Financial Regulatory Reform is Necessary for Economic Recovery

Even though recent economic reports have indicated that the worst may be over, the U.S. economy and housing markets remain in a fragile state. Recovery is tenuous at best; credit remains tight and foreign investors remain weary of our financial system. Fortunately, the Obama Administration is now focused on reforming our broken financial system which is a necessary condition for complete economic recovery.

The proposed financial regulation reforms are comprehensive, yet simple. If enacted, they will impose the greatest influence on financial activity since rebuilding our financial system immediately after the Great Depression. The focus of the Obama Administration reforms is to repair a financial system that permitted our current financial crisis to occur.

Here are some highlights of the regulatory reform proposal:

• Create a Consumer Financial Protection Agency (CFPA) that will serve to protect and educate consumers about financial products. This agency will have regulatory authority over the industries and companies that are providing financial products to consumers. A primary focus will be to better inform borrowers and investors about the risks inherent in the financial products they are obtaining. A lack of information and education about financial products contributed to our current financial crisis.

• Broaden the regulatory powers of the Federal Reserve. The Fed would have authority over the risk management activities of all financial institutions, not just banks. The Fed’s examiners would have the authority to impose capital and liquidity requirements as well as examine the risk management practices and policies of the institution. It is believed that if the Fed had these regulatory powers, the central bank may have been able to prevent some large financial institutions from collapsing during the financial crisis.

• Regulate the derivatives marketplace. It is widely believed that the production and use of derivatives got out of hand during the boom years which contributed to the financial crisis. Regulating derivatives such as credit default swaps would provide needed investor confidence back into the derivatives marketplace.

• Regulatory authority to address potential financial institution failure. The inability of federal agencies to address early the serious problems of large financial institutions such as AIG, led to more serious and costly problems in those institutions at a later time. The proposed reforms would give regulators new authority to work with any financial institution that threatens to undermine the stability of the U.S. financial system.

• Equity requirements for asset securitization originators. There will be new capital requirements for issuers of securitized assets. The proposed regulation would require originators of securitized assets to retain some equity in the securities they issue. For example, the regulation might require originators to hold a 5 percent interest in any asset-backed security they issue. The purpose of this proposed regulation is impose more discipline in underwriting practices by requiring originators to have something at stake in their issuances. One of the major contributors to today’s financial crisis was lax and irresponsible underwriting practices.

• Expand the definition of bank holding companies. The objective is to include more financial institutions under one regulatory umbrella for more consistent oversight. Financial institutions such as thrifts, industrial loan corporations and credit card banks would now be considered bank holding companies.

• Regulatory oversight of funds and insurance companies. The proposed regulations would provide for some oversight over hedge funds, mutual funds and insurance companies. It is not yet clear as to the extent and magnitude of the oversight.

The Obama Administration’s proposed regulatory reforms have received a fairly positive response from the financial markets and Congress. But it is by no means without its flaws. The regulatory proposal continues to promote a convoluted regulatory system comprised of a mix of federal and state financial institution regulators. The existing federal/state regulatory system creates inefficiencies and perverse incentives among financial institutions depending on who is regulating them. This regulatory overlap problem is not addressed in the proposed reforms.

The proposed reforms give an enormous amount of regulatory authority to the Federal Reserve, threatening to dilute the Fed’s effectiveness as an independent agency whose primary objective is to implement monetary policy. Only time will tell if this will be problematic for the Fed. There will also be a new Financial Services Oversight Council established which will coordinate the activities of all the regulators. But this council does not appear to have much authority and is just a traffic cop. Thus, there may still remain confusion as to which regulator has authority and responsibility for oversight in particular cases.

Finally, the new Consumer Financial Protection Agency may inhibit innovation in the creation of new financial products. It may also raise the cost of existing financial products. In addition, the requirement for asset-backed originators to hold an equity interest in the securities they issue is likely to result in an increase in issuance costs, which could lead to higher mortgage rates for borrowers. Obviously there is a trade off between more disciplined and responsible underwriting and mortgage rates.

On balance, the Obama Administration’s regulatory proposals are a positive step in the right direction. These reforms are sorely and immediately needed in a financial system that broke down during the real estate bust. There will be more consistent regulation and more emphasis on risk taking and market discipline. The reforms would also permit a more orderly resolution of financial institutions that are experiencing severe financial difficulties (e.g., Fannie Mae, AIG, etc.).

We believe that most of the proposed reforms will survive the Congressional process. Most of the criticisms appear to be focused on the new Consumer Financial Protection Agency which the bank lobbyists are fiercely opposing. Nevertheless, we hope that most of these proposed reforms are enacted so that we can once again restore confidence into our financial system and get on to the business of achieving a successful economic and housing recovery.