The New Era of Swaps Market Reform

This hearing is occurring at an historic time in the markets. The CFTC now oversees the derivatives marketplace — across both futures and swaps. The marketplace is increasingly shifting to implementation of the common-sense rules of the road for the swaps market that Congress included in the Dodd-Frank Act.

For the first time, the public is benefiting from seeing the price and volume of each swap transaction. This post-trade transparency builds upon what has worked for decades in the futures and securities markets. The new swaps market information is available free of charge on a website, like a modern-day ticker tape.

For the first time, the public will benefit from the greater access to the markets and the risk reduction that comes with central clearing. Required clearing of interest rate and credit index swaps between financial entities begins next month.

For the first time, the public will benefit from specific oversight of swap dealers. As of today, 71 swap dealers are provisionally registered. They are subject to standards for sales practices, recordkeeping and business conduct to help lower risk to the economy and protect the public from fraud and manipulation. The full list of registered swap dealers is on the CFTC’s website, and we will update it as more entities register.

…continue reading: CFTC’s Progress on Wall Street Reform

Four years ago, this nation was suffering from a near-collapse of our financial system.

While there are differences of opinion as to what was the most significant trigger, a bi-partisan Senate Committee report — known as the Levin-Coburn Report — asserted that the crisis was the result of “high risk, complex financial products; undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street.”

While this period of our history will be written and re-written over and over again, Congress and the Administration knew that the status quo was unacceptable. So together they passed landmark legislation to address many of the issues that were highlighted by that tumultuous period.

The Dodd-Frank Wall Street Reform and Consumer Protection Act is a vital and comprehensive response to the financial crisis — an event that devastated the American economy, cost the American people trillions of dollars and millions of jobs, and undermined the confidence that our financial system requires if it is to thrive and support a growing economy.

The sweeping scope of this financial reform legislation sometimes obscures the fact that, despite its breadth, it is rooted in a handful of sound principles that should have been more firmly in place before the crisis, and whose embrace serves to make markets more stable and efficient. Simple principles like. . . .

…continue reading: Dodd-Frank Principles and Provisions

The impact of Dodd-Frank—like the U.S. financial industry it regulates—is greater than the sum of its parts. Dodd-Frank seeks to oversee and regulate financial markets as a whole, by increasing regulation of individual companies with the potential to compromise market stability, as well as implementing regulation of certain areas of the financial services sector previously not subject to federal supervision and regulation. Dodd-Frank also addresses consumer protection, through the creation of a new agency with broad consumer protection powers and new rules governing residential mortgage markets.

In comments regarding the impact of this historic legislation, Timothy Geithner, Secretary of the Department of Treasury, noted that “By almost any measure, the U.S. financial system is in much stronger shape” than it was prior to enactment of Dodd-Frank. [1] However, a huge amount of change still lies ahead. In the short run, uncertainty regarding the impact of Dodd- Frank on operations, capital and liquidity levels, costs and revenue, and increased litigation and enforcement risk, will continue to impact strategic decisions and valuations of financial institutions of all types and sizes. The long-term impact of the legislation is uncertain, although it could quite possibly usher in a new era of accelerated consolidation in the financial services industry.

…continue reading: Reflections on Dodd-Frank: A Look Back and a Look Forward

In addition to many significant regulatory provisions, the conference report text of the proposed Dodd-Frank Wall Street Reform and Consumer Protection Act contains a number of provisions in Title IX (Investor Protections and Improvements to the Regulation of Securities) which, if enacted, would have a significant impact on securities litigation and enforcement. Other proposed provisions were considered and discarded during the conference committee process. The highlights of the conference report text as it now stands include:

Private Cause of Action for Aiding and Abetting Violations Rejected. Efforts by some lawmakers to overturn well-settled Supreme Court authority by creating a private cause of action for aiding and abetting violations of the Securities Exchange Act of 1934 proved unsuccessful. The conference report text, at Sections 929M-929O, instead augments the SEC’s existing authority to pursue civil enforcement actions alleging aiding and abetting of violations of the Exchange Act by lowering the requisite state of mind to encompass “reckless,” in addition to “knowing,” acts, and by empowering the SEC to pursue actions premised on “knowingly or recklessly” aiding or abetting violations of the Securities Act of 1933, the Investment Company Act of 1940 and the Investment Advisers Act of 1940. Section 929Z of the conference report text requires the Comptroller General to conduct a “study” analyzing the impact of authorizing a private right of action for aiding and abetting violations of the federal securities laws.

…continue reading: The Impact of Financial Reform on Securities Litigation and Enforcement

(Editor’s Note: This post is based on a letter sent by Hal S. Scott, R. Glenn Hubbard and John L. Thornton of the Committee on Capital Markets Regulation, an independent and nonpartisan research organization dedicated to improving the regulation and enhancing the competitiveness of the U.S. financial system, to the Chairmen and Members of the House Financial Services Committee and the Senate Banking, Housing and Urban Development Committee.)

The Committee on Capital Markets Regulation (“Committee”) has, since its establishment in 2005, provided empirical, independent research dedicated to improving the regulation of U.S. capital markets. In May 2009, the Committee published its report entitled, The Global Financial Crisis: A Plan for Regulatory Reform, setting out 57 recommendations for enhancing the soundness and effectiveness of the U.S. financial regulatory framework. [1] As part of its recommendations, the report sets out the Committee’s proposals for reforming the U.S. regulatory architecture to make it more robust and better designed to address the needs of investors and consumers of financial services. In this context, we felt that it would be useful to set out our position on the Administration’s proposal— presently embodied in H.R. 3126, the Consumer Financial Protection Agency Act of 2009 (Act)—that would establish the Consumer Financial Protection Agency (CFPA) as a dedicated agency for regulating and overseeing consumer protection issues in the provision of financial services. Where appropriate, we also make reference to the revised discussion draft of H.R. 3126 (revised discussion draft), proposing changes in the CFPA bill, circulated by Chairman Frank to the House Committee on Financial Services on September 22, 2009. [2]

From the outset, the Committee wishes to emphasize that establishing an independent regulatory agency for consumer and investor protection is one option the Committee believes deserves serious consideration; the other option, in our view, would be to incorporate this function as a division of a new consolidated regulatory agency. The Committee’s position on the Administration’s proposal, outlined below, is premised on the understanding that an independent agency would be created along the lines of H.R. 3126.

…continue reading: CFPA Legislation Goes Too Far on Some Issues, Not Far Enough on Others

(Editor’s Note: This post is based on an article from Lombard Street.)

On June 30, 2009, the Obama Administration delivered to Congress the draft Consumer Financial Protection Agency (CFPA) Act of 2009. On July 8, House Financial Services Committee Chairman Barney Frank unveiled the Consumer Financial Protection Agency Act of 2009 (HR 3126), which shares key features with the President’s proposal. The proposal to create a new agency to police consumer financial products has been the subject of much debate. My goal, in this article, is to sort out and evaluate the different critiques levied against the proposed CFPA Act, in light of the underlying case for a new agency charged with the regulation of Consumer Financial Products (CFPs). To that end I begin by recounting the arguments for a CFPA. I then examine the critiques of the CFPA Act, reframed as challenges or counterarguments to the arguments for a CFPA. I conclude that there is broad agreement on the need for institutional reform, which would include a CFPA. At the same time, there is much disagreement about what mandate and authority the CFPA should have. I end with an optimistic note, suggesting that even a CFPA with less power than envisioned in the proposed Act could do much good. Specifically, I argue that a presumably less controversial section of the proposed CFPA Act – the section establishing a consumer right to access information – could promote efficiency and consumer welfare in the market for CFPs.

A. The Case for a CFPA

I begin by recounting the main reasons for the creation of a new federal agency with the mandate and authority to police consumer financial products. [1] A new agency is needed because (1) market forces fail to maximize welfare in important CFP markets, and (2) the current regulatory structure that was supposed to deal with this market failure has proved inadequate. I discuss these two elements in turn.

1. Market Failure

The proposed CFPA Act is a solution to a problem – excessively risky CFPs, or, more accurately, CFPs that impose underappreciated risks on consumers. The claim is that market forces have not worked to constrain CFP risks. This claim is based on theoretical arguments about the limits of market discipline in the CFP context. More importantly, the claim is supported by empirical evidence that many consumers do not make informed, welfare-maximizing choices in CFP markets. …continue reading: The Consumer Financial Protection Agency: Sorting the Critiques

(Editor’s Note: This post by Richard A. Posner is the second part of a two-part series, and is based on a recent article in Lombard Street; the first part was posted on the Forum here.)

If the proposals in the Obama Administration’s report on financial regulatory reform are adopted, the restriction on the size or form of executive compensation on Tier 1 Financial Holding Companies (FHCs) may be the one that most alarms financial enterprises. Let me turn to that issue.

We should separate issues of compensation of CEOs and other top management from issues concerning the compensation of traders, loan officers, and other financial executives at the operating rather than the management level. The Federal Reserve would be authorized to regulate compensation at both levels, but at the top level the aim would be to make management a more faithful agent of the shareholders, while at the operating level it would be to curb the risk‐taking incentives of financial executives by requiring that much of their compensation be deferred. The deferred component might consist of restricted stock that could not be sold for a period of years. Or the deferred component might consist of cash bonuses that could be recovered by the company if the deals for which the bonuses were a reward later soured.

The two aims—better aligning executives’ incentives with those of the shareholders, and reducing the riskiness of executives’ compensation—are inconsistent. Shareholders are generally less risk averse than executives because they have less stake in the enterprise, as they can diversify away any risk that is peculiar to the enterprise by holding a diversified portfolio of securities. Top executives have much more to lose, in reputation and future earnings prospects, from the collapse of their company.

That means that top executives, provided that they are allowed by the Federal Reserve to remain imperfect agents of the shareholders, have strong incentives to establish procedures that will prevent traders, loan officers, and other subordinate executives from taking excessive risks. But “excessive” from the standpoint of private businessmen means something crucially different from “excessive” as perceived by the Federal Reserve. Risks, including the risk of bankruptcy, that are cost‐justified from a corporation’s standpoint may be unacceptable from a broader social standpoint because of their potential for bringing down the entire financial system, and in its wake the nonfinancial economy as well. But the measures that have been suggested for reducing risk‐taking by traders and other financial executives have their own problems. Many things can affect a stock’s price besides a trader’s deals, as critics of stock options as devices for compensating top executives point out, and retractable cash bonuses (would they have to be placed in escrow?) make it difficult for recipients to manage their finances.

…continue reading: A Critique of the President’s Financial Regulation Reforms

In our memorandum, available here, we describe the Obama Administration’s White Paper on Financial Regulatory Reform. The White Paper is just the beginning of what is likely to be a legislative, regulatory and ideological marathon, despite the Administration’s best efforts to achieve domestic political support before its publication. It is far less revolutionary than some either feared or hoped for and reflects an “art of the possible” approach to regulatory reform by the Obama Administration. Ultimately the White Paper reflects a compromise designed to avoid as much as possible the most difficult regulatory, state and congressional turf battles.

As a result, the plan is notable as much for what it does not do as for what it does. It is not a once-in-a-lifetime regulatory overhaul. It does not propose a CFTC-SEC merger, it does not propose an optional federal insurance charter and it does not streamline the alphabet soup of financial regulatory agencies. If anything, it adds more regulators than it eliminates. Its key innovations involve expanded power for the Federal Reserve as the sole systemic risk regulator, with the creation of a Financial Services Oversight Council to mollify those who are concerned about the aggregation of power in the Federal Reserve; the long anticipated registration of advisers to hedge funds, private equity funds and venture capital funds; the regulation of OTC derivatives; the merger of the OTS and the OCC; the creation of a Consumer Financial Protection Agency with vast new powers delineated in such a way that future jurisdictional turf wars are inevitable; and the creation of a resolution regime for bank holding companies and Tier 1 FHCs. While the White Paper is an incomplete framework, one possible benefit is that it creates the skeleton of a “twin peaks” structure, with a prudential and a business conduct regulator, into which other agencies could be merged in the future.

The Administration has set a goal of passing its reform package by the end of the year and promises that legislative text will soon be sent to the Hill. Naturally, the political reaction has already begun, with Republicans outlining their own plan and individual Senators and Congressmen proposing, or soon to propose, competing proposals and language.

Other stakeholders, both domestic and international, will also have a view and, in some cases, a voice. Indeed, the White Paper proposals are made at a time of parallel UK and European regulatory reform driven in part, as is the White Paper, by the G-20 proposals. The European Council of Ministers proposed its own plan this past week for which legislative text is expected in the fall, and the UK is expected to publish more details on its own version shortly. The era when financial regulation was purely a matter for domestic politics is over. More and more the domestic US financial regulatory agenda is being influenced by international fora, by an active EU regulatory structure which has created extraterritorial standards and imposed requirements of comparability and by the international and US domestic push for harmonization of standards across regulatory bodies.

The shifting dynamics of the regulatory reform proposals and the politics involved in any consolidation, reorganization or redistribution of regulatory responsibilities mean that it is too early to predict with certainty which proposals are likely to be enacted and in what form. In light of the many competing proposals and legislative texts, we believe that it is possible that some elements, such as the Consumer Financial Protection Agency, will be enacted separately and attached to other bills rather than as an omnibus package.

Our memorandum discusses the White Paper’s proposals from a range of perspectives, domestic and international, and sets forth how the proposals may impact a range of institutions, financial and non-financial.

The memorandum is available here.

This post, and the accompanying memorandum, summarizes the key proposals in the Obama Administration’s White Paper on Financial Regulatory Reform based on the “near final” draft White Paper posted by the Washington Post on June 16th. It has also been prepared in advance of the President’s news conference on June 17th and Secretary Geithner’s testimony on June 18th and assumes a reader that is familiar with U.S. regulatory reform. Readers are cautioned that there may be changes in the final version of the Obama White Paper. We will post a full memorandum with analysis and commentary in the coming days, but, in the meantime, we hope readers will find this factual outline helpful.

* * * * *

Executive Summary
The five areas covered in the White Paper are:

1. Supervision and regulation of financial firms, including:

• creation of a Financial Services Oversight Council,
• identification of systemically important firms, which are called “Tier 1 FHCs,”
• enhanced standards for all banks and BHCs,
• BHC status for any firm owning a thrift, ILC, credit card bank, trust company, or other non-traditional bank,
• subjecting Tier 1 FHCs and firms owning non-traditional banks to non-financial activities restrictions in the BHC Act,
• merger of the OTS and OCC into a new National Bank Supervisor,
• registration and reporting requirements for most advisers of private pools of capital including hedge funds,
• establishment of an Office of National Insurance in Treasury, but no federal insurance charter, and
• stronger requirements for money market funds and government sponsored enterprises;

2. Regulation of financial markets, including:

• skin-in-the-game and compensation requirements for originators and sponsors of asset-backed securities,
• regulation of OTC derivatives and OTC derivatives dealers,
• proposal to harmonize futures and securities regulation, and
• enhanced oversight by the Federal Reserve over systemically important payment, clearing and settlement systemsand activities of major participants;

3. Consumer and investor protection, including:

• creation of a Consumer Financial Protection Agency with rule making, supervisory and enforcement authority over credit products,
• creation of a Financial Consumer Coordinating Council to advise on gaps in consumer and investor protection and to promote best practices, and
• other initiatives to bolster the authority of the SEC, FTC and to address retirement security;

4. Resolution authority and Section 13(3) authority, including:

• giving Treasury resolution authority over BHCs and Tier 1 FHCs modeled on the FDIC’s resolution authority over insured banks and thrifts, with the FDIC (or in the case of a group that is primarily a securities firm, the SEC) acting as receiver or conservator, and
• requiring the Federal Reserve to obtain prior approval from Treasury for all lending under Section 13(3); and

5. International regulatory standards and cooperation, including:

• support for existing G-20 and other initiatives, and
• rules for determining whether a foreign financial firm is a Tier 1 FHC.

Our memorandum, available here, provides a more detailed outline of the key proposals.

This week in the Law, Economics, and Organization Seminar at Harvard Law School I presented my paper Consumer Biases and Firm Ownership (joint with Alex Kaufman). In the paper we examine the role of firm ownership in mitigating incentives of firms to exploit consumer biases. Recent work has explored the implications of behavioral biases among consumers and has documented that profit-maximizing firms exploit consumer biases in the contracts they offer consumers. This behavior can result in substantial social costs as the resulting contracts distort decision-making from the social optimum.

In the paper we show how ownership of the firm can be used as a commitment device to avoid using contracts that exploit consumer biases. In particular, if customers of the firm own the firm, as in a consumer cooperative, or if the firm has no owners, as in a nonprofit, then firm managers have less incentive to offer contracts that exploit consumer biases. We thus identify a “governance strategy” of shaping the incentives of firm management through assignment of ownership of the firm, rather than a regulatory strategy of dictating contractual terms or processes, as a way to reduce the social costs that result from consumer biases.

As a paradigmatic example, consider a bank that offers credit card services to consumers. Because of the complexity of the contractual relationship between banks and their customers, consumers have trouble understanding all of the charges, penalties, and other payments they are obliged to make to the bank under their credit card contract in various contingencies, such as the penalty interest rate that applies if they fail to make a minimum payment on time. Furthermore, many consumers have self-control problems that lead them to trigger commonly charged fees and penalties. Consequently, investor-owned for-profit banks have a strong incentive to charge high fees and penalties. The use of penalties in credit card contracts can persist even in competitive markets, since banks simply compete on the salient, easily observable and understood features of accounts (e.g., the introductory interest rate and rewards programs), and then cover their costs through penalty income.

…continue reading: Consumer Biases and Firm Ownership