The ERM Current™

Last week, the Wall Street Journal in the United Kingdom published an article featuring the views of Britain’s Financial Services Authority Chairman Adair Turner.  Given the continued debate and relative inaction from the U.S. Congress, the thoughts from Lord Turner are particularly refreshing.  Here’s what he had to say:

One, finance got too big. “We must be more willing to ask…whether the financial system is delivering its vital economic functions as efficiently as possible, or whether parts of it can, and before the crisis did, swell beyond their economically efficient size,” he said in a recent speech.

Two, there was too much debt in the system. “There is a huge bias in the tax system towards debt,” he said, largely because companies can deduct interest payments before computing taxable profits. “If we can’t change that, then the regulatory approach needs to lean against that.”

Three, regulators failed to curb excesses, but politicians hardly encouraged aggressive regulation. The cry for “better regulation” meant less regulation, both in the U.K. and U.S. The diagnosis of Britain’s economic woes was that regulation was stifling entrepreneurship, he said.

Four, erecting a wall between ordinary deposit-taking and lending, on one hand, and trading on the other is impractical and unwise. Economies benefit when banks turn loans into securities or hedge their positions — to a point. But by forcing banks to hold capital in the trading operations to provide thicker cushions to absorb losses — he calls it “a bias towards conservatism” in trading beyond what is necessary for ordinary banking — speculative trading will migrate away from banks toward hedge funds and the like, a change Lord Turner welcomes.

Five, for all the angst about the slow pace of post-crisis repair of the financial system, global regulators are making surprising progress toward consensus on a new regulatory regime. “We are attempting in 18 months to do changes far more radical than we did in Basel II that took between 12 and 15 years and dealt with some of the areas which proved to be less important,” Lord Turner said, referring to the pact regulators reached in the Basel Committee on Banking Supervision that didn’t avoid the crisis. Pushed by the newly empowered Financial Stability Board, the process, he said, “has worked better than I would have expected,” he said.

Since the crisis was global in both cause and impact, it is encouraging that some are working towards global solutions to the problem.  As the regulatory reform effort unfolds, the U.S. must ensure that our reforms are aligned with our global partners.

U.S. House Financial Services Committee Chairman Barney Frank (D-MA) distributed a proposal for derivatives regulation this week and it was the subject of a hearing by the committee yesterday.  A major part of the discussion centered on a potential loophole that would allow many corporations, if not all, to avoid the new regulation altogether. Here is what Bloomberg.com reported about the hearing and draft legislation prepared by Chairman Frank.

A plan offered by the Obama administration would subject all swaps dealers and “major market participants” to new regulations for capital, business conduct, record-keeping and reporting. Frank’s version would exempt corporations from that definition if they use derivatives for “risk management” purposes.

While Frank’s proposal is a “step in the right direction,” its “ambiguous” definition of risk management may leave a large number of corporations unregulated, Henry T.C. Hu, director of the SEC’s new division of risk, strategy and financial innovation, told the committee.

“As just about all swaps could be defined as being used for risk management purposes, we’re concerned that unintentionally the category of ‘major swap participant’ could have been narrowed so significantly, or even to a null set,” CFTC Chairman Gary Gensler told reporters after the hearing.

“Major hedge funds” may be excluded from oversight, as may the mortgage-finance companies Fannie Mae and Freddie Mac “because of course the government-supported enterprises use swaps for risk management purposes,” Gensler said.

It looks like Chairman Frank may need to re-educate himself on the use of derivatives and go back to the drawing board on this proposal.

Yesterday, the U.S. Senate Banking Committee conducted a hearing to discuss ideas for financial regulatory reform.  Senator Christopher Dodd, chairman of the committee, argued the case for streamlining the governmental agencies that currently oversee the nation’s largest financial institutions.  In his remarks, he pressed the need for the creation of a new, single regulatory agency that will consolidate the handful of agencies that provide oversight today.  Here’s what he had to say.

“I have heard from many who have argued that I should not push for a single bank regulator.  The most common argument is not that it’s a bad idea – it’s that consolidation is too politically difficult.  That argument doesn’t work for me,” said Dodd. “We must eliminate the overlaps, redundancies, and additional red tape created by the current alphabet soup of regulators.”  Dodd went on to detail priorities in bank regulation.  “We need to preserve our dual banking system.  And I feel just as strongly on that point as I do the earlier point.  State banks have been a source of innovation and a source of strength, a source of tremendous strength, in their communities.   A single federal bank regulator can work with the 50 state bank regulators.” The chairman also recognized the important role played by community banks.  “Community banks did not cause this crisis and they should not have to bear the cost or burden of increased regulation necessitated by others.  Regulation should be based on risk – community banks do not present the same type of supervisory challenges their large counterparts do.”

Streamlining oversight in this way will not only strengthen the regulatory framework, it will also eliminate much of the excess governmental spending and bureaucracy that currently exists.

Today, the U.S. House Financial Services Committee will welcome several experts to debate financial regulatory reform approaches.  Paul Volcker, former Federal Reserve Chairman and current Head of the President’s Economic Recovery Advisory Board, will testify first by offering his views on how reforms should be enacted.   Here is an excerpt from his prepared testimony.

Important parts of the Administration’s proposed reforms can be – and some are being – implemented and enforced under existing authority. The Treasury has set out principles for capital and liquidity standards. Other prudential approaches are under consideration. Most notably risk management practices, for banks and certain other regulated institutions have been placed under urgent review. At the supervisors’ initiative, useful and needed steps are being taken to encourage more prudent compensation practices.

These are needed steps toward a stronger reformed financial system. However, I want to emphasize two inter-related issues of fundamental importance that run across the more particular elements of reform. One is a matter of broad regulatory practice: how to deal with the insidious, potentially risk-enhancing, spread of “moral hazard”, the presumption that systemically important institutions may be protected in the face of imminent failure. The overlapping question is one of administrative responsibility: in particular the appropriate role of the central bank (the Federal Reserve) in regulation, supervision and oversight of the financial system.

Mr. Volcker has defined the problem very well.  The answer lies in the need to decelerate the consolidation of financial institutions and accelerate the consolidation of regulatory oversight.  Just the opposite has occurred over the past few decades and led us to the brink of financial collapse.

As we are emerging from the financial crisis, the debate on Capitol Hill is firmly focused on health-care rather than financial regulatory reform.  It seems as though Congress can only single thread major legislation and, as a result, financial regulatory reform has taken a back seat.  However, the American Banker reported this week that the president is still intent on passing meaningful regulatory reform this year.  Here is what they had to say.

With much of the political world focused on health-care reform, the president appeared to signal that a financial services overhaul is still a priority for him. He reiterated that he hopes Congress will act this year — an increasingly unrealistic timeline by most estimates — and warned that bankers and other lenders cannot return to business as usual now that the crisis appears to be passing.

“The growing stability resulting from these interventions means we are beginning to return to normalcy,” President Obama said in a speech at Federal Hall in the heart of New York’s financial district. “But what I want to emphasize is this: Normalcy cannot lead to complacency. … We will not go back to the days of reckless behavior and unchecked excess at the heart of this crisis, where too many were motivated only by the appetite for quick kills and bloated bonuses.”

Unfortunately, a well conceived plan to reform our financial regulatory structure has not been put forth. Without a clear plan, action will come later rather than sooner. Let’s hope the bail-out band-aids hold long enough to see meaningful reform.

Details of the Obama administration’s plan for regulatory reform are beginning to trickle out and it appears as though the devil for financial institutions is truly in the details.  Here is what the Associated Press reported yesterday.

Under the administration’s proposal, companies such as Citi, Goldman Sachs and others in a broad top tier engaged in complex transactions would face stricter scrutiny and have to hold more assets and more cash as cushions against a downturn. They also would have to anticipate their own demise, drafting detailed descriptions of how they could be dismantled quickly without causing damaging repercussions. Think of it as planning their own funerals — and burials.

Obama’s plan, in short, aims to make it far less appealing to be so big. That was the middle ground the administration sought, a step short of an outright ban on systemically risky companies. ”Without banning them we’re providing some pretty heavy penalties for entering” the top group of institutions that could pose a risk to the entire financial system, said Diana Farrell, deputy director of the White House’s National Economic Council. ”The regulator might say to a large institution, ‘Make sure there is very good reason to allow yourself to get that big, or that interconnected, or that complex because the penalties will wipe out any advantages, such as lower cost of capital, you might have.’”

Large financial institutions in the U.S. will face many regulatory challenges and should be preparing their companies for the imminent changes to come.  Many of these companies’ strategic plans will be impacted by the new rules and the risks they carry.

The Wall Street Journal reported yesterday that the White House is backsliding on its goal to streamline financial regulations.  While not surprising in the highly politicized world of Washington D.C., the compromise may haunt the current administration and others for years to come.  Here is what the WSJ had to say.

The Obama administration is backing away from seeking a major reduction in the number of agencies overseeing financial markets, people familiar with the matter say, suggesting that the current alphabet-soup of regulators will remain mostly intact.

Administration officials had suggested they might push for major regulatory consolidation in the wake of the financial crisis. But now they expect to call for most existing agencies to have broader powers to limit risk-taking by financial institutions, say the people familiar with the planning.

Opportunities to reform and eliminate duplicate activities do not come around very often.  This is truly a missed opportunity of the greatest proportions.  Companies facing changes in regulation among the spaghetti-like structure we have today will need to spend more to comply with conflicting rules that may or may not reduce risk in the long run.

As the great Thomas Edison once said, “opportunity is missed by most people because it is dressed in overalls and looks like work.”  That is certainly the case here.

As expected, the U.S. government is making its move to reform regulatory oversight and strengthen risk management practices at major U.S. financial institutions.   More will be required from these institutions, both in terms of capital as well as compliance and control.  Here is what the Wall Street Journal reported yesterday about U.S. Treasury Secretary Tim Geithner’s plans.

Mr. Geithner is expected to call for a strict and consistent set of regulations for large firms, as well as more power for the government to monitor emerging risks to the economy. The new rules will likely require financial institutions to hold more capital as a buffer against losses and will bolster risk-management standards. All told, the proposals would mean significant expansions of power for the Treasury, Federal Reserve and other regulators.

Preparations for these sweeping changes must begin now.  Is your company ready?  Visit www.WheelhouseAdvisors.com to learn more about how we can help.