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Slouching Toward Reform

Last fall, as the stock market plummeted and the economy reeled, Saturday Night Live sought the advice of a “financial expert.” “They need to clamp it down and fix it,” the faux expert ranted. “When I wake up tomorrow morning, it better be fixed. Fix it! Fix it! Fix it!”

The comedian’s words echoed the urgency being felt across the nation, and in Congress as well. Legislators quickly announced that the reform of financial industry regulations was a top priority. Hearings were held, a flurry of new regulations was suggested, and in June, the Obama administration weighed in with a proposed reform package addressing a range of issues. “If this crisis has taught us anything, it is that risk to our financial system can come from almost any quarter,” U.S. Treasury Secretary Timothy Geithner said at the time. “So we must be able to look in every corner and across the horizon for dangers.” Reform was expected to come quickly—perhaps by the end of summer.

That original timetable proved to be far too optimistic, largely because health care reform turned out to be more time-consuming than anticipated. But the debate about how best to oversee the country’s financial system has continued, and in the coming months it is likely to become louder and livelier.

“Congress is intent on moving forward with regulatory reform legislation,” says Todd Cranford, Of Counsel at Patton Boggs. “There is a lot of pressure to make sure that this kind of financial crisis does not happen again.” Indeed, in the wake of the last year’s economic events, regulatory reform appears to a near certainty. Far less certain is the precise shape that reform will take. The debate is likely to involve a range of fundamental issues, from the size and role of government to the financial competitiveness of the country. Ultimately, it is expected to change the rules for the entire financial services industry.

Risky systems

Throughout 2009, financial regulatory reform has moved forward on several fronts, with agencies, congressional committees and lawmakers weighing in with ideas. The hope among the administration and congressional leaders is to bring these threads together into a comprehensive package. “It seems clear that this reform will be broad in scope,” says Vincent Frillici, senior policy advisor at Patton Boggs. “We’re talking about closing gaps in a regulatory structure that was created 70 years ago after the Great Depression, and updating that structure to reflect the modern financial system.”

For Congress, a fundamental issue is strengthening the ability to manage systemic risk. By and large, regulation has been handled in a fragmented fashion, with each agency focusing on its specific area of responsibility. During the credit crisis, no regulatory authority had a big-picture perspective, which meant that no one really knew how bad things were getting until it was nearly too late. Thus, says Micah Green, a partner at Patton Boggs, “Congress wants to make sure that regulators have all the information they need to identify where the risks are in a timely way, so that they can be on top of it and do whatever is necessary to manage those risks.”

Proposed changes include improved information-sharing across agencies, consolidation of some agencies’ responsibilities and the creation of some kind of entity to manage systemic risk and improve interagency cooperation. That new entity could take the form of a new agency, a council of existing regulators or an existing regulator with expanded powers. The administration hopes to see the Federal Reserve Bank take on the risk-manager role. It has proposed giving the Fed new authority to supervise all firms that could pose a threat to financial stability, even those that do not own banks. But that view is hardly unanimous. “The politics around the Fed right now make that difficult,” says Frillici.

Politicians on both sides of the aisle—including Senate Banking Committee Chairman Christopher Dodd and his Republican counterpart, Richard Shelby—have expressed doubts about the Fed’s ability to take on new responsibilities. Others have pointed to the Fed’s failure to stay on top of large, complex banking organizations in the period leading up to the economic crisis. Yet others see a strengthened Fed as a distasteful expansion of government. Meanwhile, the SEC and FDIC—which would presumably lose some responsibilities to a more powerful Fed—have opposed the plan, instead suggesting the establishment of a strong oversight council made up of regulatory agency heads.

The Fed’s role in systemic risk oversight has become one of the more controversial points in financial regulatory reform. One possible outcome, says Green: The Fed takes on the oversight role, backed by a council of regulators with advisory powers.

Regulators’ long arm

The Obama administration seeks to extend regulatory supervision to “all systematically important institutions, markets and products.” Congress will likely comply, bringing regulatory oversight to more financial products and financial industry players.

One target will be derivatives, which have essentially escaped regulation until now. Various proposals, including the administration’s reform plan, seek to bring products such as credit default swaps and over-the-counter derivatives under the regulatory umbrella. There is fairly broad support for such a move. “For many members of Congress, reform is about fixing the credit default swap problem,” says Frillici. “The prevailing view among many on Capitol Hill is that credit default swaps equals AIG, which equals financial crisis, so they feel strongly that they need to reform the use of derivatives, particularly credit default swaps.”

Congress is likely to require standardized derivatives—relatively simple, widely used instruments—to be traded through a regulated exchange, while complex, customized derivatives will still be traded privately. However, the administration hopes to expand the definition of standardized derivatives and institute capital and margin requirements that will make customized derivatives less attractive, with the goal of moving more derivatives to the exchange model. Much of the discussion will hinge on determining which derivatives qualify as standardized and which are considered customized.

Frillici says that instead of trying to reengineer regulatory oversight of such vehicles, Congress may leave the current regulatory responsibilities in place. “Rather than create more turf battles between regulators, they may say that if you create a derivative and are regulated by the [U.S. Commodity Futures Trading Commission], the CFTC will regulate that derivative, and if the derivative is based on securities, it will come under your regulator,” he says.

A wider regulatory net will also include some previously unregulated institutions such as hedge funds and private equity funds. The administration has proposed requiring SEC registration of all advisors to large hedge funds and other private capital pools. Funds would also have to disclose details about assets under management, use of leverage, and trading and investment positions. The SEC would examine funds to monitor compliance and assess risk.

In past years, private equity firms had eluded congressional attempts at regulation. But the financial crisis has changed the political landscape. As Michigan Senator Carl Levin said recently: “If the events of the last year have taught us anything, it’s that we need to regulate firms that are big enough to destabilize our economy if they fail. It’s time to subject financial heavyweights like hedge funds to federal regulation and oversight to protect our investors, markets and financial system.”

Catering to consumers

As the financial crisis unfolded, consumers were hit hard and bankruptcies and home foreclosures dominated the news. As a result, says Green, many officials have concluded that the government needs to do more to keep individuals out of financial trouble.
“The feeling is that while there is a ‘moral hazard’ of the federal government assisting people who potentially borrowed more than they should have,” he says, “keeping people in their homes and protecting the value of other homes in impacted neighborhoods remains a high priority for the administration and Congress.”

This view has led to new regulations governing the credit card and mortgage industries. The administration, however, decided that something more comprehensive was needed, and proposed the creation of a new federal agency. The Consumer Financial Protection Agency would formulate and enforce consumer protection regulations and oversee financial products and services not currently regulated by the SEC or the CFTC.

The CFPA garnered widespread support upon its introduction. But, as the financial markets have recovered and the opposition has had time to bolster its case, it has become more controversial. Some critics oppose adding a new agency to the array of regulatory organizations already in place, while others feel the agency’s proposed powers are too broad. More fundamentally, some question the wisdom of creating an agency with the relatively narrow mission of protecting consumers from fraud without considering the impact on business and ultimately, the potentially higher costs of credit that are liable to circle back to consumers.

These concerns are likely to be overshadowed by political realities. “When you talk about derivatives and margin requirements, the average person on Main Street doesn’t really care,” says Green. “But setting up an agency to protect people from what they see as ‘scoundrels’ has a lot of appeal. It will be perceived as something that will be understandable and tangible by voters. So even though it’s controversial, Congress—with an eye to next year’s elections—will probably create an entity of some form that has the authority to act to protect consumers against financial abuse.”

Fair hearings

When the dust settles and financial reform is passed, “it will definitely be a landmark piece of legislation,” says Green. “But that’s not to say that it will be all over when President Obama takes a pen to this bill in the White House.”

Indeed, the passage of legislation will be just the beginning of a lengthy rule-making process. Once Congress passes new laws, it will be up to government agencies to create rules and regulations that put the legislation into action. In this process, agencies propose rules and affected parties have an opportunity to provide written comments and, often, meet with agency staff to provide input. Typically, after several months of this review period, the agencies adopt and publish final rules, often delaying implementation to give businesses time to comply. Even then, companies can take the agency to court if they feel that a regulation is onerous.
Overall, the process provides numerous opportunities for affected parties to have input into the final rules. And with the controversial and complicated nature of regulatory reform, it is likely to take a considerable amount of time.

“There will be many years of agencies interpreting the legislation, promulgating rules pursuant to the legislation, and then implementing new rules,” says Cranford. He adds that businesses affected by reform should consider getting involved in that process, where they are likely to get a fair hearing. “The reality is that the agencies, Congress and the administration are generally sensitive to the competitive forces that are necessary in a capitalist system. They don’t want to take away that drive to take risks, to excel and to innovate that make our markets so successful,” he says. “They don’t want to make it harder to do business—they just want to make it harder to do bad business.”