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financial system regulation

Page history last edited by Brian D Butler 12 years, 1 month ago

Table of Contents


 

 see also: regulatory quality , credit crisis of 2007  policy and regulation , Financial marketsCommercial Banking

 

 

Trend:

 

"In America, we feature the growing burden of regulation that threatens to suffocate the economy in the land of laissez-faire. The Dodd-Frank act to regulate financial services is the most egregious, but by no means the only, example of this dangerous trend."  read more from TheEconomist.com

 

 

Problems with Complexity:

 

"Complexity costs money. Sarbanes-Oxley, a law aimed at preventing Enron-style frauds, has made it so difficult to list shares on an American stockmarket that firms increasingly look elsewhere or stay private. America’s share of initial public offerings fell from 67% in 2002 (when Sarbox passed) to 16% last year, despite some benign tweaks to the law."   read more from TheEconomist.com

 

 

Financial System Regulation 

 

Defining the need for regulation:  Investors take all sorts of precautions to ensure that the people they deal with will honour their promises. They demand regulation and accurate accounts that price assets at market values; they want loans to be backed by collateral and covenants; they ask specialist agencies to rate borrowers’ creditworthiness; and so on.

 

 

 

 

 

Potential un-intended consequences:

 

“We run a big risk of feeling the love of unintended consequences and feeling it in all its unleashed fury.” said former SEC Chairman Harvey Pitt

 

Lessons from the past

"unintended consequences, which has happened before when lawmakers have tried to rein in U.S. corporations. The risk is higher, opponents argue, in complex areas such as financial regulation.  For example, Congress in 1993 tried to curb excessive pay by prohibiting tax deductions on annual salaries that exceeded $1 million. Companies could continue deducting pay that they didn’t dole out as salary, such as stock options.  As a result, businesses issued a flood of options to their employees. Some companies then began abusing options by backdating grants to periods when stock prices were lower to ensure big payouts to executives -- prompting more than two dozen enforcement actions by the SEC."  source: bloomberg

 

Regulation Arbitrage potential:

If all countries dont pass regulations at the same time, there is the possiblity that "the overhaul would unintentionally push derivatives trading overseas"   source: bloomberg

 

 

Capital Ratios:

 

suddenly started to demand that banks hold much more capital against their assets. For decades this ratio had been stable, below 10% of book assets, though it was over 50% in the 1840s, when banks were apt to fail more often.

 

Nobody can be sure how much capital shareholders now want banks to hold, but Alan Greenspan, a consultant these days, thinks the figure could have grown to 15% of their assets. If so, the banks will have to raise money and sell loans and securities even as politicians are asking them to lend more. Investors’ desire for extra protection has made the contraction of credit worse.

 

Basel I

 

Basel I has glaring deficiencies that virtually encourage the creation of off-balance sheet instruments that contributed to the subprime crisis. See for instance “New Bank Capital Requirements Helped to Spread Credit Woes” (David Wessel, The Wall Street Journal, 30 August 2007.

 

Basel II

 

note that most of the institutions that failed during the credit crisis of 2007 were Basel II compliant. 

 

In Banking on Basel- the Future of International Financial Regulation (Institute of International Economics, October 2008) he points out that: “Thus, there is a strong possibility that the Basel II paradigm might eventually produce the worst of both worlds—a highly complicated and impenetrable process (except perhaps for a handful of people in the banks and regulatory agencies) for calculating capital but one that nonetheless fails to achieve high levels of actual risk sensitivity”.

 

 

 

increased regulations of financial markets  

 

after the credit crisis of 2007 there will surely be increased pressure for highted regulations of the financial system...bu-t what will that mean?

 

Policy and regulation are important to watch.  As they change, there will be opportunities for entrepreneurs

 

Issue:

global regulations, local regulators

 

 

 

Balancing the need for regulations with innovation (and economic growth)

 

In a macro sense;  too much regulation, and we see a lack of competition, and a lack of Innovation.  But too little regulation, and we see scandals, crises...and later, a call for more regulation.  Think about the results of the credit crisis in the USA (2007), and the resulting calls for more regulations... is that a good thing?  Well, on one hand we can see that wrong things happened, and regulation should be put in place to make sure it doesn't happen again...but, on the other hand... if we look at any developing nation, and in country after country...we see that over regulations cuts off competition, and stymies investment, and with underinvestment comes under performing asset classes.  In each of these emerging markets, we see that "deregulations" is often the key to spurring innovation, competition and economic growth. Think about this before you call for more regulations (and learn these lessons before willingly committing your market to more regulations).

 

Innovation

Wherever you see policy and regulation, you will see innovation (to get around the regulation).  Commercial Banking is one the most creative sectors when it comes to developing products to get around regulation.  For example, there has been massive Innovation in the financial sector when it comes to the securitization of mortgages (which partly is to blame for the subprime lending crisis). 

 

 

 

effect on Private equity industry:

 

More threats for private equity: The Treasury Department's proposal for regulating the financial market poses more threats for private-equity firms. It calls for more involvement from the Federal Reserve, gives the central bank extra visibility into firms' investments and even gives the Fed the power to force buyout firms to address financial-stability problems. Chicago Tribune (04/01)  see more:  private equity trends

 

Change in rules for PE in Banking sector:

 

09/2008:   In response to the credit crisis, there has been a change in rules regulating Private equity in the banking sector.  The fed loosened the rules.  It was 25% if a private equity firm wanted to buy into a bank, that was the limit.  If you owned more than 25%, you were essentially regulated like a bank.  But, they changed the rules to 35% in an effort to bring the PE "smart-money" in from the sidelines, and to have the wealth of PE funds help get the US banking sector through this crisis. 

 

 

 

Financial Regulation history

 

Recent History

 

 

2010

 

New financial regulations are coming.  "Among other things the bills would create a new agency to oversee consumer financial products, establish a council to monitor systemic risk and increase regulation of derivatives, mortgage brokers, credit-rating companies and hedge funds."  source: bloomberg

 

Impact of new regulations:  "“There are estimates that range up to $2 trillion of credit that would be sucked out of the economy.”  said David Hirschmann, president of the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness.

 

Potential changes to the bill:"that some of the measure’s more contentious aspects get changed in a House-Senate conference, including a requirement that banks wall off their swaps-trading desks and another that directs higher capital requirements"  source: bloomberg

 

June 2009

 

economists reactions to the new financial regulations proposal.

The quotes from Krugman and others are interesting... http://is.gd/14KqT

 

 

Background

Government regulation of Wall Street began in earnest after the 1929 stock market crash, when Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934, which created the SEC, required investment banks to disclose material information about securities they peddled and prohibited brokers from deceiving clients. The laws responded to abuses that were rampant in the 1920s, such as banks selling stocks and bonds in companies that were already bankrupt.

 

Congress repealed Glass-Steagall in 1999, contributing to mergers and the growth one-stop-shopping financial services companies.

The repeal helped pave the way for the formation of Citigroup by the $46 billion merger of Citicorp and Travelers Group Inc. It also made it possible for Goldman Sachs and Morgan Stanley, the two biggest U.S. securities firms, to convert into bank holding companies, enabling them to get cheap funding from the Federal Reserve during the financial crisis. If the law hadn’t been repealed, Bank of America Corp. wouldn’t have been allowed to acquire Merrill Lynch & Co.

 

 

Sarbanes - Oxley Act 2002-2003

 

SEC as it implemented an overhaul of corporate accounting in 2002 and 2003, the Sarbanes- Oxley Act.

 

The 2002 law was born out of the massive accounting frauds at Enron Corp. and WorldCom Inc. It required corporate executives to attest to the accuracy of their books and put new strictures on the accounting industry.

 

Glass-Steagall Act

 

The Glass-Steagall Act, which separated commercial and investment banking in 1933, “was the most effective antitrust law we’ve ever had,” said Charles Geisst, a finance professor at Manhattan College in New York, who has written about Wall Street’s history.   Glass-Steagall was as much about breaking up companies as ensuring customer deposits wouldn’t be used for risky practices, Geisst said.

 

Savings-and-Loan

 

while it may be true that "Under Glass-Steagall, the financial system didn’t approach a meltdown", it should also be noted that: "The law also didn’t prevent government rescues when banks failed. The biggest collapse before the 2008 crisis occurred in 1984, when Continental Illinois National Bank and Trust became insolvent, prompting the Federal Deposit Insurance Corp. to buy $4.5 billion of its bad loans. The savings-and-loan crisis of the 1980s and 1990s cost the taxpayers about $124 billion." source: bloomberg

 

 

 

 

How it was before the crisis 2007+

 

The following is an outline of the U.S. financial regulatory system as it currently stands, delineating the different regulatory bodies and their respective roles.

Federal Reserve System

 

The Federal Reserve,

commonly referred to as the Fed, is the central bank of the United States. The Fed is responsible for regulating the U.S. monetary system (i.e. how much money is printed, and how it is distributed), as well as monitoring the operations of holding companies, including traditional banks and banking groups. Broadly speaking, its mandate is to promote stable prices and economic growth.

The Federal Reserve exerts regulatory oversight in a few different ways:

 

  • Board of Governors: The national component of the federal reserve system is run by a seven-person Board of Governors, commonly called the Federal Reserve Board. This group is managed by a chairman (currently Ben S. Bernanke) and vice chairman (Donald L. Kohn). Its main responsibility is to guide monetary policy by coordinating with the Federal Open Markets Committee (FOMC) and regional reserve banks. Toward this end, the board organizes a wide range of research and analytical operations. The board is also charged with overseeing the U.S. government's system of payments; supervising the financial services industry, including approving bank presidents and setting requirements for the amount of cash banks must hold in reserve; and coordinating and overseeing the actions of regional reserve banks.
  • Federal Open Markets Committee: The FOMC is the Fed's primary monetary policymaking body. It consists of twelve members, including the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the presidents of four other regional banks (who serve on a rotating basis). The FOMC typically meets eight times a year and is charged with assessing the economic and financial landscape and setting the "federal funds rate," the benchmark interest rate at which the Fed loans money to banks.
  • Reserve banks: The federal reserve banking system encompasses twelve regional banks with twenty-five total branches. These banks are regional arms of the U.S. central bank that act as intermediaries between local banks and the U.S. reserve banking system. They store and distribute reserves, process checks and other forms of interbank payments, and generally supervise the operations of commercial banks in their region. Reserve banks have additional regulatory authority over the 38 percent of U.S. commercial banks (mainly larger banks, including all national banks) that are members of the Federal Reserve system. These banks are considered stockholders of their local reserve bank and thus are required to hold 3 percent of their total capital at that bank.

 

Amidst the financial crisis of 2008, the Fed sought to use policy statements and its control of interest rates to influence legislative policy and calm capital markets. Chairman Bernanke has also encouraged lawmakers to pass a plan aimed at stimulating liquidity in financial markets, and has supported moves by the U.S. Treasury to make money available to some failing U.S. financial institutions.

 

Department of the Treasury

 

The U.S. Department of the Treasury, originally created specifically to manage government revenues (whereas the Federal Reserve manages payments), has evolved to encompass several different duties. It recommends and influences fiscal policy; regulates U.S. imports and exports; collects all U.S. revenues, including taxes; and designs and mints all U.S. currency.

 

In terms of financial regulation, the Treasury Department functions primarily through the operations of two agencies it oversees, the Office of the Comptroller of the Currency and the Office of Thrift Supervision, which regulate banks and savings and loans:

 

  • Office of the Comptroller of the Currency: The Office of the Comptroller of the Currency, or OCC, is the primary means through which the Treasury regulates U.S. banks. It is headed by the comptroller of the currency (currently John Dugan). The OCC is responsible for chartering all U.S. banks and, more broadly, for ensuring the stability of the banking system. According to the OCC's website, it attempts the latter task by monitoring: "a bank's loan and investment portfolios, funds management, capital, earnings, liquidity, sensitivity to market risk, and compliance with consumer banking laws." Its responsibilities thus overlap, to a degree, with those of the Federal Deposit Insurance Corporation (FDIC), which must also monitor banks' capital reserves and sensitivity to risk. If a bank doesn't comply with OCC standards, the agency holds the authority to take a variety of actions. It can force the ouster of senior bank personnel, force the bank to change certain practices, issue fines or penalties, and ultimately issue orders for the bank to close its operations.
  • Office of Thrift Supervision: The Office of Thrift Supervision (OTS) is tasked with supervising federally-chartered savings and loan associations, also known as "thrifts." (Thrifts generally specialize in managing large savings deposits and issuing mortgages, and are often mutually held, meaning that involved borrowers and lenders have the ability to guide the association's management and financial practices.) The OTS regulates the formation and management of thrifts. It is also responsible for regulating savings and loan holding companies-firms that buy up rights to all the loans held by various thrifts-which gives it purview over several major U.S. banks and financial firms.

 

Treasury Secretary Henry M. Paulson has taken a very active role amidst the financial turmoil of 2008. He has pressed the need for a plan aimed at stimulating liquidity in financial markets and has made Treasury money available to some failing U.S. financial institutions on the grounds that their failure would severely damage the U.S. economy. He also devised and recommended a series of reforms aimed at reorganizing the manner in which the United States regulates financial institutions.

 

Securities and Exchange Commission

 

The Securities and Exchange Commission (SEC) is an independent government agency tasked with overseeing U.S. securities markets, enforcing securities law, and monitoring exchanges for stocks, options, and other securities. The commission was created by Congress in 1934 and is also responsible for overseeing corporate takeovers. One of the primary tasks assigned to the commission is the promotion of transparency in securities markets and thus the protection of investors from fraud or corporate malfeasance, in part through requiring that firms file quarterly and annual financial reports. The SEC is tasked with providing guidance to corporations regarding U.S. accounting rules, and Congress authorizes the commission to bring civil charges against firms thought to have committed fraud or other accounting wrongdoings. The commission has subdivisions focused on regulating: corporate finance, trading and markets, investment management, and enforcement. The agency is governed by five commissioners, though all decisions ultimately run through the chairman. The current chairman, Christopher Cox, is a conservative former California representative and an advocate of market deregulation. In late September 2008, Cox moved to shut down the Consolidated Supervised Entities program, a largely voluntary regulatory program that oversaw investment banks like Bear Stearns and Lehman Brothers, saying it was "fundamentally flawed" and that the financial turmoil of 2008 "made it abundantly clear that voluntary regulation does not work."

 

The SEC administers the body of financial law established through seven major acts governing the financial industry, including most recently the Sarbanes-Oxley Act of 2002 and the Credit Rating Agency Reform Act of 2006 (PDF). As a means of regulating market behavior, the SEC polices and licenses stock exchanges, and is responsible for regulating credit ratings agencies, which also have taken criticism during the current crisis. The SEC has enforcement authority in that it can bring civil charges against individuals or companies thought to have violated securities law (violations include trading on insider information, committing accounting fraud, providing false information to the SEC, etc.). When criminal charges are involved, the commission recommends to the Justice Department whether to prosecute a case. The Justice Department has little direct oversight over financial market regulation, other than the ability to prosecute these cases sent to it by the SEC. In terms of direct jurisdiction, the Justice Department's main purview in terms of corporate governance is limited to anti-trust cases-it cannot independently pursue charges in cases involving securities market violations.

 

In some cases, state and local officials get involved in regulating markets and companies, independent of the SEC. For instance, in New York, which has extensive state law on securities regulation, the state attorney general has historically undertaken and prosecuted criminal legislation in fraud cases and other securities cases. New York State Attorney General Andrew Cuomo and former Attorney General Elliot Spitzer, for instance, pressed to prosecute several high-profile executive-pay cases.

 

Federal Deposit Insurance Corporation

 

Created in 1933 following a wave of bank closures, the Federal Deposit Insurance Corporation, or FDIC, was intended as a financial backstop to provide the broader U.S. population a guarantee that individual savings wouldn't evaporate when a bank did. The agency insures holdings in checking and savings accounts at member banks, currently guaranteeing up to $100,000 per person per bank, and up to $250,000 in retirement accounts.

The FDIC exerts regulatory authority in that, to qualify for FDIC insurance, member banks must meet certain requirements. Banks are categorized based on the extent of their reserves and liquidity. Typically, a U.S. bank holding less than 8 percent of the assets it is managing in reserves is considered "undercapitalized." A bank holding less than 6 percent becomes subject to FDIC regulation-the agency can oust the bank's management or call for other corrective measures.

 

Commodities Futures Trading Commission

 

The Commodities Futures Trading Commission, or CFTC, was founded as an independent agency in 1974 to provide a regulatory framework for the increasingly complex market in futures contracts (through which traders agree to buy or sell a good at a specific time in the future for a specific price). At the time of the commission's founding, the vast majority of futures trading involved commodities in the agricultural sector. Traders now speculate on the future prices of any number of financial entities-from currencies, to government securities like Treasury bonds, to the valuation of different stock indices-and the CFTC has come to regulate all futures contracts, not just those involving commodities.

Among other oversight roles, the CFTC regulates the derivatives clearinghouses that bring together buyers and sellers of futures contracts; approves and regulates the organizations responsible for actually executing futures trades; and monitors buyers and sellers in an attempt to ensure against fraud and other violations.

 

National Credit Union Administration

 

The National Credit Union Administration, or NCUA, in some ways functions both like the FDIC and the OCC, though it regulates credit unions rather than banks (credit unions are nonprofit savings and loan institutions that pool the money of members in order to provide credit and banking services to one another, theoretically at lower rates than for-profit banks). The NCUA is responsible for chartering and supervising U.S. credit unions. It also insures savings in all federal- and most state-chartered unions through a fund called the National Credit Union Share Insurance Fund.

 

source:  http://www.cfr.org/publication/17417/

 

 

 

 

 

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