Reforms on the Table

Two New Agencies

The Obama administration wants to create two regulatory agencies: one to keep tabs on potential threats to the financial system -- such as the problems Brooksley Born flagged in the derivatives market in the late 1990s -- and one to protect consumers from abusive practices by the financial services industry. In Congress, both agencies have been the subject of intense scrutiny as regulators spar over who should have which powers and Wall Street lobbyists fight to protect profits.

Financial Services Oversight Council

A cross-agency observer and facilitator

The Financial Services Oversight Council will "facilitate coordination of financial regulatory policy and resolution of disputes and identify emerging risks in financial markets." The council will replace the President's Working Group on Financial Markets. It will report to Congress, and its members will include representatives from the eight principal federal financial regulatory agencies.

The debate: A useful risk monitor, or a toothless compromise?

Some critics believe the new agency will be all bark and no bite. Under the current administration proposal, the new council will monitor the financial system, but most of the expanded powers to deal with potential threats -- including monitoring "too big to fail" financial firms and overseeing the payment, clearing and settlement systems that create market transparency -- will be delegated directly to the Federal Reserve, not the council itself.

"The Oversight Council described in the administration's proposal currently lacks sufficient authority to effectively address systemic risks," said Sheila Bair, chairman of the Federal Deposit Insurance Corporation, at an open House hearing on the plan. In its current conception, some argue, the council is a weak compromise intended to placate those wary of imbuing the Federal Reserve with more power.

Those who support the proposal argue that the Federal Reserve has experience in market oversight and that its new responsibilities are a logical extension of its current role. Transferring these powers to a new agency would be complicated and time-consuming and could lead to a greater disruption of the market. "For purposes of both effectiveness and accountability, the consolidated supervision of an individual firm, whether or not it is systemically important, is best vested with a single agency," Federal Reserve Chairman Ben Bernanke testified in front of the House Financial Services Committee.

Supporters also argue that a council bringing together a melting pot of financial regulators is best suited to maintaining big-picture supervisory responsibilities rather than acting as a responsive regulator. "You don't convene a committee to put out a fire," Treasury Secretary Timothy Geithner stated at a Senate hearing.

Consumer Financial Protection Agency

A consolidated regulatory hub to protect consumers

The Consumer Financial Protection Agency (CFPA), as envisioned by the administration, will have wide-reaching power to regulate not only banks and mortgage companies but also financial services previously outside the purview of federal regulation, such as payday loans, personal investment services, credit reporting agencies and stored-value cards.

It would have the power to levy substantial fines -- up to $10,000 per day for some offenses -- and to prosecute financial services providers who break the rules the CFPA creates. The CFPA would be tasked with writing disclosures in standard, clear language that make financial transactions, such as mortgages, easier to understand. The creation of the CFPA will consolidate regulatory powers currently spread among several agencies.

The debate: Is it a stifling behemoth or a necessary bulwark?

While banks and mortgage brokers have generally admitted the need for some reform in light of the current financial crisis, the financial services industry is strongly opposing the creation of the CFPA as proposed by the Obama administration. Industry representatives argue that unlike the current system, in which bank regulators charged with consumer protection are also responsible for monitoring banks' financial soundness, the new agency will lack an understanding for the business side of the industry. This disconnect, they argue, will create unnecessary hurdles for lenders and, according to Mortgage Bankers' Association President John Courson, will "stem innovation." (PDF) They also argue a new agency will mean new layers of bureaucracy and intimidating levels of liability.

Federal Reserve Chairman Ben Bernanke also opposes the creation of the CFPA. He believes its responsibilities would be better managed by his agency. He testified before the House Financial Services Committee: "The Federal Reserve is already the consolidated supervisor of some of the largest and most complex institutions in the world. I believe that the expertise we have developed in supervising large, diversified and interconnected banking organizations, together with our broad knowledge of the financial markets in which these organizations operate, makes the Federal Reserve well suited to serve as the consolidated supervisor for those systemically important financial institutions that may not already be subject to the Bank Holding Company Act."

Supporters of the CFPA argue that the current system has failed to protect consumers and more drastic measures must be taken.

"If the status quo is about choice, then explain why half of those with subprime loans chose high-risk, high-cost loans when they qualified for prime mortgages. The truth is, no consumer chose to accept the tricks and traps buried in the legalese of financial products," Elizabeth Warren, overseer of the Troubled Assets Relief Program and Harvard Law School professor, wrote in an online post defending the CFPA.

The House Financial Services Committee's most recent draft of legislation to create the CFPA attempts to placate critics by clearing up the definitions of who will fall under CFPA regulation -- non-financial businesses that offer credit systems would not, nor would real estate brokers or accountants -- and stressing that the CFPA will work with existing agencies to minimize the regulatory burden. However, The New York Times reports that the move would exempt more than 98 percent of banks from the agency's oversight.

A rift has also developed among supporters of the CFPA. A contingent of moderate and conservative Democrats -- with support from the financial services industry -- recently said that their support of the CFPA legislation hinges on its including language that bars states from enacting tougher regulations than those created by the CFPA. They argue that allowing states to enact their own tightened regulations would create a patchwork regime of regulation that would confuse consumers and hamper the financial services industry.

Update: On Oct. 22, the House Financial Services Committee voted in favor of creating the CFPA; the previous day it had compromised on state vs. federal regulatatory powers. Under the compromise, the Office of the Comptroller of the Currency would be able to override state regulations if the law "significantly" interferes with federal regulations.

The Regulation of Derivatives

As of October 2009, the House Financial Services Committee (overseer of the SEC) has approved a bill to regulate the derivatives market. The House Agriculture Committee (overseer of the CFTC) has drafted a similar bill that they will vote on on Oct. 21, 2009. The two bills are expected to be reconciled and brought to a vote on the House floor later this fall. Here's an overview of the key points in the two bills and areas where the CFTC fears the current legislation falls short.

Key points from the Financial Services Committee bill (PDF) (approved by the committee on Oct. 15):

• Increase transparency and visibility: Create a centralized clearing system -- a tool requiring most derivatives (those identified by the SEC and CFTC) to go through organizations that track the transactions. Require the CFTC and SEC to publish data that provides an overview of the derivatives market.
• Ban "abusive" swaps: Grant regulators the power to ban derivatives deemed harmful to those involved or to market stability.
• Exempt non-major market participants from regulation: Derivatives need not go through the centralized clearing system if "one of the counterparties to the swap is not a swap dealer or major market participant." This exemption would cover non-financial services businesses that use derivatives as a portion of their portfolio or to spread their commercial risk. Exempted transactions would still be reported to regulatory authorities.
• Set capital requirements and position limits for influential derivatives: If the CFTC or SEC thinks a given derivative transaction could significantly impact the market, they can require that its participants have a certain amount of cash on hand to counterbalance the risk of the transaction. The CFTC and SEC can also place limits on how much of the market given types of derivatives can make up, so that the highest risk derivatives are limited to a smaller proportion of total transactions.
• Maintain regulatory flexibility: Give the CFTC and SEC power to exempt derivatives users from established rules and limits on a case-by-case basis.

Key points from the Agriculture Committee bill (PDF) (Update: Passed by the committee on Oct. 21, 2009):

• Regulate foreign exchange swaps: The Agriculture Committee bill defines derivatives more broadly and includes foreign exchange swaps -- a form of derivative based on currency speculation -- in its regulation, a category of transaction exempted by the Financial Services Committee bill.
• Increase transparency with a central clearing system: Require central clearing of derivatives, but give the clearing organizations the right to choose who is required to participate.
• Require trading on a regulated exchange: Unlike the Financial Services Committee bill, this legislation requires most derivatives to be traded openly on a regulated exchange (a derivatives-only version of a stock exchange). Derivatives that the exchanges do not want to list will be exempted from this requirement.
• Set capital requirements and position limits for influential derivatives: If the CFTC or SEC thinks a given derivative transaction could significantly impact the market, they can require that its participants have a certain amount of cash on hand to counterbalance the risk of the transaction. The CFTC and SEC can also place limits on how much of the market given types of derivatives can make up, so that the highest risk derivatives are limited to a smaller proportion of total transactions.
• Maintain regulatory flexibility: Give the CFTC and SEC power to exempt derivatives users from established rules and limits on a case-by-case basis.

Key points from the CFTC's Response (PDF):

• Shift the presumption from exemption to regulation: Make trading derivatives on regulated exchanges mandatory, not simply an available option. Allow some exemptions, but make them the exception rather than the rule.
• Tighten rules requiring central clearing: Require centralized clearing of all derivatives, not only those regulators specifically identified on a case-by-case basis. Rather than exempting non-financial businesses using derivatives from a central clearing system, require them to partner with a financial entity already involved in the clearing system. Do not make blanket exemptions for derivatives used for "risk-management purposes" because this definition could be stretched to cover almost any derivative.
• Close foreign loopholes: Tighten language to ensure derivatives users cannot move their activities overseas or evade regulation through partnerships with foreign entities.
• Adequately regulate all types of swaps: To prevent loopholes, eliminate distinctions between different types of commodity swaps and ensure that all commodity swaps, including agricultural swaps, are standardized and protected.
• Require regular reporting and "robust business conduct standards": Impose stringent recordkeeping and reporting rules to improve the transparency of the market and introduce industry-wide rules for standard business practices to replace the current "back-office" standards.