Originally published on June 12, 2008
In the wake of the recent credit crisis, regulators and Congress are accelerating their efforts to address the governmental oversight of U.S. financial markets. The convergence of domestic and foreign markets, the increasingly important role of large, relatively unregulated investment pools and the development of derivative products that blur the lines between banking, insurance, securities and commodity products have raised legitimate concerns. The near failure of Bear Stearns combined with lingering adverse economic conditions have increased the likelihood of action by Congress as it questions whether our existing regulatory regime can adequately maintain the competitiveness and integrity of our financial system and provide appropriate protection to investors and consumers.
To help our clients respond to this ever-changing market place and evolving regulatory landscape, we have formed a Regulatory Reform Task Force that is made up of a diverse group of lawyers with experience in banking, securities, insurance, energy regulation and enforcement. The Task Force will expand on our various practice groups' monitoring efforts to track current and future proposals to reform regulation of the financial sector of the U.S. economy and identify their potential impact on a more integrated basis. These include the recent U.S. Department of the Treasury ("Treasury") Blueprint for a Modernized Financial Regulatory Structure summarized below (the "Blueprint"), which proposes a complete overhaul of the existing regulatory framework through short-term, intermediate-term and long-term recommendations. Many of the Blueprint's recommendations are being or have been considered previously in different forms, such as reconciling federal banking regulation, establishing an optional federal insurance charter and merging the Securities and Exchange Commission ("SEC") and the Commodities Futures Trading Commission ("CFTC"). For example, bills are already pending before the House and Senate that would create a new Office of National Insurance and allow insurance companies to obtain an optional federal charter.
As a service to our clients, for updates on regulatory developments, as well as links to governmental and other information relevant to regulatory reform efforts, please visit our Regulatory Reform Task Force Web page.
Treasury Blueprint for Regulatory Reform
Timing
There has been a mixed response to the Treasury's proposal. Immediate congressional action to implement the longer term aspects of the Blueprint is unlikely in light of upcoming elections and the current focus on alleviating the mortgage crisis. However, post-elections, Congress and a new presidential administration can be expected to offer new legislation impacting the financial services sector, particularly if adverse economic conditions continue. Moreover, the Federal Reserve is already making efforts to expand its role on Wall Street and, if lawmakers perceive that swift movement is necessary to avert an impending crisis, the pace of regulatory reform could accelerate.
More or Less Regulation?
Initial concerns raised by the proposed merger of the SEC and the CFTC are that it may yield an amalgamated agency more like the SEC's prescriptive rule-based model and less like the CFTC's more flexible principle-based model, harming the efficiency and competitiveness of the CFTC-regulated markets and its participants. The resulting regulatory framework may leave undecided existing jurisdictional struggles between the CFTC and the Federal Energy Regulatory Commission concerning over-the-counter (OTC) energy derivatives. To view Sutherland's May 19, 2008 Legal Alert: FERC Provides Guidance on Enforcement Policy Procedures, click here. As a result, market participants may face lingering uncertainty over the regulations and regulators that apply. To view Sutherland's April 11, 2008 Legal Alert: PGC and Sutherland to Address Regulatory and Market Issues Affecting Purchasers of Natural Gas at GasMart 2008 in Chicago, click here. The Blueprint also makes it clear that for the U.S. financial services industry to retain a dominant position in global securities markets, and even to remain a strong competitor, the U.S. must adopt a different regulatory model for its exchanges, broker-dealers and investment advisers. However, maintaining regulatory competitiveness would not necessarily mean less regulation. For example, the Blueprint raises the possibility that broker-dealers and investment advisers would be subject to greater regulation and oversight than they are currently, and that insurers could be regulated by the federal government.
Dual Banking System
The intermediate and long term proposals for the restructuring of the banking industry raise questions about activities, branching, preemption and the viability of the dual banking system (without the establishment and acceptance of private deposit insurance). The Blueprint once again opens the door for commercial enterprises' ownership of banks, but counters with the potential for more restrictions on affiliate transactions and bank activities. In addition, bank merger transactions may become subject to competitive reviews by the Federal Trade Commission and Department of Justice under the Hart-Scott-Rodino Antitrust Improvements Act.
Enhanced Regulation of OTC Products
Given the recent response of the Federal Reserve to the near collapse of Bear Stearns, which many attribute to systemic risk posed by a Bear Stearns insolvency as a result of its trillion dollar positions in the OTC derivatives markets, it is interesting how little discussion there is in the Blueprint regarding federal regulation and supervision of the OTC derivatives market. To view Sutherland's March 17, 2008 Legal Alert: OTC Counterparty Credit Risk in the Post-Bear Stearns World, click here. While acknowledging that the prevailing consensus view of federal regulators in recent years has been that "market discipline is the most effective tool to limit systemic risk," the Treasury Department now, for the first time, "recognizes the need for enhanced regulatory authority to deal with this risk." We expect an increased focus on addressing systemic risk as decision-makers come to grips with the exact form that this new regulatory authority should take.
Focus on Mortgage Market Reforms
In addition to the suggestions made by Treasury in the Blueprint, the President's Working Group on Financial Markets (the "PWG") has also considered the need for regulatory reform. The policy statement issued by the PWG on March 13, 2008 recommended additional reforms with respect to mortgage origination, credit rating agencies, securitization, financial institutions, investors, credit default swaps and OTC derivatives, and regulators. The PWG's stated objectives behind its recommendations are to strengthen (1) transparency and disclosure, (2) risk awareness, (3) risk management, (4) capital management, (5) regulatory policies and (6) market infrastructure. In February of 2007, the PWG also issued principles and guidelines relating to private pools of capital, including hedge funds, that focus on investor protection and systemic risk.
The financial upheaval in the mortgage market has triggered immediate calls for reforms that have already resulted in Congressional action to address potential foreclosures. To view Sutherland's May 20, 2008 Legal Alert: The Subprime Mortgage Crisis – Somebody Has to Pay, click here. In addition, law enforcement at the federal, state and local levels has initiated investigations into mortgage-related activities of brokers, lenders and others. As companies and financial institutions continue to take large write-downs and sell off assets in the wake of subprime losses, legislators and the Federal Reserve will continue to evaluate the possible need for increased government oversight. To view Sutherland's April 3, 2008 Legal Alert: Regulators Focus on Subprime and Structured Product Issues During the Orlando SIFMA Compliance and Legal Seminar, click here.
Market participants will need to follow the developments in these arenas very closely to ensure that they are not subject to unexpected regulations and/or oversight. We will continue to analyze the impact of the Blueprint and future proposals. Following is a brief summary of the Blueprint.
Blueprint Summary
Short-Term Recommendations
Treasury designed the short-term recommendations in the Blueprint to address the current credit crisis. Treasury recommends updating the Executive Order that established the PWG to include responsibility for the entire financial sector, not just the financial markets. To accomplish this goal, Treasury suggests that the heads of the Office of the Comptroller of the Currency ("OCC"), the Federal Deposit Insurance Corporation ("FDIC") and the Office of Thrift Supervision ("OTS") become members of the PWG.
Another set of short-term recommendations addresses the oversight of mortgage origination and advocates the creation of a Mortgage Origination Commission that rates the licensing and regulation of each state's mortgage origination process. To further monitor mortgage origination, Treasury advises that federal legislation should dictate uniform minimum licensing qualification standards for state mortgage market participants. Treasury also advocates clarification of enforcement authority under federal laws; for example, with respect to mortgage originators that are affiliates of depository institutions within a federally regulated holding company.
The last set of short-term recommendations relate to the Federal Reserve's response to the credit crisis. Treasury suggests that the Federal Reserve's liquidity provisioning process to non-depository institutions become more transparent and better protect its balance sheet, possibly through on-site examination conducted jointly with the SEC or CFTC.
Intermediate-Term Recommendations
Treasury's intermediate-term recommendations in the Blueprint are intended to affect its long-term goal of establishing an objectives-based regulatory approach instead of the functional regulatory approach currently in place. In particular, the Blueprint advises decreasing the number of regulators in areas such as securities and commodities and banking while establishing a new federal insurance regulator.
Securities and Commodities. To achieve objectives-based regulation, Treasury recommends merging the SEC and the CFTC and outlines steps for ensuring a successful merger of the agencies. These steps include the following actions to be taken by the SEC: (1) adoption of core principles regarding exchanges and clearing agencies modeled after the Commodity Futures Modernization Act; (2) streamlining and expediting the self-regulatory organization rule approval process; (3) streamlining the approval for securities products common to the marketplace much like certain derivatives securities products; (4) general exemption under the Investment Company Act for actively traded exempted products, such as exchange traded funds; and (5) recommending to Congress expansion of the Investment Company Act to permit registration of a new "global" investment company.
The Blueprint also endorses a new regulatory regime that would (1) treat institutional investors differently than retail investors; (2) establish a joint SEC-CFTC task force to resolve differences in key rules such as suitability and private rights of action; and (3) establish a self-regulatory organization to oversee investment advisers similar to that for broker-dealers.
Insurance. To reduce duplicative regulation, Treasury advocates the creation of an optional federal charter ("OFC") for insurers. The OFC structure should include a system of federal chartering, licensing, regulation and supervision for insurers, reinsurers and insurance producers. States would have no jurisdiction over those entities that opted for the OFC although state tax laws and requirements to participate in state mandatory residual risk mechanisms and guarantee funds could still apply to entities with an OFC. An OFC would be issued to specify the lines of insurance that each national insurer would be permitted to sell, solicit, negotiate and underwrite. No OFC would allow an insurer to hold a license as both a life insurer and a property and casualty insurer.
For regulation of entities with an OFC, Treasury recommends the establishment of the Office of National Insurance ("ONI"). Treasury acknowledges the bureaucratic difficulties in establishing the ONI in the near future and thus recommends the establishment of an Office of Insurance Oversight ("OIO") in the interim. The OIO would be responsible for international regulatory issues, such as reinsurance collateral, as well as standardization and coordination of state regulation of the insurance industry, e.g., insurance agent licensing. The Blueprint essentially adopts proposals on the OFC and ONI that are consistent with the bills proposed in 2007 and in prior years and becomes part of the ongoing debate in the insurance industry, and among regulators, over whether there is a need for federal regulation of insurance. To view James M. Cain's February 2002 "National Insurance Charter – A New 2001 Odyssey" presentation, click here.
Banking. The Blueprint proposes (1) elimination of the thrift charter and the OTS, (2) changes to state bank regulation, and (3) imposing new payment and settlements systems. More specifically, Treasury recommends phasing out the federal thrift charter and merging the OTS into the OCC. This would occur over a two-year period to give existing thrifts time to convert (by operation of law) to national banks and the OCC time to assume the operations of the OTS.
Treasury suggests that either the FDIC or the Federal Reserve have exclusive jurisdiction for federal supervision of state-chartered banks, and state-chartered thrifts, with federal deposit insurance. The Blueprint also calls for a study of the roles of the Federal Reserve and the FDIC in state bank regulation together with an overall study of the Federal Reserve Bank structure.
Treasury considers payment and settlement systems to be "a critical underpinning of the financial services sector, and of the economy as a whole." The Blueprint recommends creating a federal charter for payment and settlement systems that are of systemic importance to the U.S. financial system and economy in order to minimize associated risks and increase efficiency. The Federal Reserve would grant the charters and have primary regulatory authority.
Long-Term Recommendations
Treasury designed the Blueprint's long-term recommendations to create an objectives-based regulatory approach that moves away from the current institutionally-based functional regulatory system with the goal of separating out the oversight of consumer based transactions from that of business to business transactions. The proposed objectives-based regulatory approach would (1) formally establish the Federal Reserve as a Market Stability Regulator and set up a single federal payment and settlements regulation regime, (2) create a Prudential Financial Regulator, similar to the OCC, to focus on safety and soundness of institutions, expenses guaranteed by the U.S. government such as FDIC deposit insurance and potentially including government sponsored enterprise (so called GSE's), i.e. Fannie Mae of Freddie Mac, (3) form a new Business Conduct regulator, similar to the SEC and CFTC but with broader authority, to monitor and regulate the financial services industry overall and (4) a Corporate Finance Regulator, responsible for corporate disclosure and governance, and accounting oversight.
© 2008 Sutherland Asbill & Brennan LLP. All Rights Reserved.
This article is for informational purposes and is not intended to constitute legal advice.