Commentary: An Assessment of President Obama’s Proposed Financial Reform Legislation

The financial crisis and resulting economic downturn have had many observers asking for more oversight and accountability within the Financials sector. Recently, the Obama administration announced its plans for reforming how financial services firms are being regulated. While this plan offers increased supervision for non-banks, early identification of firms whose collapse would cause systemic issues, and enhanced consumer protection, there are many aspects that have been met with skepticism.

A Summary of the Proposed Legislation

With the proposed legislation, the administration seeks to “restore confidence in the integrity of our financial system” through initiatives designed to:

1. Promote robust supervision and regulation of financial firms.

New entities would be established and tasked with supervising federally chartered banks and financial firms whose failure would pose a “significant risk to the financial system.” The Federal Reserve would be given supervision over non-financial firms whose failure would “pose a threat to financial stability.” Stronger capital requirements would be imposed, particularly for firms dubbed too big to fail. Compensation standards would “prevent compensation practices from providing incentives that could threaten” a company’s viability. Loopholes that permitted depository institutions to avoid bank holding company regulation would be closed. Hedge funds and private equity funds would be required to register with the Securities and Exchange Commission.

2. Establish comprehensive supervision of financial markets.

Derivatives, such as credit default swaps, would be subject to stricter regulation. The Federal Reserve would oversee payment, clearing, and settlement of security transactions.

3. Protect consumers and investor from financial abuse.

Increased consumer protection from abusive practices used by unethical firms would be accompanied by regulation designed “to improve the transparency, fairness, and appropriateness of consumer and investor products and services.”

4. Provide the government with the tools it needs to manage financial crisis.

A new process for resolving the failure of large non-financial corporations (think General Motors) would be accompanied by increased lending resources that would be used by the government in times of financial crisis.

5. Provide the government with the tools it needs to manage financial crisis.

Efforts to develop international financial regulations to address firms doing business on a global basis would be developed in conjunction with crisis management tools.

The Proposed Watchdogs

In order to accomplish these goals, new regulatory organizations and positions will be created, such as the Financial Services Oversight Council (FSOC), the Consumer Financial Protection Agency (CFPA) and a National Bank Supervisor. The FSOC would consist of top regulators, including the Secretary of Treasury and the chairman of the Federal Reserve (Fed), who would convene to identify possible risks, remedy inconsistencies within regulatory agencies and make sure that the lines of communication stay open so that each agency is well-informed. The CFPA would act as an independent organization solely dedicated to protecting consumers of financial products from fraud and abuse by setting high standards for financial services firms and enforcing any violations that might occur through fines and penalties. Both of these groups would be created for the purpose of expanding and enforcing new and existing regulations within the financial services industry. The National Bank Supervisor would have the authority to supervise all federally chartered banks.

Increased authority would also be granted to existing regulators, such as the Federal Reserve, the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC). Under the new proposal, the Fed would supervise not only bank holding companies but also any large, interconnected company whose collapse could bring about another severe financial crisis. These firms would need to increase their capital requirements in case of large portfolio losses. Hedge funds and private equity firms would be required to register with the SEC, and both the SEC and the CFTC would have the power to put new rules in place for the trading of derivatives.

Costs and Benefits

Since the proposal was unveiled on June 17, many lawmakers and industry representatives have spoken out against certain facets of the plan. The increase in the Fed’s regulatory power is cited as particularly concerning. Some worry that the Fed’s new responsibilities will cause it to reduce its focus on fighting inflation and managing the money supply. Others feel that the Fed was largely responsible for the latest dearth of regulatory oversight and blame the Fed for the current economic crisis. Alternative suggestions have been made, which include splitting the functions of a regulator and central banker into two different entities or using a committee of regulators to oversee the entire system. The Obama administration argues that these alternatives would create further break-downs in communication. They believe it is best to centralize accountability within one organization, and that the Fed has the most experience working with large firms that could pose a systemic threat.

The U.S. Chamber of Commerce strongly opposes the formation of the CFPA, stating that it would simply add another layer of chaos to an already-confusing patchwork of regulatory systems. In some cases, they argue, it could actually weaken current agencies by duplicating processes. The Obama administration has responded that their goal is to fill in existing structural weaknesses rather than scrapping the current system.

The CFPA would be an organization focused only on protecting the consumer from misleading practices in the financial services industry. While simplified language and documentation would help the consumer, increased regulation in the financial industry usually means increasing the volume of disclosure and more paperwork. Often, consumers are then more discouraged from reading the materials given to them when they invest in a product and become less informed than they were originally. Increased regulation and increased paperwork also lead to increased costs for businesses, which leads to lower returns for investors.

Another aspect of the legislation that has drawn criticism lately has been the government’s proposed creation of a “resolution regime” for handling distressed companies that are too big to fail. If government agencies determine ahead of time which companies fall into this category, it would have severe implications for smaller competitors. If investors know that a firm will be aided by the government when it falls on tough times, it will decrease the firm’s risk profile, giving it an unfair advantage in the form of having lower borrowing costs than its other industry peers. The marketplace would no longer decide which companies had failing business models and unwanted products. Instead, taxpayers would be responsible for subsidizing companies that did not add value. This could result in heavy inefficiencies, as overt risks are taken with the knowledge that the government will act as a safety net. On the other hand, smaller companies would have the advantage for recruiting better talent because larger companies would be subject to limitations on employee compensation.

In any case, new regulation is expensive to implement, and the resulting benefits are unclear at this time. When the Great Depression occurred, regulations were put in place afterward to prevent another catastrophe of that magnitude from happening; obviously, this goal was not met. There are no guarantees that new regulations will foil other future crises since in many cases, these regulations are reactive rather than proactive. While some standards should be in place for the proper functioning of financial markets, too many additional rules can stymie competition and innovation.

Watch and Wait

Lobbyists and other interested parties are all making bids to shape the final legislation, which should be ready for the President’s signature by year end. In the meantime, the administration must work with Congress to find a comprehensive solution that allows the government to identify possible risks early and be able to deal with them in an efficient manner so that history doesn’t repeat itself.

 

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Research and commentary provided by SEI Investments Management Corp (SIMC) for educational purposes. SIMC is a wholly owned subsidiary of SEI Investments Company.