■ by Richard Neiman, Vice Chairman, PricewaterhouseCoopers, and Mark Olson, Chairman, Treliant Risk Advisors
Certain weaknesses of the U.S. financial regulatory structure that were highlighted by the financial crisis either were not addressed or were inadequately addressed by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Today, the U.S. financial system remains too fragmented, with gaps in regulation that contribute to systemic risk and inefficiencies in both government and private markets.
This April, the Bipartisan Policy Center (BPC) issued Dodd-Frank’s Missed Opportunity: A Road Map for a More Effective Regulatory Architecture. This report presents a road map for how to achieve a more rational and effective financial regulatory architecture over time in line with some important, basic principles. These include clarifying and closing gaps in the U.S. regulatory architecture; improving regulatory quality; better allocating, coordinating, and efficiently using scarce regulatory resources; ensuring that financial regulators have the independence and authority they need; and making the system more transparent and accountable.
With these principles in mind, the report proposes six major areas in which to improve the quality of the U.S. regulatory architecture and achieve better regulatory outcomes for both financial institutions and the end users of financial services:
- Improve the quality of examinations;
- Create a modern financial regulatory architecture;
- Enhance the independence, authority, and transparency of the FSOC and the OFR;
- Create a single capital markets regulator;
- Provide independent funding to financial regulators;
- Conduct cross-border impact assessments.
It is encouraging that regulators have already begun to embrace some of the specific proposals we make here. In May, a new transparency policy was agreed to by the Financial Stability Oversight Council (FSOC). Later in May, Federal Reserve Governor Daniel K. Tarullo called for increasing the threshold at which bank holding companies are automatically subject to heightened prudential standards, which would allow regulators to better focus resources on financial institutions that present the greatest systemic risk. Since then, raising the threshold has been the subject of increased debate on Capitol Hill and in August, the Systemic Risk Designation Improvement Act was introduced in the U.S. House to move away from a strict size threshold.
Background
The existing structure, or architecture, for regulating financial firms in the United States has evolved over time, largely due to ad hoc responses to financial crises (see Figure 1). In the aftermath of the most recent crisis, Dodd-Frank continued this pattern. The Act made some needed refinements to the U.S. regulatory structure. These refinements include: the creation of the FSOC to facilitate information-sharing and coordination among the various financial regulators; the consolidation of the Office of Thrift Supervision (OTS) with the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve; and the establishment of a new agency dedicated solely to consumer protection, the Consumer Financial Protection Bureau (CFPB).
Fragmentation, however, remains in the current structure. An example is the separation of securities and commodities regulation, which creates conflict between agencies and inefficiency for institutions that must comply with two sets of similar rules for similar activities. Likewise, the separate regulation of banks and their parent holding companies can produce regulatory overlap, especially in those cases in which a holding company is in essence a corporate shell for the bank. Furthermore, the United States is one of the few remaining major industrialized countries that does not regulate the business of insurance on a national basis. This complicates coordination with international insurance authorities and impedes national platforms for serving consumers more effectively and efficiently. Finally, the new FSOC is a positive first step toward better regulatory coordination, but it is too large, cumbersome, opaque, and weak to effectively coordinate and rationalize the regulatory actions of independent agencies.
Fragmentation in the U.S. financial regulatory structure contributed to the most recent financial crisis. For example, the lack of comprehensive oversight of the mortgage market, from the underwriting process through the securitization of mortgage loans, was at the heart of the crisis. Opportunities for regulatory arbitrage, particularly in the establishment and operation of thrift holding companies, further amplified these problems.
Past proposals for greater rationalization of the U.S. financial regulatory architecture typically have foundered as a result of three major forces:
- 1. The natural resistance to changing existing regulatory agencies, both federal and state, because existing stakeholders are familiar and comfortable with the system at the time;
- 2. Stakeholders’ unwillingness to concede advantages they gain from the status quo, even if such advantages may be inefficient or lead to inequitable treatment; and
- 3. The division of jurisdiction among multiple congressional committees, each of which has historically been interested in preserving its existing authority.
All of these factors influenced the extent to which Dodd-Frank was able to alter the U.S. financial regulatory architecture. Nonetheless, the financial crisis demonstrated a pressing need for more fundamental reform. It is true that past and current political realities make any structural change difficult. That said, the United States needs a financial regulatory system that is both effective and efficient, and one that will not be a significant contributor to the next crisis.
Our report’s recommendation drew on previous proposals, our long experience in the world of financial regulations, and observations on events since the passage of Dodd-Frank.
Recommendations
I. Improve the Quality of Examinations
Banks and thrifts, and their holding companies, are subject to examination by multiple federal and state financial regulators. Prudential supervision ensures that financial institutions are sufficiently capitalized, are not engaging in activities that are too risky, are liquid enough to meet their obligations, and are otherwise safe and sound. The current examination system, however, is often fragmented, with overlapping and duplicative responsibilities.
The efficiency and quality of examination and supervision of insured depository institutions and their holding companies could be improved through the creation of a consolidated examination force for the institutions subject to supervision by the three federal banking agencies (the FRB, FDIC, and OCC). This approach contemplates an integration of examination personnel and related human resources functions under the direction of a “supervisory” committee within the Federal Financial Institutions Examination Council that would provide a coordinated focus for examiners. As a result, the federal banking agencies would be able to draw from a common set of examiners with consistent training and uniform, dedicated expertise. This approach promises more consistent and translatable examination results, improved communication and coordination, greater efficiencies, and reduced duplication. Moreover, this approach supports the dual banking system by making more resources available to states through common examination reports and employing specialized skills more effectively. II. Create a Modern Financial Regulatory Architecture
The current U.S. financial regulatory system is the result more of accretion than design. The system evolved over time, largely in response to individual financial crises, and with insufficient regard to questions of coordination and cooperation. As a result, the United States has a fragmented financial regulatory structure, which contributed to the financial crisis in part because no single regulator was charged with monitoring the financial system as a whole. The FSOC and the Office of Financial Research (OFR) are designed to address part of this problem. Yet, additional steps should be taken to provide for greater coordination and cooperation among regulators.
A structure where a single banking agency is responsible for prudential regulation will be more accountable to all stakeholders, including the public, regulators, and industry. Under this new model:
- All individual banks and thrifts and their holding companies would be supervised and regulated by a new Prudential Regulatory Authority (PRA). The PRA’s jurisdiction would include all banks—including systemically important banks (SIBs)—and thrifts, and their holding companies. The PRA would be the primary micro-prudential regulator and rulemaking body for individual financial institutions and holding companies. This would complement the Federal Reserve’s repurposed role of focusing on more systemic, macro-prudential threats to the U.S. financial system.
- The Federal Reserve would retain its important role as a financial stability and macro-prudential regulator for systemic risk, and have the power to recommend enhanced prudential standards for financial institutions as part of its macro-prudential role. Working with an enhanced FSOC and OFR, the Federal Reserve would focus its efforts on monitoring and identifying market trends, activities, and conditions that need greater systemic attention by a macro-prudential regulator able to look across individual institutions. The Federal Reserve would also have full and immediate access to all PRA exam reports and data and would be the unified financial stability regulator for systemically important non-bank non-insurer financial institutions. The agency would transfer its remaining supervisory authority for banks and thrifts, and their holding companies, to the PRA.
- The FDIC would focus on its current roles as deposit insurer and resolution authority and transfer its primary supervisory authority over state non-member banks to the PRA. The FDIC would have backup supervisory authority over all institutions that it insures and full and immediate access to all exam reports and data.
- A single federal insurance regulator would oversee and supervise a modern national insurance charter that would be mandatory for all insurance companies designated by the FSOC as SIFIs but optional for all other companies that wanted to meet the needs of their customers from a single national charter and one set of regulations. Systemically important insurance companies should be subject to federal regulation, but the rules applied to them need to take into account the significant differences in the business models, balance sheets, revenue streams, and risk profiles of insurance companies compared to banks and other financial institutions.
These changes would result in clearer lines of authority and enhanced transparency; greater focus, efficiency, and accountability; cost savings; and improved quality of financial supervision. Such changes would also lead to better regulation and regulatory outcomes for all stakeholders and for the U.S. economy.
III. Enhance the Independence, Authority, and Transparency of the FSOC and the OFR
Given the enormous economic and social costs associated with financial crises, the FSOC was vested with authority to respond to substantial threats to the financial system. In addition to its power to designate non-bank financial institutions as systemically important, Dodd-Frank allowed the FSOC to recommend that its member agencies adopt “new or heightened standards and safeguards” for “a financial activity or practice … if the Council determines that the conduct, scope, nature, size, scale, concentration, or interconnectedness of such activity or practice could create or increase the risk of significant liquidity, credit or other problems spreading.” Yet, the power to recommend is not the power to require action. If the safety and soundness of the financial system is to be given the priority it should have, the FSOC should have the authority to act to respond to systemic threats.
The Council is also charged with serving as an information-sharing and regulatory policy-coordinating body for its members agencies. However, it is not evident that greater coordination or cooperation among member agencies has been achieved. The difficulty agencies have had writing and implementing the Volcker Rule is a case in point. The ability of the FSOC to fill a greater coordination role is limited by the fact that each member of the FSOC remains an independent agency, and the FSOC is not able to require its members to take any specific actions they do not want to take.
Therefore, the FSOC’s macro-prudential authority should be enhanced by giving it power to set minimum heightened standards and safeguards on systemically risky activities and practices for member agencies. Further, joint rule-writing should be made more efficient and timely by empowering the FSOC to adjudicate rulemaking disputes among member agencies when two or more regulators miss statutorily imposed deadlines for agreeing on rule or regulations by more than 180 days.
In line with these new powers, it is important to improve the FSOC’s accountability and transparency using the Government Accountability Office’s 2012 recommendations as a guide. In addition, the FSOC should also consider releasing additional details about the closed-door conversations that occur during their regular meetings, much as the Federal Reserve does when it releases detailed minutes from its Federal Open Markets Committee meeting. The FSOC’s new transparency policy, adopted in May, is a step in the right direction, promising more open FSOC meetings, enhanced summaries or minutes of meetings, and more disclosure regarding the Council’s agenda. It is important that this new disclosure policy clarify that the FSOC’s minutes are “subject to redactions, as determined by the Chairperson.” This raises the potential that the Treasury Department, rather than each individual FSOC agency or member, will decide on when to redact information in the minutes. This should allow the Treasury Department to take additional steps to increase transparency through more detailed FSOC minutes.
Good oversight also requires focus and prioritization. Dodd-Frank automatically subjects all bank holding companies with more than $50 billion in assets to heightened prudential standards. Enhanced prudential standards for the largest, most systemically important financial institutions are appropriate. The size of a bank’s balance sheet, however, is only one of several important factors in determining the systemic risk it can generate. BPC agrees with Governor Tarullo that the $50 billion threshold is too low. Adjusting the threshold to, for example, $250 billion should allow regulators to focus more resources on a smaller set of institutions that presents the greatest potential systemic risk. And, since any threshold is arbitrary, regulators should have flexibility on whether to apply enhanced standards to institutions above and below that line. The threshold line, in other words, would move from being solid-red to dashed, from hard-and-fast to presumptive. While the debate about the exact size at which a bank’s systemic importance merits the costs of additional regulatory burden can and should be debated and analyzed empirically, it is good to see thoughtful and experienced policy makers such as Governor Tarullo speak about the problems with the current threshold.
Another promising change in Dodd-Frank was the creation of the OFR, which was intended to provide unbiased information, critical analysis, and insights to the FSOC. While placing it within the Treasury Department may seem to guarantee that the OFR would be at least somewhat captive to the culture and outlook of Treasury, the OFR has wide latitude to determine with how much independence it will act. The OCC is set up as a separate bureau within the Treasury Department, but it has a long tradition of operating independently from the Treasury with respect to its regulation and supervision of banks.
Because of its unique role among financial regulators, it is important that the OFR be established structurally in a way that allows and encourages it to offer objective, thoughtful, far-seeing, and timely analysis and recommendations that are as free from political influence as possible. To help achieve these ends, the OFR should be removed from the Treasury Department and set up as an independent entity to allow it to speak unambiguously with its own voice on systemic, macro-prudential matters.
IV. Create a Single Capital Markets Regulator
Calls in recent decades to merge the CFTC and SEC into a single capital markets regulator have been numerous. The logic for doing so has only increased over time. Since Congress created the CFTC as a separate agency in 1974, it has become more difficult to clearly define the space supervised by each agency. Innovations and techniques have cross-pollinated and blurred the line between securities and futures trading, leading to turf battles between the two agencies and confusion among those regulated by them. Disagreements between the two agencies can cause friction with U.S. trading partners. The United States is the only OECD country without a single capital markets authority. International cooperation is increasingly important and being able to speak with a unified voice on such issues on the global stage is a worthwhile and achievable goal.
The CFTC and SEC should be merged into a single Capital Markets Authority. As an interim step toward full consolidation, the CFTC and SEC should immediately begin to conduct their board meetings jointly. This will allow the two agencies to better prepare for the logistical and cultural changes that will be necessary to effectuate the merger. It also will help to achieve the goal of speaking with a unified U.S. voice on capital markets regulatory issues at an international level.
Proposed Task Force Structure
The two figures on the previous pages depict key aspects of the U.S. regulatory architecture in three stages: prior to the Dodd-Frank Act; the current, post-Dodd-Frank structure; and the new structure recommended by the task force. Figure 2 shows changes in agency responsibility for micro- and macro-prudential regulation. Figure 3 describes changes to the regulation of selected kinds of financial activities over the same stages. BPC’s plan results in a more streamlined regulatory structure that is more conducive to financial stability and economic growth.
V. Provide Independent Funding to Financial Regulators
The U.S. financial regulatory system was deliberately constructed to give significant independence to its constituent agencies, largely to insulate them from political influence, especially during times of crisis. A bipartisan set of former regulators, including CFTC Chairman Brooksley Born and SEC Chairman William Donaldson, argue that to truly be independent, financial regulators require independent funding not subject to congressional appropriation. This call was echoed by then-acting CFTC Chairman Mark Wetjen in Senate testimony in which he indicated that the agency’s ability to carry out the mandates given to it in Dodd-Frank is threatened by a lack of sufficient funding.
Independent financial regulators must have sufficient resources to complete the job that Congress has given them through the Dodd-Frank Act and other actions. The creation of independent financial regulators was a wise and essential element of a well-functioning financial regulatory structure. Therefore, the SEC and CFTC should be given the authority by Congress to collect and keep funds generated through fees and assessments to fund their own operations.
VI. Conduct Cross-Border Impact Assessments
Financial markets are global in their reach, so the actions of regulators in one country affect financial institutions in multiple jurisdictions. The actions of U.S. regulators carry special weight around the globe due to the reach of U.S. markets and U.S.-based financial institutions. Confusing, duplicative, or contradictory regulations can negatively impact growth and the operation of global capital markets. Lack of cooperation can lead to “ring-fencing” of financial institutions in a way that “comes at a cost for banking groups and the efficiency of the overall global financial system.”
It is important that U.S. regulators work in good faith with their counterparts in other jurisdictions to harmonize and make the regime of international regulation most effective and supportive of economic growth, safety and soundness, and consumer protection. Therefore, the FSOC should review all provisions of Dodd-Frank that have extraterritorial effects and make recommendations to the Congress and/or financial regulators for ways to prevent unnecessary and avoidable negative impacts on international cooperation, financial stability, competitive opportunity, and economic growth.
Conclusion
These proposals are aimed at reforming the federal financial regulatory system, while preserving the best features of the dual banking system that has served the country well for more than 150 years. They are achievable and consistent with the dual banking system. Moreover, the reforms would benefit state regulators by giving them more options to access and leverage federal resources, while avoiding unnecessary overlap and duplication.
Taken as a whole, these recommendations will make the U.S. financial regulatory system more efficient, accountable, rational, resilient, and better able to identify and respond to future threats to financial stability and economic growth. They will close regulatory gaps and contribute significantly to enhanced safety and soundness of individual financial institutions and the financial system as a whole. They will put the U.S. financial regulatory system more on par with other developed countries’ regulators on critical cross-border issues embedded in a global financial system. Finally, by collectively strengthening the U.S. financial regulatory architecture, these recommendations will help ensure that the United States maintains its standing as the world’s preeminent provider of financial services.
The FSOC and Congress should each regularly conduct reviews to find potential regulatory gaps and ways to improve the U.S. regulatory structure. The 2014 elections are close at hand, but both the House and Senate would be wise to devote at least a day of hearings to this issue later this year to pave the way for a more thorough look at the subject in the next Congress. ■