The Obama Administration has released a Report entitled “Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation” (“Report”), which contains its recommendations for restructuring the regulation of financial services in the United States. Among other things, the Report would make the Federal Reserve Board (“FRB”) the regulator of systemically significant financial organizations, eliminate the federal thrift charter, consolidate the Office of Thrift Supervision (“OTS”) and the Office of the eComptroller of the Currency (“OCC”) and establish a new consumer protection agency for financial services.

In a recent article in the Washington Post, Secretary of the Treasury Geithner and Lawrence Summers, Director of the National Economic Council, wrote that among the causes of the recent financial crisis were “basic failures in financial supervision and regulation.” Their view is that the current regulatory framework is “riddled with gaps, weaknesses and jurisdictional overlaps and suffers from an outdated conception of financial risk.” According to Secretary Geithner and Director Summers, the Administration’s proposals, as embodied in the Report, are intended to “create a more stable regulatory regime that is flexible and effective.”

The Report calls for giving the FRB significant new authority. That agency would become the regulator of consolidated systemically significant financial organizations, referred to in the Report as “Tier 1 FHCs,” without regard to whether they control an insured depository institution. Such organizations would be designated by the FRB, in consultation with a newly created regulatory council, according to standards to be set forth in the law. Functionally regulated and bank subsidiaries of Tier 1 FHCs would continue to be primarily regulated by the functional or bank regulator, but the FRB would have responsibility for supervision of the consolidated company. The Report contemplates that, in the case of Tier 1 FHCs, the FRB would adjust its general framework for supervising bank holding companies from focusing on the safety and soundness of individual banking subsidiaries to a more organization-wide risk-based approach. The Report further contemplates that Tier 1 FHCs will be subject to more rigid regulation than other financial firms given the greater systemic risk presented.

The Report also calls for the creation of the aforementioned council of federal regulators, the Financial Services Oversight Council, to monitor risk throughout the entire financial system. That council would be chaired by the Secretary of the Treasury and is intended to have a consultative role rather than to exercise substantive authority.

Secretary Geithner had previously proposed that legislation be enacted that would provide the Treasury Department with authority to resolve failing systemically significant financial companies, including bank holding companies, insurance companies and investment bankers, under certain conditions. Such authority would include appointing the FDIC as conservator or receiver in appropriate cases. That concept is included in the Report and was the subject of a prior Kilpatrick Stockton Legal Alert  on March 31, 2009. The Report also suggests that the FRB’s emergency lending authority, which it has used several times in the recent economic crisis, be made subject to prior written approval of the Secretary of Treasury.

The Report recommends giving the FRB authority over systemically important payment, clearing and settlement systems. Affected systems would be identified by the FRB, in consultation with the Financial Services Oversight Council. Such systems would become subject to risk management standards, safety and soundness examinations and enforcement mechanisms. If a system is already subject to comprehensive regulation by the Commodities Futures Trading Commission (“CFTC”) or Securities and Exchange Commission (“SEC”), the examinations would be led by that agency, although the FRB could participate. The Report also contemplates that the FRB would be given authority to provide systemically important payment, clearing and settlement systems access to Federal Reserve Bank accounts, financial services and the discount window.

Another aspect of the Report is the consolidation of the OTS and OCC into a new National Bank Supervisor (“NBS”). The NBS would be a bureau of the Treasury Department and led by a single executive, rather than a board. The bank regulatory roles of the FDIC and FRB would not change, nor would the status or regulation of credit unions. The Report does, however, call for the abolition of the federal thrift charter, citing a decline in need for a specialized class of depository institution focusing on mortgage lending. The Report is not specific on the mechanism for eliminating the federal thrift charter but it is expected that federal thrifts would be given a period of years to convert to a national or state bank charter. The Report contemplates incorporating the nationwide branching authority (both de novo or by acquisition) of federal thrifts and applying it to all national and state banks.

The Report suggests that companies that are not currently regulated as bank holding companies but control specialized depository institutions through exceptions to the Bank Holding Company Act would be brought within such regulation. That would require nonfinancial companies controlling entities such as industrial loan companies, trust companies, credit card banks and grandfathered “nonbank banks” to choose between disposing of the institution to avoid regulation or becoming a regulated company and terminating nonconforming commercial activities.

The Report provides for the establishment of a working group led by the Treasury Department to produce studies on the design and structure of existing regulatory capital requirements for, and the overall supervision of, banks and bank holding companies. The Report also calls for standards and guidelines to be issued by federal regulators to better align executive compensation practices with long-term stockholder value and to prevent compensation practices from threatening the safety and soundness of regulated entities.

The Report would create a new independent Consumer Financial Protection Agency (“CFPA”) to assume the role of implementing federal consumer protection and fair lending laws. That role is currently performed by the FRB and the other federal bank regulatory agencies as to depository institutions and agencies such as the Department of Housing and Urban Development and the Federal Trade Commission (“FTC”) as to nondepository lenders. The CFPA would be under the authority of a Board and a Director. Its role would be to interpret the existing regulations under consumer financial services and fair lending statutes such as Truth in Lending, Community Reinvestment, Equal Credit Opportunity, Real Estate Settlement Procedures and the Secure and Fair Enforcement for Mortgage Licensing Act of 2008 and to issue new regulations as deemed appropriate. The CFPA would have supervisory, examination and enforcement authority over all entities that are subject to its regulations and a range of other firms not previously subject to comprehensive federal supervision. The Report allows for individual states to develop and enforce stricter requirements, including enforcing such requirements on federally chartered depository institutions, and calls for coordination between the CFPA and the states. The FTC would retain a “backup role” for statutes for which it currently has jurisdiction and would remain the lead consumer protection agency on matters of data security.

The Report calls for the CFPA to have authority to require all providers and intermediaries to offer certain “plain vanilla” products, such as mortgages with basic structures and terms. The Report suggests that approach would be desirable due to the simplicity and ease of comparison by consumers of such products.

The Report recommends that investment advisers to hedge funds and other private pools of capital, including private equity funds and venture capital funds whose assets under management exceed a “modest threshold,” be required to register with the SEC. According to the Report, the goal of registration would be to provide the government with more comprehensive data for evaluating whether such funds require greater regulation. In addition, the Report suggests that private investment funds advised by SEC-regulated investment advisors become themselves subject to recordkeeping, disclosure and reporting requirements, as well as SEC examination.

The Report does not call for a consolidation of the CFTC and SEC. However, it does require the CFTC and SEC to report to Congress by September 30, 2009 on ways that jurisdictional overlap between the two agencies can be harmonized. Any matter upon which the two agencies cannot reach an agreement would be referred to the Financial Services Oversight Council to make recommendations to Congress as to resolution.

The Report proposes greater regulation of over-the-counter (“OTC”) derivatives and asset-backed securities markets. Federal bank regulators would issue regulations that require the originator or sponsor of a securitized credit exposure to retain five percent of the credit risk of that credit exposure. Regulations would also be issued to link the compensation of participants in the securitization process, such as brokers, originators, sponsors and underwriters, to the longer-term performance of the securitized assets, rather than solely to the production, creation or inception of the products. The SEC’s authority to require reporting and disclosure by issuers of asset-backed securities would be strengthened. The Report also calls on the SEC to continue efforts to strengthen the regulation of credit rating agencies to promote the integrity of the credit rating process and suggests that regulators reduce their dependence on credit ratings in their regulatory efforts to the extent possible.

The Report proposes comprehensive regulation of OTC derivatives, including credit default swaps. The Commodities Exchange Act and securities laws would be amended to require clearing of all standardized OTC derivatives through regulated regional counterparties. Dealers would be subject to prudential supervision and regulation. The CFTC and the SEC would be authorized to impose recordkeeping and reporting requirements on all OTC derivatives. The CFTC and SEC would also be given enhanced authority to prevent fraud, market manipulation and other market abuses involving over-the-counter derivatives.

The Report contemplates given expanded authority to the SEC to promote transparency in investor disclosures through improvements in timing or quality. The SEC would also be directed to harmonize the regulation of investment advisers and broker-dealers, such as by establishing a fiduciary duty for broker-dealers offering investment advice, similar to the relationship that now exists between an investment adviser and its customer. The Report suggests that the SEC should be given authority to prohibit mandatory arbitration clauses in broker-dealer and investment advisory accounts with retail customers and to require nonbinding “say for pay” stockholder votes for all public companies.

The Report encourages the SEC to continue to strengthen regulation of money market mutual funds (“MMMF”). The MMMF industry recently experienced runs after one MMMF “broke the buck.” The runs required the federal government to provide guarantees and liquidity for MMMFs. The Report also calls for the President’s Working Group on Financial Markets to prepare a report assessing whether more fundamental change in MMMF regulation is required.

The Report also contains proposals designed to raise international financial regulatory standards and cooperation and level the playing field between the regulation of domestic and international financial companies. They include continued strengthening the Based II capital accord, promoting the standardization and improved global oversight of derivatives, enhancing supervision of internationally active financial firms and improving crossborder resolutions of financial firms.

The Report does not propose increased federal regulation of insurance except to the extent that insurance companies are Tier 1 FHCs. It does, however, provide for the establishment of an “Office of National Insurance” within the Treasury Department to gather information, develop expertise and coordinate policy. Similarly, the Report does not address the future role of Government Sponsored Entities such as Fannie Mae, Freddie Mac and the Federal Home Loan Bank system. Instead, it calls for the Treasury Department and the Department of Housing and Urban Development to study the issue and make recommendations.

Although some aspects of the Report were expected, others are likely to be highly controversial. The accumulation of authority and responsibility in the FRB is one area over which senators and congressmen have voiced concern. Some have suggested that too much power is being placed in one agency and that the agency’s independence could be compromised by certain of its proposed new roles . An alternative concept that may garner support on Capitol Hill is giving a council of regulators the systemic risk responsibilities instead of the largely consultative role contemplated by the Report.

Another controversial proposal is the elimination of exemptions from bank holding company status for companies that control specialty lenders. While the exemption for industrial loan companies has been controversial in recent years, neither such companies nor trust companies, credit card banks or grandfathered “nonbank banks” appear to have played a material role in the recent economic crisis. The same is true of grandfathered unitary savings and loan holding companies. And certain of the states that are primary issuers of industrial loan company charters have senators who may be prominent in the legislative process, such as Utah’s Robert Bennett (a minority member of the Senate Banking Committee) and Nevada’s Harry Reid (Senate Majority Leader).

Some banking trade groups and bank regulators have already voiced strong opposition to the creation of the CFPA, arguing that safety and soundness and consumer protection are interrelated and that divorcing the two will create less effective regulation overall. The concept of the CFPA being authorized to mandate that private sector companies offer particular products is likely to be controversial as well. And the Report’s indication that the Administration seeks to make federally chartered depository institutions, such as national banks, subject to a state’s enforcement of its consumer protection laws raises the very federal preemption issue that has been hotly litigated over the past few years. Indeed, at this writing, there is now pending a Supreme Court case on that issue.

Finally, there is the issue of the federal thrift charter. There had been much speculation about the combination of the OTS and OCC, while the Administration’s attempt to eliminate the federal thrift charter was less certain. The Report suggests that the charter is no longer needed in modern financial markets and that it provides an opportunity for regulatory arbitrage. However, the Report’s aversion to regulatory arbitrage goes only so far, as it does not appear that an effort will be made to restrict healthy banks from changing to or from a national or state bank charter or to or from Federal Reserve member bank status, all of which involve changes of regulators. The Report is silent on the proposed mechanism for and practicalities of the termination of the thrift charter and that silence raises many questions that will have to be answered as the legislative process unwinds.

Equally as important as what is in the Report is what is not in the Report. The Treasury Department had recently floated the concept of a single federal regulator that would assume the bank regulatory functions of the OCC, OTS, FRB and FDIC. The negative reaction to that concept appears to have caused the Administration to decide that such a proposal was not achievable legislatively. Similarly, its seems that the Administration has decided that an enhanced federal role in regulating insurance and/or developing a federal insurance chartering option are not battles that it currently wants to fight. There had been speculation of such initiatives since some of the prominent systemically important companies involved in the economic crisis were insurance companies.

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