Financial Regulation: reforms in the US and EU

Abel M Mateus

Universidade Nova de Lisboa

University College London

The Global Financial Crisis

• Major regulatory failure

• Problems of lax regulation in particular in – Systemic risk

– Lack of expedite resolution mechanism

– Counterpart risk

• Taxpayers suffered initially the brunt of the losses

• Lack of clear assigned responsibilities to regulators

Problem of Global Regulation Reform

• The Financial Market today is global • Major role played by global financial centres

– New York (US) – London (UK) – Less extent Tokyo, Singapore, Frankfurt, Shangai

• Nature of reform game: equilibrium is “Minimum required reform” for fear of business leaving to other location

• Solution: more international cooperation • Like Prisoner´s Dilemma

US Financial Reform

• Proposed to Congress by Geithner on June 2009

• Frank-Dodd Act of June 2010

• President Obama signs it on July, 21st, 2010

• Always ahead of EU

Initial Proposal Treasury: Improve the institutional framework for supervision and regulation of financial firms

It comprehends the rationalization of the regulatory system, creation of a systemic regulator and closing loopholes in the regulatory system for financial institutions, mainly the ones that are critical to market functioning. The objective is that no financial firm that poses a significant risk to the financial system should be unregulated or weakly regulated. It proposes: • A new Financial Services Oversight Council of financial regulators, at the Treasury, with the heads of the

FED, the new National Bank Supervisor, FDIC, capital markets supervisors, FHFA, and the new Consumer Protection Agency, with the authority to gather information to identify emerging systemic risks, refer troubled banks to the FED and improve interagency cooperation.

• New authority for the Federal Reserve to supervise, on a consolidated basis, all firms that could pose a threat to financial stability, even those that do not own banks, designated by Tier 1 FHC.

• Stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms, namely Tier 1 FHC. Prevent managers and staff remuneration systems to feed in the crisis. Improve accounting standards in accordance with a more forward-looking provisioning.

• A new National Bank Supervisor to supervise all federally chartered banks, by consolidating the Comptroller of the Currency and the Office of Thrift Supervision, and elimination of the federal thrift charter and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve.

• The supervisory system in the US is quite complex. The most important supervisors at federal level of banking firms are the FED, Comptroller of the Currency, Office of Thrift Supervision, FDIC, and National Credit Union Association.

Outcomes

• Oversight and Systemic Risk. The Act gives regulators new resolution authority, creates a new council to monitor and address systemic risk, and changes the mandate of the Federal Reserve.

• Orderly Liquidation Authority• . Regulators receive new authority under the Act to take control of and liquidate troubled financial firms if their failure would pose a significant risk to the financial stability of the United States. The Act specifies the types of financial companies subject to this authority, the elements of the systemic risk determination, and the mechanics and funding of the liquidation process.

• Key Measures to Address Systemic Risk• . Under the Act, for the first time, the mitigation of systemic risk and the maintenance of system-wide financial stability will be regulatory objectives. – New Financial Stability Oversight Council established to fulfill these objectives and their

application to financial firms, including nonbank financial companies. – No merger is authorized if merged company has more than 10% of market share (in liabilities)

• Federal Reserve Emergency Credit• . The Act limits the Federal Reserve’s authority to extend credit in “unusual and exigent circumstances” to participants in facilities with broad-based eligibility.

Extended powers to the FED

• Financial Institutions. The Act imposes significant new regulations on banking organizations. In addition, for the first time, the Act will allow the Federal Reserve to regulate companies other than banks — such as insurance companies and investment firms — if they predominantly engage in financial activities and are selected for regulation by the Council based on an evaluation of their balance sheets, funding sources, and other risk-based criteria.

New system of regulation

• Federal Reserve: will regulate bank and thrift holding companies with

assets of over $50 billion, where the Fed’s capital market experience will enhance its supervision. As a consolidated supervisor, the Federal Reserve can see risks whether they lie in the bank holding company or its subsidiaries. They will be responsible for finding risk throughout the system. The Vice Chair of the Federal Reserve will be responsible for supervision and will report semi-annually to Congress.

• FDIC: will regulate state banks and thrifts of all sizes and bank holding companies of state banks with assets below $50 billion.

• OCC: will regulate national banks and federal thrifts of all sizes and the holding companies of national banks and federal thrifts with assets below $50 billion. The Office of Thrift Savings is eliminated, existing thrifts will be grandfathered in, but no new charters for federal thrifts.

Too Big to Fail

• Tough to Get Too Big: Makes recommendations to the Federal Reserve for

increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with significant requirements on companies that pose risks to the financial system.

• Regulates Nonbank Financial Companies: Authorized to require, with a 2/3 vote, nonbank financial companies that would pose a risk to the financial stability of the US if they failed be regulated by the Federal Reserve. With this provision the next AIG would be regulated by the Federal Reserve.

• Break Up Large, Complex Companies: Able to approve, with a 2/3 vote, a Federal Reserve decision to require a large, complex company, to divest some of its holdings if it poses a grave threat to the financial stability of the United States – but only as a last resort.

• Technical Expertise: Creates a new Office of Financial Research within Treasury to be staffed with a highly sophisticated staff of economists, accountants, lawyers, former supervisors, and other specialists to support the council’s work by collecting financial data and conducting economic analysis.

• Securitization• . Under the Act, issuers or originators of asset-backed securities generally will be required to retain at least five percent of the credit risk associated with the securitized assets. We describe these provisions of the Act and explore their potential impact on the securitization field.

• Credit Rating Agencies• . Credit rating agencies will enter into an entirely new regime of regulation under the Act in terms of new substantive standards, disclosure obligations, and private litigation rules applicable to rating agencies.

• Investor Protection and Securities Enforcement• . The Act enhances the SEC’s enforcement program and investor protection mission by establishing a new whistleblower bounty program, providing the SEC with new enforcement authority, and permitting the SEC to impose a “fiduciary duty” on broker-dealers that provide retail investment advice. We consider the implications of these changes and conclude that the Act will make the SEC a stronger and potentially more assertive agency

• The “Volcker Rule” is embodied in the Act’s limitations on insured depositary institutions and their affiliates conducting “proprietary trading” and investing in hedge funds and private equity funds. The “Volcker Rule” : – Prohibits insured depository institutions from sponsoring or detaining capital in hedge funds and private

equity funds and invest in those – Prohibits insured depository institutions from conducting proprietary trading in securities except State

bonds – Prohibits those institutions to conduct transaction on “short-term price movements” and conflicts of

interest with client accounts

• Private Fund Investment Advisers• Advisers to hedge funds and private equity funds have new

requirements for registration, recordkeeping, and reporting. • Insurance Companies• . The Act will potentially subject some of the largest insurance companies to

designation as nonbank financial companies and oversight by the Federal Reserve for the first time. The new Federal Insurance Office created by the Act is to monitor the industry, along with related provisions designed to promote uniformity among the states in market regulation of specified types of insurance.

• Supervision of Payment, Clearing and Settlement• . Greater role that the Act assigns to the Federal Reserve in the supervision of systemically important financial market utilities and payment, clearing and settlement activities conducted by financial institutions

• Capital Markets. The Act brings significant changes to the rules that affect the process of financing business enterprises:

• Derivatives and Swaps Clearinghouses. The Act imposes a new regulatory regime on over-the-counter derivatives, which includes clearing, exchange trading and other requirements intended to increase transparency, liquidity and efficiency, and to decrease systemic risk

Improve supervision of capital markets

Review and consolidate procedures among government and regulators in order to make the financial system able to withstand both system-wide stress and the failure of one or more large institutions. It proposes: • Enhancing regulation of securitization markets, including new

requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that issuers and originators retain a financial interest in securitized loans, as a way to align incentives in the originator and distribute system.

• Comprehensive regulation of all over-the-counter derivatives. • Registration of advisers of hedge funds and other private pools of

capital with the SEC. • New authority for the Federal Reserve to oversee payment,

clearing, and settlement systems.

Control of OTC Derivatives Commodities Futures Trading Commission and SEC

The main mechanisms for achieving this are: • to require that as many product types as possible be centrally cleared and

traded on exchanges (Derivatives Clearing Organizations) or comparable trading facilities (swap execution facilities) – Most swaps have to be cleared through an exchange

• All swaps cleared or not cleared have to be reported to a swap data repository

• to subject swap dealers and major market participants to capital and margin requirements

• to require the public reporting of transaction and pricing data on both cleared and uncleared swaps

• Lincoln Provision ( Swaps push-out by banks): – prohibition of federal assistance to swap entities – Banks have to segregate non-related own swaps to a capitalized nonbank

affiliate

• the Act prohibits “manipulative” short sales

Rating agencies

The Act requires rating agencies to: • Disclose rating methodologies and publish reports on ex-post accuracy • establish internal controls to monitor adherence to credit rating policies and

procedures • the Act rescinds previous exemption to litigation, thus exposing rating agencies to

expert liability if they consent to the inclusion of a credit rating in a registration statement

• pleading against a rating agency would satisfy the state-of-mind requirement if it alleges facts with particularity giving rise to a strong inference that the rating agency knowingly or recklessly “failed to conduct a reasonable investigation” of the factual elements relied upon in evaluating the credit risk of the rated security

• Eliminate the regulatory requirement of credit ratings and require institutions to conduct their own risk analysis

• submit annual compliance reports to the SEC and maintain an independent board of directors,

• take steps to prevent sales and marketing considerations from influencing ratings (prevent forum shoping)

• apply qualification standards to credit analysts • establish procedures to evaluate possible conflicts of interest

Protect consumers and investors

To lower the risk of moral hazard for consumers and to make financial instruments more transparent and simpler, it proposes: • A new Consumer Financial Protection Agency to protect consumers across

the financial sector from unfair, deceptive, and abusive practices. • Further regulations to improve the transparency, fairness, and

appropriateness of consumer and investor products and services. • To prevent regulatory capture within the SEC and increase the influence of

investors, the Act creates an Office of the Investor Advocate, an Investor Advisory Committee composed of 12-22 members of whom serve 4-year terms, and an ombudsman appointed by the Office of the Investor Advocate

• Transparency & Accountability for Exotic Instruments: Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated - including loopholes for over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders

Consumer Protection

• Bureau of Consumer Financial Protection (BCFP) within the Federal Reserve to regulate consumer financial products and services. The BCFP, which will consolidate and strengthen consumer protection responsibilities currently managed by the Federal Reserve, the OCC, the OTS, the FDIC, the NCUA, the FTC, and HUD, will have extensive authority to regulate and enforce substantive standards for any person that engages in the offer or sale of a financial product or service to any consumer.

• The BCFP will be led by a presidentially appointed, Senate-confirmed director.

• The BCFP’s central mission will be to implement and enforce relevant federal laws to ensure that markets for consumer financial products and services are “fair, transparent, and competitive.” The BCFP is specifically tasked with protecting consumers from discrimination and “unfair, deceptive, or abusive acts and practices.”

Mortgage lending

• The Act mandates that lenders shall verify a mortgage borrower’s ability to repay the loan, and requires the lender to consider certain factors, such as – credit score, – income and – debt-to-income ratio, in making that decision.

• A violation of the “ability to repay” standard (and certain other provisions) may be raised as a foreclosure defense by a borrower against a creditor or assignee without regard to any statute of limitations

• The Act bans the payment of yield spread premiums or other originator compensation that is based on the interest rate or other terms of the loans

• The Act bans certain loan provisions, including prepayment penalties on certain types of loans

Debit cards fees and increasing competition in processing

• Requires that the amount of any interchange transaction fee for a debit transaction be “reasonable and proportional” to the cost incurred by the issuer with respect to the transaction, and directs the Board of Governors to prescribe regulations within nine months of the enactment of the legislation to establish standards for assessing whether such fees are “reasonable and proportional” to the cost incurred by the issuer

• eliminates exclusive arrangements between issuers and networks for electronic debit transactions; require that all debit transactions be processed by at least two independent networks

• payment card networks may not, directly or indirectly (including through any licensed member of the network), limit a merchant’s ability to provide discounts, or other in-kind incentives, for payments by use of cash, checks, debit cards or credit cards

• limits restrictions on merchant discounting and minimum or maximum dollar-amount thresholds as a condition for acceptance of credit cards.

Governance

• Governance and Compensation. The Act authorizes the SEC to adopt rules giving nominating shareholders access to the company’s proxy. In addition, the Act requires enhanced disclosure of executive compensation and gives shareholders the right to a “say-on-pay” vote on executive compensation

• transparency and disclosure, no new regulation of compensation (studies by academics consider it OK)

• the prohibition on excessive compensation at covered financial institutions, the pay-versus-performance disclosure, and the clawback requirements (recoup past incentive compensation)

New tools to solve problem banks and manage financial crises

To strengthen the capacity of regulators and liquidity interventions by the lender of last resort and clarify choices between bailouts and financial collapse, it recommends:

• A new regime to resolve nonbank financial institutions whose failure could have serious systemic effects.

• Revisions to the Federal Reserve’s emergency lending authority to improve accountability

New resolution system

• The Secretary of Treasury, in consultation with FED, can declare and place a “covered financial institution” with “systemic risk determination” under the receivership of FDIC

• Limited capacity of Court to intervene • Speedy process • Limits losses to creditors and shareholders, FDIC can use borrowed funds up to 60

months • Remainder losses have to be distributed to large financial institutions • Charges the largest financial firms $50 billion for an upfront fund, built up over

time, that will be used if needed for any liquidation • Management is fired and may be prossecuted for bad management or fraud, and

may be banned for given period • Funeral Plans: Requires large, complex companies to periodically submit plans for

their rapid and orderly shutdown should the company go under. Companies will be hit with higher capital requirements and restrictions on growth and activity, as well as divestment, if they fail to submit acceptable plans.

The strong points in the Plan

• creation of a systemic risk monitoring system entrusted to the FED,

• strengthening the solvability requirements of major institutions,

• centralizing the supervision of major banking in the FED, and • a receivership regime for insolvent institutions. This regime is

very important when we compare the case of Washington Mutual that was promptly resolved by the FDIC with the court-based bankruptcy proceedings of Lehman Brothers that are still going on. Besides, this regime will strip shareholders and management of most of its rights to reduce the moral hazard problem, since the Treasury is bailing-out depositors.

The weakest points are

• it proposes a timid reform of the institutional system of regulation that is prone to forum shopping and too complex,

• does not propose a federal regulator for insurance, but only a kind of observatory in the Treasury, leaving regulation fragmented by 50 states,

• proposes more regulation for rating agencies without solving the fundamental problem of perverse incentives,

• does not propose instruments for the monetary authorities to control asset bubbles, and

• does not propose a reform of Fannie Mae and Freddie Mac for the second tier market in mortgages, clearly separating a social housing policy and the secondary market that should be privatized.

EU Financial Reform (milestones)

• de Larosière Report (2009), published in 25th of February, 2009

• In September 2009 the Commission started to send to the European Parliament a set of legislative proposals for the regulatory reform

• Directives about new EU regulatory Authorities adopted on

• Rest of legislation under discussion until end 2012

Strengthening the institutional regulatory system, establishing EU-wide bodies, and

improving prudential supervision • A EU-wide systemic regulator • The European Systemic Risk Board (ESRB) is composed by the head of the ECB,

which will act as a secretariat, heads of national central banks, European Supervisory Authorities, a representative of the European Commission and national supervisors, with a total of 61 members. The objectives of the ESBR are to monitor and assess potential threats to financial stability that arise from macro-economic developments, with fragmented national markets, and from developments within the financial system as a whole. To this end, the ESRB would provide an early warning of system-wide risks that may be building up and, where necessary, issue recommendations for action to deal with these risks.

• Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on Community macro prudential oversight of the financial system and establishing a European Systemic Risk Board, {COM(2009) 500 final}, {COM(2009) 501 final}, {COM(2009) 502 final}, {COM(2009) 503 final}, {SEC(2009) 1234} and{SEC(2009) 1235}. The ESRB is established on the basis of Article 95 of the EC Treaty as a body without legal personality.

• Proposal for a COUNCIL DECISION entrusting the European Central Bank with specific tasks concerning the functioning of the European Systemic Risk Board {COM(2009) 499 final}, {COM(2009) 501 final}, {COM(2009) 502 final}, {COM(2009) 503 final}, {SEC(2009) 1234} and {SEC(2009) 1235}.

• A EU-wide coordinating network of supervision • In the proposal of de Larosière and the Commission, financial supervision will

continue to be mainly carried out by national supervisors. The proposed European System of Financial Supervisors (ESFS) is simply a network of national financial supervisors working in tandem with new European Supervisory Authorities (ESAs), created by transforming the existing European supervisory committees into a European Banking Authority (EBA), a European Insurance and Occupational Pensions Authority (EIOPA), and a European Securities and Markets Authority (ESMA). This structure aims to combine the advantages of an overarching European framework for financial supervision with the expertise of local micro-prudential supervisory bodies that are closest to the institutions operating in their jurisdictions.

• The ESAs will be Community bodies with a legal personality with primary responsibilities: (i) to adopt a EU rule book applicable to all financial institutions in the EU, trying to eliminate major differences in the transposition of directives to national jurisdictions, (ii) adopt technical standards, (iii) ensure consistent application of Community legislation by national authorities by referring to the Commission cases of noncompliance or acting on its own recommendations, (iv) in emergencies require national supervisors to take certain actions, and (v) participate in the colleges of supervisors.

Establish colleges of regulators for multinational financial firms • Since supervision remains decentralized, the Commission is studying the model of

establishing colleges of national supervisors for multinational financial firms. Revision of bank capital requirements and accounting procedures • Due to the role played by repackaging of mortgage securities into complex

instruments, for which it was difficult to assess risk, the Commission proposes stringent rules, topped up by a risk weight of 1250% in case due diligence is not performed. It also requires disclosure of securitization risks, including off-balance sheet positions.

• It also proposes adding an additional capital buffer based on stress test VAR to the regular VAR, based on the short-term trading books of the bank.

• The Commission is also studying corrections to the pro-cyclicality of solvency ratios. The proposal being advanced is the Spanish dynamic provisioning that increases requirements in booms and lowers them in recessions. Another alternative is the expected cash model.

• Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Directives 2006/48/EC and 2006/49/EC as regards capital requirements for the trading book and for re-securitisations, and the supervisory review of remuneration policies SEC(2009) 974 final SEC(2009) 975 final .

Improve supervision of capital markets

Revision of the role of credit rating agencies • After referring that self-regulation has failed, and the need to level

the playing field with the US where most of the rating agencies have their parent companies, the proposal aims at avoiding conflicts of interest, by separating their rating and business consulting functions, strengthening internal controls. It obliges rating agencies to disclose publicly its methodologies, models and key rating assumptions used for rating. Rating agencies will also be subject to registration and supervision by designated national authorities and the Committee of European Securities Regulators (future ESMA).

• Proposal for a REGULATION OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on Credit Rating Agencies {SEC(2008) 2745}, {SEC(2008) 2746}.

Supervision of hedge funds, commodity funds and private equity funds • The Commission proposes registration of all these types of

funds, establishes minimum requirements for entry, and submits them to regulation by the competent supervisors and to periodic disclosures. Funds with a systemic relevance would be subject to tighter regulation. It also establishes a de minimis principle of 100 million Euros for exclusion from the Directive.

• Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on Alternative Investment Fund Managers and amending Directives 2004/39/EC and 2009/…/EC, {SEC(2009)576}, {SEC(2009)577}

Regulate derivative markets • The proposal contemplates EU-wide regulation of center

counterparties, mandating central clearing for standardized contracts and using exchanges in case of standard derivatives, raising capital requirements for bilaterally-cleared compared with centrally-cleared derivatives, and improving collateralization of exposures to large systemic institutions. It also requires more transparency on all transactions not centrally cleared.

• COMMUNICATION FROM THE COMMISSION Ensuring efficient, safe and sound derivatives markets, {SEC(2009) 905 final}, {SEC(2009) 914 final}.

Originator-distributer model in mortgage securitization

• Restrict full mortgage securitization, which has been demonstrated that misaligns the incentive to monitor debt agents by the originator with the subsequent layers of institutions that take the securities, by retaining the equity tranche to the originator.

Protect consumers and investors

• Executive pay The proposal of the Commission is to include remuneration schemes under the capital requirement exercises to promote sound risk management policies. Bonus should be aligned with the duration of the risk in the transaction, determined over the cycle

EU Regulatory reform

• The strong points are: (i) creation of a financial systemic board, (ii) strengthening of the present committees of financial supervisors and its upgrading to European Regulatory institutions, (iii) creation of a coordinating body of these European Regulatory institutions, (iii) brings into the financial regulatory structure hedge, commodity and private equity funds, and (iv) establishes colleges of supervisors for multinational financial firms.

weak points

• the financial systemic board does not have any decision power, only issues recommendations to the European Council or Commission, and in case of acute crisis where swift action is required this is fundamental, and is made up of too many people to be able to reach effective agreements,

• the coordinating body does not centralize enough the power required for an effective EU-wide and single financial market. These problems are major weaknesses of the proposed institutional framework and are not consistent with the objective of building a single market for banking and financial services as it is written in the Treaty. The problem is even more serious within the euro area, where there is a single Central Bank, that may be required to intervene supplying liquidity to save one or several major financial institutions and then 15 or more fragmented national supervisory systems. This contradiction has already been questioned by a number of academics, even from the beginning of the euro,

• the proposal regarding rating agencies is ineffective and does not go to the crux of the matter,

• it increases regulation in derivatives markets but does not specify the domain of standardized products,

• the European proposals lack any concern about consumer protection.