The ERM Current™

The Obama Administration unveiled its proposed regulatory legislation for derivatives yesterday.  This legislation is the centerpiece of the financial regulatory overhaul due to the role derivatives played in the recent economic meltdown.  The new legislation to be considered by Congress aims to prevent future abuse of derivatives and, as a result, decrease the systemic risks posed by these markets.  Here is a summary of the goals of the legislation.

As part of the Administration’s proposed legislation, credit default swap markets and all other OTC derivative markets will be subject to comprehensive regulation in order to:

1. Guard against activities in those markets posing excessive risk to the financial system
2. Promote the transparency and efficiency of those markets
3. Prevent market manipulation, fraud, insider trading, and other market abuses
4. Block OTC derivatives from being marketed inappropriately to unsophisticated parties

These goals will be reached through comprehensive regulation that includes:

1. Regulation of OTC derivative markets
2. Regulation of all OTC Derivative dealers and other major market participants
3. Preventing market manipulation, fraud, insider trading, and other market abuses
4. Protecting unsophisticated investors

While the goals are clear, the methods to regulate are less so.  Responsibility for enforcement of the new regulations will be assigned to multiple agencies and may over time prove to be less than effective.  Warren Buffett famously described derivatives as “financial weapons of mass destruction”.  Given the size and magnitude of the markets to be regulated, the accountability for enforcement should be strengthened to ensure proper oversight of these potentially deadly securities.

A recent op-ed article in the Wall Street Journal by professors from Columbia and Harvard Business Schools provides a view on the political impact on financial regulatory reform in the United States.  Here what they had to say about the missed opportunity in the current proposal by the Obama administration.

For political reasons the administration has decided not to upend the current system. Instead it proposes four federal entities—Financial Services Oversight Council, the Office of National Insurance, the Federal Consumer Coordinating Council, and the Consumer Financial Protection Agency—on top of the current alphabet soup of regulatory agencies. This is a shame. We need fewer, not more, regulators. The Committee on Capital Markets Regulation, a private, nonpartisan organization on which we serve, recommended in its May report that serious consideration should be given to the creation of a unified supervisor, such as a U.S. Financial Services Authority, modeled on the approach of the United Kingdom. Our financial system has had a complete meltdown and our outmoded regulatory structure is partially responsible. This is the time to redesign the system for the future, not for politics as usual.

Reduced complexity and more accountability will result from a streamlined regulatory system.  The professors should take their case to Capitol Hill.

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 Obama administration today released their much anticipated blueprint for financial regulatory reform.  As expected, it outlines several goals of a reform effort.  The goals include the following:

1. Promote Robust Supervision and Regulation of Financial Firms
2. Establish Comprehensive Regulation of Financial Markets
3. Protect Consumers and Investors from Financial Abuse
4. Provide the Government with the Tools it Needs to Manage Financial Crises
5. Raise International Regulatory Standards and Improve International Cooperation

While these are noble goals, the blueprint document offers little in terms of specific actions other than the creation of more agencies and committees to address the concerns.  This will result in greater regulatory complexity and reduced governmental accountability.   For individual companies, this will certainly require greater investment in compliance programs to address the new governmental requirements.  Since the requirements are unknown at this point, companies will be well served to have a nimble and flexible infrastructure in place in order to adapt to the new regulatory regime.  Are you prepared?  Wheelhouse Advisors provides cost-effective solutions to help companies meet the increasing risk management and compliance demands.   Visit www.WheelhouseAdvisors.com to learn more.