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From Banking and Finance Law Daily, April 20, 2015

Volcker Alliance calls for urgent reform of nation’s financial regulatory structure

By John M. Pachkowski, J.D.

Noting that the foundational elements of the nation’s financial regulatory system, which have been in place since the 1930s, have become “fragmented, outdated, and ineffective,” the Volcker Alliance has released a report outlining recommendations for “much-needed reform of the financial regulatory structure and emphasizing the urgency of implementing such reforms.”

The Volcker Alliance is a non-partisan, non-profit organization founded by former Chairman of the Federal Reserve Board Paul A. Volcker to address the challenge of effective execution of public policies and to help rebuild public trust in government.

Outpaced. The report, entitled “Reshaping the Financial Regulatory System: Long Delayed, Now Crucial,” noted that the regulatory system has not kept pace with the “significant transformation” that has occurred in the financial system over the past few decades. Examples of these changes included:

  • a concentrated banking system consisting of a handful of extremely large, exceedingly complex, globally active, and highly diversified institutions, with huge trading books and even, in some cases, ownership of industrial assets such as coal mines, oil tankers, and power plants;

  • the emergence of shadow banking, as a bigger part of the whole financial system; and

  • equities markets that have become fragmented, more complex, and less transparent, in part as a result of technological advances, with increasing participation from unregulated entities, such as high-frequency trading firms.

Other factors cited that necessitate reform included:

  • interagency jurisdictional conflicts that have “often resulted in delays or inaction on critical matters”;

  • no single agency having a comprehensive understanding of the risks in the financial system, as each agency remained focused only on its area of supervision; and

  • increased opportunities for regulatory arbitrage.

Keeping pace. The reforms proposed in the report are aimed to create a simpler, clearer, more adaptive, and more resilient regime that would have a mandate to deal with the financial system as it exists now and would be capable of keeping pace with the evolving financial landscape.

Guiding principles. In making its recommendations, the report noted that it “remains true to certain core organizational principles that are designed to ensure a balanced, comprehensive, independent, and effective regulatory framework aimed at achieving sustained financial system stability.”

These guiding principles are:

  • Ensuring that the Fed, as the nation’s central bank, must retain primary responsibility for—and have the tools to enhance—financial stability. However, the report stressed that regulatory authority must not become overly concentrated or centralized in any single agency. It cited that one agency could not undertake such a large responsibility effectively and it would fail to provide adequate checks and balances.

  • Acknowledging that the Secretary of the Treasury, as the representative of political and executive authority and broad economic policy, should be kept well-informed of developments in the financial system and remain able to intervene promptly in crises requiring governmental action, but at the same time providing that the Secretary should not be involved in regulation and supervision in an ordinary, continuing way or otherwise encroach on the independence of the regulatory agencies.

  • Requiring that the regulatory system have broad competence, with the ability to identify, monitor, and address in a timely manner systemic risks as they develop throughout the financial system, especially all activities and practices that may pose a threat to financial stability.

  • Providing the regulatory system with effective safeguards to help ensure the independence of the responsible agencies; reduce the risk of groupthink; and guarantee a broad perspective in governance and decision-making, including arrangements to spur corrective action when necessary.

  • Recognizing that the regulatory system should not be based on a foundation of “one size fits all.” For example a true community bank that recycles its deposits in the form of loans to the community it serves should not be subjected to the regulatory framework for institutions engaged in a broader range of risky activities.

  • Allowing each agency to rely on independent financial resources to appropriately fund its operations while remaining subject to effective congressional oversight.

  • Realizing that expertise and experience must be infused in the professional staffs of regulatory and supervisory agencies, recognizing the need for appropriately attractive compensation practices and engaging with colleges and universities to offer more coursework and degree programs to enhance the stature of the profession.

Following these guiding principles, the report makes three recommendations for reform:

  1. oversight and surveillance;

  2. supervision and regulation; and

  3. investor protection and capital market conduct.

Oversight and surveillance. To “shore up” the regulatory system’s oversight and surveillance functions, the report recommends that oversight and surveillance: (i) be independent, comprehensive, adaptive, and effective; (ii) contain appropriate checks on the power of various regulatory agencies; (iii) reflect a breadth of perspectives; and (iv) facilitate appropriate coordination and communication among regulatory authorities.

These characteristics would be achieved by establishing a Systemic Issues Committee (SIC) as part of the Financial Stability Oversight Council. The SIC would to vote on designations of systemically important financial institutions and risky activities and practices. It would be composed of the chairman of the Federal Reserve, the chairman of the Federal Deposit Insurance Corporation, the director of the Federal Housing Finance Agency, the director of the Consumer Financial Protection Bureau, the chair of a newly-created Investor Protection-Capital Market Conduct Regulator, the director of the Office of Financial Research (OFR), and a state insurance commissioner designated by the state insurance commissioners. In addition, the OFR would be moved out of the Treasury Department and become an independent entity, with its director continuing to be appointed by the president and subject to Senate confirmation.

Supervision and regulation. A new Prudential Supervisory Authority (PSA) would be established as an independent agency. The PSA would assume the prudential supervisory functions currently performed by the Fed, Office of the Comptroller of the Currency, and FDIC with respect to bank and thrift holding companies, federally and state-chartered depository institutions, branches of foreign banking organizations, financial market utilities, and systemically important financial institutions. The PSA would also assume the prudential supervisory functions of the Securities and Exchange Commission and the Commodity Futures Trading Commission with respect to broker-dealers, swap dealers, derivatives clearing organizations, clearing members, futures commission merchants, and money market funds.

The Fed would have no supervisory authority but would have an enhanced role in rulemaking for entities, activities, and practices subject to PSA supervision or as authorized by the SIC. This rulemaking authority would include establishing enhanced prudential standards, including setting capital, liquidity, and margin requirements. The PSA would be authorized to propose any such regulations or guidelines to the Federal Reserve for approval.

Although the FDIC would lose its supervisory authority over the portion of state-chartered banks it currently supervises, it would retain its deposit insurance function, as well as its authority for receivership and resolution with respect to all insured banks and significant financial institutions.

The report noted that consolidating the supervisory functions of the banking agencies, as well as certain such functions of the SEC and the CFTC, would bring greater efficiency into the supervisory process, enhance supervision of certain capital markets participants, and eliminate current coordination challenges. Moreover, it would limit regulatory competition and jurisdictional conflicts among agencies and lead to quicker and more effective action and better supervisory outcomes. A separation between supervision and regulation would allow the PSA to focus sharply on supervisory matters, permitting it to deploy its resources more effectively and efficiently and to maintain an additional check on any agency concentrating too much authority.

The report anticipates that there would be no change in respect to consumer protection, which would remain an important objective of the reconfigured regulatory system. Likewise, the insurance and mortgage markets are beyond the scope of the report but remain an important area of concern for public policy.

Investor protection and market conduct. The final recommendation would merge the SEC and CFTC into a new, independent investor protection and capital market conduct regulator—the Investor Protection-Capital Market Conduct Regulator—which would have a seat on the PSA and the SIC. The new agency would combine the current rulemaking authority of the SEC and the CFTC with respect to matters of investor protection, the structure of securities and derivatives markets, and the integrity of those markets.

The report noted that merging the SEC and the CFTC would (i) eliminate the unnecessary and artificial bifurcation of the securities and derivatives markets; (ii) permit the regulators to better understand financial firms’ activities and practices by enabling improved market oversight and surveillance of linked markets; (iii) reduce the regulatory burden on regulated entities; and (iv) eliminate the asymmetrical regulatory treatment of like products, activities, practices, and financial instruments.

Background papers. In addition to the report and its recommendations, the Volcker Alliance also released a series background papers giving greater detail about prior proposals for reform, international regulatory systems, and specific aspects of the U.S. regulatory system. The background papers are:

  1. Background Paper #1: Prior Proposals to Consolidate Federal Financial Regulators;

  2. Background Paper #2: Consolidated Financial Regulation: Six National Case Studies and the Experience of the European Union; and

  3. Background Paper #3: Memorandum Concerning The SEC And The CFTC

“Step up” to debate. Commenting on the report’s release, Paul Volcker noted, “Even as America continues its long climb back from the financial crisis, it is all too clear that the Federal financial regulatory system needs restructuring to deal effectively with the threats to financial stability. We urge Congress, the administration, existing regulatory agencies, and financial institutions themselves to step up to the needed debate and set out an agreed framework for reform suitable for the 21st century.”

Epilogue. The Volcker Alliance report is just the latest reform measure to be issued. The report noted that there have been more than 25 official reform proposals since World War II, spanning Democratic and Republican administrations; virtually none have met with significant success. Opposition from various stakeholders that benefited from the status quo has been cited as the major impediment to these historic reform efforts.

The last two government-issued reform measures were issued in 2008 and 2009. The Treasury Department issued its “Blueprint for a Modernized Financial Regulatory Structure” in March 2008. The Blueprint presented a series of “short-term” and “intermediate-term” recommendations that the Treasury Department believed would have immediately improved the U.S. regulatory structure. The Blueprint also presented a conceptual model for an optimal regulatory framework.

The Obama Administration issued its own reform initiative “Financial Regulatory Reform: A New Foundation” in June 2009. This initiative outlined the president’s plan to restructure the regulation of the U.S. financial services system. Many of the recommendations formed the basis of the Dodd-Frank Act.

Companies: Volcker Alliance

MainStory: TopStory BankHolding BankingOperations CapitalBaselAccords ConsumerCredit DepositInsurance DoddFrankAct FederalReserveSystem FinancialStability OversightInvestigations PrudentialRegulation SecuritiesDerivatives

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