the Fed's discount window.
III. Protection of Consumers and Investors from Financial Abuse
The Proposal aims significantly to change the culture of consumer protection regulation of financial services firms, by creating a new independent agency whose sole mission is consumer protection regarding financial services. The Consumer Financial Protection Agency will have exclusive power to issue consumer protection regulations presently handled by the bank regulatory agencies, free of "conflicting" responsibility for financial firms' safety and soundness. The authority of the CFPA will extend to deposit products, lending products, community reinvestment, fair lending, debt collection, and related matters. It will cover all insured institutions, as well as entities not now subject to direct federal supervision.
The CFPA's authority will include supervision, examination, regulation-writing and enforcement. In addition, the CFPA will have the authority to establish new federal registration and licensing requirements, including for intermediaries and servicers. The Federal Trade Commission and the surviving federal bank regulatory agencies will have some back-up authority, but the Proposal is murky about how this will work.
The Proposal includes major substantive changes to standards of conduct. The goal of CFPA regulation will be "reasonableness" from the consumer's point of view. The CFPA will have the authority to prohibit unfair practices generally. It is envisioned that the CFPA will define "plain vanilla" products that institutions may be required to offer in parallel with any more complex products. Institutions' solicitations will be required to present products' risks and benefits, prioritizing them by significance. The CFPA may establish federal duties of care for intermediaries, such as a duty of best execution or a duty to determine affordability. Mortgage originators may be required to make new specific warranties to borrowers. The CFPA is expected to ban arbitration clauses in at least some contexts.
At the same time, state regulation will be less inhibited. Financial firms of all types will be subject to state regulatory standards, which may impose stricter requirements than federal law–a change from preemption standards currently applying to federally chartered firms. In addition, federally chartered institutions will be subject to state enforcement actions, subject to appropriate arrangements with prudential supervisors. States also will generally have the authority to enforce CFPA regulations, subject to CFPA intervention.
The SEC, which will retain its consumer protection responsibilities, will be given the statutory tools to require greater disclosure to and promote fairer treatment of investors. The Proposal will establish a fiduciary duty for broker-dealers offering investment advice and will harmonize regulation of investment advisers and broker-dealers, consistent with SEC efforts in this regard. The Proposal will also give the SEC authority to establish a fund for the protection of whistleblowers, will harmonize liability standards across all aspects of the industry and will expand sanctions available in enforcement actions.
Finally, the Proposal will establish a Financial Consumer Coordinating Council under the Financial Services Oversight Council and will make the role of the SEC's Investor Advisory Committee permanent by statute.
IV. Managing Financial Crises–Resolution Authority and Federal Reserve Emergency Lending Authority
Our current system has strong procedures in place to handle the failure of banks. However, there is no resolution mechanism in place when a bank holding company or other nonbank financial firm is failing, other than bankruptcy. For systemically significant entities, i.e., those determined to be Tier 1 FHCs, neither the option of bankruptcy nor emergency government funding is appropriately tailored to manage the crisis.
The Proposal will create a new resolution regime, modeled on existing FDIC authority, to allow the government to resolve failing BHCs, including Tier 1 FHCs, in an orderly way. The proposed resolution regime will not replace bankruptcy procedures in the normal course of business but only where a "systemic risk exception" is triggered. It is thus designed to be used only in extraordinary times and it would be subject to strict controls.
Complex rules will apply to the resolution process for a firm under this special resolution regime. The process could be initiated by Treasury, the Federal Reserve or by the FDIC, or by the SEC when the largest subsidiary of the failing firm is a broker-dealer or securities firm. Although the authority to decide whether to resolve a failing firm would be vested in Treasury, it would be invoked only after consultation with the President and would be based upon the recommendations of the other agencies, as applicable. The entity acting as conservator or receiver (the FDIC or under some circumstances the SEC) would be authorized to borrow from the Treasury, which could issue public debt to finance the borrowings. The costs of such loans are proposed to be paid from the proceeds of assessments on BHCs.
As another tool to address systemic crises, the administration also plans to propose legislation to amend Section 13(3) of the Federal Reserve Act to require Treasury's prior approval of any extensions of credit by the Fed to individuals, partnerships, or corporations in "unusual and exigent circumstances." Such an amendment would place a new layer of oversight over the Fed's ability to create and to extend emergency funding facilities.
V. International Regulatory Standards and Cooperation
The US will focus on reaching international consensus on four core issues: (i) regulatory capital standards; (ii) oversight of global financial markets; (iii) supervision of internationally active financial firms; and (iv) crisis prevention and management.
The Proposal recommends that the Basel II framework continue to be refined and that the definition of capital be improved by the end of the year. Among other things, the Proposal also calls for improved oversight of global financial markets, in particular with respect to OTC derivatives, regulation of hedge funds or their managers, enhanced supervision of internationally active firms, executive compensation guidelines, and a cross-border resolution mechanism for global financial firms.
The administration's Proposal is bold and ambitious in many respects, giving sweeping new powers to the Fed and proposing comprehensive new regulation of OTC derivatives and hedge funds. As noted earlier, however, the Proposal does not deal with some issues, such as a proposed merger between the SEC and CFTC or the creation of an optional federal charter for insurance companies. This may disappoint some and please others. To the extent these decisions reflect compromises made in advance, it may be more likely that the administration will be able to build enough consensus for its proposed legislation to move to passage through Congress.
1 The Proposal, released today, is available at the following links: White Paper: Financial Regulatory Reform; Fact Sheets: (Requiring Strong Supervision And Appropriate Regulation Of All Financial Firms); (Strengthening Regulation Of Core Markets And Market Infrastructure); (Strengthening Consumer Protection); (Providing The Government With Tools To Effectively Manage Failing Institutions); (Improving International Regulatory Standards And Cooperation).
2 For details on Treasury's earlier proposal, see WilmerHale alert, "Administration Proposes Giving SEC New Rulemaking Authority on Executive Compensation Matters for all Public Companies," June 15, 2009.
3 The Proposal is generally consistent with Treasury's May 13, 2009 proposal on OTC derivatives, as discussed in the WilmerHale alert, "Regulating OTC Derivatives: How Hard Would It Be To Undo the CFMA?" May 22, 2009.