A complicated fix

The way all public companies, financial institutions and the markets as a whole are policed could be about to undergo significant change. But this has not been an overnight flight of fancy. At pretty much the same time – in the springtime, a year ago – Secretary of the Treasury Henry Paulson and New York Republican congressman Vito Fossella each set off on a singular quest.

For Paulson, it was directing two top assistants to put together the recommendation unveiled this past March 31, rebuilding the federal regulatory system that oversees the financial industry and its markets. For Fossella, it was taking the pulse of industry and experts so that his staff could write legislation calling for the rebuilding of the federal system that oversees the financial industry.

Even though each headed out with the same objectives, they moved through different routes, sometimes crossing paths, sometimes seeing the same people or organizations, touching base with one another along the way. Now they have arrived back on the scene in Washington with fairly similar receptions: warm from those who are excited for change and cold from those quite happy with the status quo.

Paulson’s blueprint looks for three primary sectors of attention: market stability regulation, safety and soundness (or prudential) regulation, and business conduct regulation. His proposal outlines detailed approaches to each across near-term, intermediate and long-term horizons.

How these ideas affect each of the major segments of the market, from mortgage issuers and insurance companies to investment banks and the securities industry will be the subject of heated debate and discussion for the next few years.

Equally, structure and reporting lines among the regulatory community are primary concerns, especially for those with vested interests. Overall leadership is tipped to be placed in the hands of the Federal Reserve, a decision that Fossella thinks would be the right one. ‘It is the most natural choice’ of all the agencies, he says. ‘It is perceived as the one to turn to and if there is any one organization that is to be improved and relied upon going forward, it is the Fed.’

In any case, those welcoming regulatory change can be just as sure as the other side that little will happen in the short term. But something will happen in the longer term and that is where the dust and smoke will rise. As one observer has said, this is shaping up to be a battle of the titans on Capitol Hill – some of the strongest lobbies in America squaring off, either to fight change or to offer their own brand of it.

A changed environment

Two major things have taken place since the reformers started their journeys last year. First, the launch platform was a relatively unsullied US credit market backed by what appeared to be uniformly strong financial institutions. It is a much different place today, shaken by the mortgage implosion, the downfall of Bear Stearns and a credit market pinched to the breaking point.

Secondly, a year ago the air was heavy with concern for the standing of American markets, markets which three separate studies in the preceding months had declared were sorely behind in the competitive global race for capital. Simply put, all three reports said the US was overburdened with regulation and money was fleeing overseas to London, to other European markets, even to Dubai and other faraway lands that the US capital market, the largest on earth, had never been much worried about. Furthermore, the highly litigious US environment was increasingly keeping foreign capital from coming here.

That atmosphere hasn’t changed, but it has been pushed out of the headlines, overwhelmed by the mortgage mess, the credit crunch and the blasting polemics of an election year. It is this last fact that most observers feel will ensure little happens in the near term.

‘Nothing major is likely to happen until after the election,’ comments Robert Hillman, a law professor at the UC Davis School of Law. The last significant change to regulatory laws came with the repeal of the Glass-Steagall Act and that was eight years in the making between 1991 and 1999 when the Gramm-Leach-Bliley Act was finally passed by Congress.

Easier said than done

‘It is much easier to propose regulatory reform than it is to implement it,’ Hillman goes on to observe. ‘We may very well see some of the specific reforms suggested; in particular, greater Fed oversight of capital adequacy of investment banking firms and a merger of the SEC and Commodity Futures Trading Commission (CFTC),’ he adds. But all this will be fraught with disagreement.

‘This will be a long discussion,’ adds Democratic representative Melvin Watts from North Carolina, a ranking Democrat on the House Financial Services Committee and head of the powerful Oversight and Investigations subcommittee, which scrutinizes all federal regulatory agencies. Nevertheless, the die is cast and Fossella is not sitting on his hands. He launched his research last year after he was asked by the House Republican Policy Committee to serve as chairman of the committee’s capital markets, economic and information security task force.

Traveling to major cities in the US as well as to London to study the UK’s much-vaunted Financial Services Authority (FSA), Fossella has taken special care to ensure interests away from his home base of New York – with all its financial service giants – are properly served. This, despite the fact that his constituents are his number one concern, inasmuch as so many of them in Staten Island and the Brooklyn district he represents either work on Wall Street or provide services to the financial community.

Fossella says that what he has been trying to do is put together a broad-based package that addresses all of the disparate issues. He has repeatedly been quoted as saying that he and his staff want to be very conscious of the law of unintended consequences in which you make one change here and it may have a rippling effect elsewhere.

That goal appears to have been met. ‘Legislation will be ready in weeks,’ Fossella said in early April.

But that’s just the beginning. The process in Washington is complex and there will have to be agreement that Fossella’s package is the right vehicle with which to approach reform. Even if it gets the proper backing, there will be hearings, hearings and more hearings. And of course, political party versions will need marking up and agreement.

The House Financial Services Committee, on which Fossella sits, is led by the powerful Democratic congressman Barney Frank of Massachusetts, who has already said he has ideas for legislation he would like to see created. The Senate, meanwhile, will be conducting its own similar show.

And, oh yes, there will be a new president bringing in an all new administration. In a breathtaking understatement, Watts says action will come ‘slowly, probably very slowly.’

Fossella is quick to acknowledge the realities. ‘Once this happens it has to be in a bi-partisan way. After all, the House is controlled by the other party. The question is: Is there a political will to make the changes that some propose? I don’t know if it is necessarily there.’

Pressed on this point, Fossella says, ‘It shouldn’t get lost. America needs to modernize and improve. We have to allow the country to sustain the economy and to maintain leadership in financial markets.’ While the business community and other leaders a year ago were quite vocal on the subject of reform, the question arises in this election year as to whether momentum can be maintained. ‘It would be a shame if people do not stand up,’ Fossella responds.

It’s about competitiveness

The overarching concern has to do with US competitiveness. That’s something both the Paulson team and Fossella are in agreement upon.

The US markets have been left behind by the rapid development of offshore markets. In the past decade alone, the Paulson report notes, we have seen globalization of trading, creation of deep and liquid pools of local capital, increased communications speed and trading reliability, growth of sophisticated products and strategies that spread risk, along with many more changes. And regulators, not just in the US, are struggling to keep up.

Part of the reason the US can’t compete with the other markets is that they have arisen only recently in this new environment, creating brand new regimes that are designed from the start to handle the changed financial world.

‘The US regulatory structure reflects a system, much of it created over 70 years ago, grappling to keep pace with market evolutions and, facing increasing difficulties in preventing and anticipating financial crisis,’ the Treasury Department report states.

 The gaps and problems that separate the US structure from newly emergent marketplaces are ‘compelling market participants to do business in other jurisdictions with more efficient regulation,’ the report adds.

Fossella emphasizes that this is truly about restructuring, not more laws. ‘The thing we have to avoid is the notion that more regulation is better. What we need now is not more over-regulation, but better regulation,’ he points out, noting that ‘once we put these things in place, they will be there for decades.’

While proposals put forth so far look at industries from banking and insurance to futures and securities, it is in the latter sector – the securities industry – where oversight proposals have drawn the first critical focus of observers.

The SEC – but not as we know it

Paulson’s proposal recommends combining the SEC and the CFTC, noting that the bifurcation of regulation for the instruments in each of these regulatory jurisdictions is based on a decades-old market custom, which has changed over the years, drawing together the instruments and the players.

‘That’s probably the most problematic of his proposals, as I see it,’ observes Watts. ‘The SEC’s mission is sufficiently different for it to probably need to survive with its separate structure.’

Hillman has a slightly different take on the question, but also leans toward the continuing dominance of the SEC. ‘The SEC will gain some influence if the CFTC merger takes place,’ Hillman believes, ‘because it will be in a position to oversee some of the derivatives that are now under the control of the CFTC.’

‘The question is whether it would remove any of the authority that the SEC needs to do its job,’ asserts Adam Pritchard, a law professor at the University of Michigan and coauthor of an industry legal guide book, Securities Regulation: Cases and Analysis.

‘Under the plan, the focus of the SEC is to be for enforcement and consumer protection purposes. From that perspective it seems that it is unlikely that it interferes with that function,’ says Pritchard, who for several years was senior counsel in the office of the general counsel at the SEC. ‘In terms of regulating the investment banks, it’s hard to see that the SEC can do a good job of regulating the systemic risk that they might be exposed to, or that they might be creating, because you need deep pockets.’

A lot will depend on just what kind of structure is ultimately agreed upon. If the Fed were to act as an umbrella organization that partners with agencies such as the SEC, it could be just what the SEC needs to be more powerful.

A matter of resources

Pritchard explains: ‘The Fed has deep pockets, which is how it was able to keep Bear Stearns from collapse. I don’t think anyone has suggested that we should give the SEC that sort of authority. So, really without the Fed we have something of a void.’

In other words, maybe teaming up is the way to go. But the status quo is hard to shift and Pritchard thinks that, along with all the entrenched political and industry interests, the staff at the SEC will not be supporters of anything that causes their power to move away to the Fed, or anywhere else for that matter.

‘My guess is that people at the staff level are very unhappy with the notion of enforcement being split away from disclosure regulation. There are some synergies there; the enforcement division gets guidance from the people who come up with the rules as to whether or not the conduct being looked at is something they had in mind when they were drafting the rules,’ he says.

‘But it’s not clear that you can’t coordinate between agencies.’ Pritchard continues. ‘In fact, it might be a good thing to separate people who write the rules from those who enforce them. Their enforcement might be more independent. I can see why the people at the SEC might not be enthusiastic about that, [but] I believe that from a public policy perspective that it may not be a such a bad thing.’

Fossella proclaims himself to be a major fan of the SEC and feels it will continue to operate, perhaps with even greater power.

‘I am a big supporter of the SEC for its role in protecting investors and maintaining the integrity of the market. But they also have a charge in ensuring that capital is allocated appropriately,’ he says, adding that stronger enforcement and a reduction in the potential for litigation are areas where it can improve. While Congress ‘cannot repeal the business cycle or the laws of supply and demand, or eliminate risk from the marketplace, we can try to make it as transparent as possible.’

‘The SEC will be around for a long time. In terms of financial specialization, the UK has a single regulator, the FSA. I don’t see that happening here. I don’t think the US is ready for it. I do think there’s a benefit to have specialization across regulators and the SEC is clearly critical to that infrastructure,’ Fossella maintains.