3 Thoughts on America's Regulatory Overhaul

by: Ryan Avent


I am slowly but surely making my way through the administration's draft regulatory policy. It's 84 pages long, but it would clock in at a solid 150 if all the acronyms were written out. The bloggers do not like this. Understandably. The proliferation of be-acronymed agencies not only makes for unpleasant reading, it indicates that when consolidation looked difficult, the administration solved the problem by adding even more agencies.

An example. One of the primary complaints about the regulatory system is the extent to which overlapping jurisdictions create loopholes and reduce accountability, clearing the way for the unchecked growth of systemic risk. One way to address this problem would be to combine some of the agencies into one coherent agency with explicit authority to keep an eye out for risk. As we've documented, however, that's not been popular with the regulators.

So the plan calls for the creation of a new body—the Financial Services Oversight Council—which will advise the Federal Reserve on the growth of systemic risk. The FSOC will be made up of members of all the other various agencies, and it will "provide a forum for resolving jurisdictional disputes between regulators". Instead of, you know, eliminating the jurisdictional disputes.

Which might work out just fine. It's just exasperating to watch the government travel around its elbow to reach its thumb in this fashion.


Despite the proliferation of acronyms, the administration's proposed regulations do seem to create a system in which the buck stops with the Federal Reserve, and the Federal Reserve has pretty broad authority to examine financial institutions of all kinds (in order to prevent firms from slipping past regulators by using special purpose vehicles or other sneaky arrangements). The draft proposes eliminating parts of the Gramm-Leach-Bliley Act, which limits Fed oversight of institutions with other primary regulators. In other words, just because you find yourself regulated by a state supervisor or the SEC doesn't mean you aren't subject to oversight by the Fed, which will be keeping an eye on any threat you might pose to the broader financial system.

Large financial institutions are to be regulated with their systemic impact kept in mind. There are obviously negative externalities to big bank failures, and so a stricter approach to institutional security is warranted than were only the health of the one firm at stake.

There are recommendations that mirror proposals floated during the regulatory discussion which has been ongoing during the past year or so. Banks should hold sufficient capital in good times to get them through stressed time, and some of that capital should be in the form of contingent instruments (such as debt which automatically converts to equity during crisis periods). Banks will have to hold capital against off-balance sheet vehicles; sensible, given that as soon as trouble hit, bank actions quickly demonstrated that they were never really off the bank's balance sheet.

Meanwhile, the creation of a National Bank Supervisor is also proposed, to keep chartering and oversight capacities of all federal banks in one place. In an interesting but seemingly sensible bit of deregulation, the draft proposes to eliminate any remaining restrictions on interstate branching. Oh, and if you own a bank, you're regulated like a bank, it doesn't matter what your primary business is or what share your business is tied up in the insured depository institution.

Implementation and specifics will be an issue, of course, but there is a lot to like here.


The administration's new regulatory plan also seeks to clean up some of the toxicity that developed in the area of structured finance. For starters, the bill would have originators of asset-backed securities keep 5% of the credit risk of their securitised exposures on their own balance sheets. Federal authorities can also dictate which slice of a security gets retained (for instance, no just holding on to the super senior tranche) and for how long it must be kept on a balance sheet.

There are some passages about improving ABS transparency, and improving reporting of conflicts of interest among ratings companies. Perhaps more importantly, the draft suggests that regulators ought to reduce their use of credit ratings when they can.

OTC derivatives, including credit default swaps, get some attention. They are to be brought within the regulatory fold, and will be cleared through regulated central counterparties. And then we have the creation of the much discussed Consumer Financial Protection Agency. The CFPA is designed in part to give consumers an independent voice in the regulatory process. It will also be intended to protect consumers from various kinds of abuse and to provide them with information about any financial product widely marketed to consumers.

Sounds lovely, but it remains to be seen how widely and vigorously such an organisation would use its authority in practice. Tyler Cowen seems to be concerned that the CFPA will limit the flow of financial innovation. I suppose I'm inclined to believe that its efforts to protect consumers will be overriden more often than not by those looking to safeguard "innovation", in its benign and malignant forms.

Much remains to be seen at this point.

Ryan's first, second and third reactions to the government's regulatory reform originally appreared on The Economist.com