Monday, March 31, 2008

Risk Of Paulson’s Proposal Of Merging Regulators

According to Bloomberg, Treasury Secretary Hank Paulson will announce his proposal to overhaul the federal regulatory framework, during his planned speech on Monday at 10 AM. While Paulson’s recommendations desire to streamline the regulation o f financial institutions, including investment banks, the recommendations pose several risks of creating more problems than solving.

Risk Of Adding To The Bureaucracy
One of the recommendations is to turn the President's Working Group on Financial Markets, president’s advisory body since 1987, into a government-chartered interagency organization that will coordinate financial regulatory policies. The problem with this short-term proposal is that it will add to another layer to the government bureaucracy. A simple executive order, with congressional approval, to empower the advisory group to coordinate the financial regulations and then hand off the regulations to the respective super-agency to implement should be sufficient.

The FFIEC already exists to ensure uniformity of regulatory application, so it may create a confusing overlap of responsibility. By turning the President's Working Group on Financial Markets into a government-chartered interagency organization, there is a heightened risk of creating another bloated governmental agency, a la Homeland Defense and a possibility of interagency struggle for dominance.

Risk Of Diluting SEC’s Current Authority
NY Times states this risk very clearly:

“The blueprint also suggests several areas where the S.E.C. should take a lighter approach to its oversight. Among them are allowing stock exchanges greater leeway to regulate themselves and streamlining the approval of new products, even allowing automatic approval of securities products that are being traded in foreign markets.”
This is not acceptable given the current market condition and events, all of which indicate that SEC oversight should be increased.

How does one rationalize a self-regulated stock market that can easily introduce more risks into the market? The honor system is noble but current events fully indicate that the loosely regulated institutions have been able to heavily influence the stock market through the derivate market. By proposing dilution of SEC’s current authority, it will increase the risk of more market volatility and potential for further influence by institutions using highly leveraged derivative trades.

Risk Of Expanding The Federal Reserve’s Authority
The proposal to grant the Federal Reserve the authority to supervise the market and to ensure stability is an idea that is filled with risks. How will the Federal Reserve be empowered to supervise the market and oversee its stability when their actions (or inactions) to affect liquidity and interest rates can move the market dramatically? It is a circular logic: The Fed currently is trying to stabilize the market by injecting or removing liquidity. However, by their actions, they change the way the market and have caused unintended consequences (see Greenspan’s bubble).

It would be better to grant SEC this responsibility rather than the Federal Reserve since the SEC already has some authority in this area. Moreover, the SEC has the review function embedded in its organization that can easily be expanded. Having the Federal Reserve monitor and supervise the investment banks only invites more bureaucracy and further dilutes the authority of the SEC.

Risk From Leaving Major Risk Gaps Intact
It is incredulous that two areas that should be regulated have been left out of Paulson’s proposal: Hedge Funds and the International Swaps and Derivatives Association (ISDA), a derivatives trade group. After all, unregulated trades in the derivative market and the use of highly leveraged derivate trades by the hedge funds are two major components of the current credit crunch. According to Wikipedia, hedge funds conduct “approximately 30% of all U.S. fixed-income security transactions, 55% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, as well as 30% of equity trades. Hedge Funds dominate certain specialty markets such as trading in derivatives with high-yield ratings, and distressed debt.”

Currently, there is no regulatory agency that monitors hedge funds. The regulators steps in only when they suspect fraud is involved. Furthermore, hedge funds have able avoid regulatory scrutiny by conducting private offerings to “qualified purchasers.”

The highly opaque hedge funds and loosely supervised ISDA have had a major influence in the stock market. Knowing this, one could justly ask: “why are hedge funds and ISDA not on the proposal for regulation?” “Could it be intentional?” This is open to debate and speculation. I am certain that there will be conspiracy theorists expounding on this point ad nausea.

Proposal Leaves Out Critical Regulators
The longer-term proposals recommend combining the OCC (Office of Comptroller of the Currency) with the OTS (Office of Thrift Supervision), and combine the SEC (Securities and Exchange Commission) with the CFTC (Commodity Futures Trading Commission).

This seems to be a good move but it leaves out two important regulatory bodies: (1) The Federal Deposit Insurance Corporation (FDIC), which insures deposits, examines and supervises financial institutions, and manages failed banks; and (2) The National Credit Union Administration (NCUA), which charters and supervises federal credit unions. FDIC and NCUA should be included in with the combination of the OCC (charters, regulates, and supervises all national banks) and OTS (supervises savings associations and their holding companies) since their functions are similar and somewhat overlapping.

If the Treasury is really serious about streamlining financial market supervision, why leave out these two out? Especially the FDIC. This is another one of those things with the proposal that raises more questions.

Risk Of Partisan Dilution Of The Proposal’s Benefits
Even with its gaps and unanswered questions, the Treasury proposal is a step in the right direction. However, like all grand plans in Washington, D.C., this one will most likely get bogged down in partisan bickering and backroom compromised legislation that will sap all of the benefits out of it – a whole lot of wheeling and dealing with a healthy participation by special interest groups. The end result would be a motley work of legislations that may mildly modify supervision of the money center banks and investment banks while leaving hedge funds and ISDA out altogether.

Paulson’s proposal will have a difficult time getting congressional approval as Democrats are seeking legislation on an even tighter supervision of Wall Street, including hedge funds and credit derivatives.

Finally, it may be sometime before congress can pass a compromise to approve some of the proposal’s recommendations. Given their process, or lack thereof, it is highly unlikely that anything will be done in 2008 or even in 2009. Since we are in an election year, there is also the risk that the incoming President may decide to veto any overhaul of the current regulatory framework. Stay tuned.

Ed Kim

Sphere: Related Content

No comments: