I thought I would lay out the specifics of the U.S. Treasury plan to centralize and consolidate the U.S. financial regulatory system before commenting on it. A description of Treasury Secretary Paulson’s proposals is posted at the U.S. Treasury web site:

Treasury Releases Blueprint for Stronger Regulatory Structure
Remarks by Secretary Henry M. Paulson, Jr. on Blueprint for Regulatory Reform

RECENT HISTORY

The fact sheet accompanying the proposals describes recent discussion of centralizing regulation, including industry panels assembled by Secretary Paulson in March 2007 who agreed that “the competitiveness of our financial services sector — and its ability to support U.S. economic growth — is constrained by an outdated financial regulatory framework.”

Panel speakers at the March 2007 event included:

Warren E. Buffett, Chairman and CEO, Berkshire Hathaway Inc.
James Dimon, Chairman and CEO, JPMorgan Chase & Co
Jeffrey R. Immelt, Chairman and CEO, General Electric Company
Charles R. Schwab, Founder, Chairman, and CEO, Charles Schwab Corporation
John A. Thain, CEO, NYSE Group

Ann Yerger, Executive Director, Council of Institutional Investors

Michael R. Bloomberg, Mayor, New York City
Sir Alan Greenspan, Greenspan Associates
Arthur Levitt, Jr., Senior Advisor, The Carlyle Group
Robert E. Rubin, Director and Chairman of the Executive Committee, Citigroup Inc.
Paul A. Volcker

On March 13, 2008, the President’s Working Group on Financial Markets Policy Statement lead by Secretary Paulson issued a memorandum to the President regarding the underlying causes of financial market “turmoil” with recommendations to address the “current situation.”

The fact sheet emphasizes the importance of the U.S. ability to attract capital. It states “The United States is the world leader in financial services, so it is from this position of strength that we must constantly work to improve our system. Treasury’s working assumption is that we are engaged in a global race-to-the-top, to achieve the optimal regulatory structure for the financial services industry. The optimal regulatory structure needs to attract capital based on its effectiveness in promoting innovation, managing system-wide risks, and fostering consumer and investor confidence.”

The fact sheet indicates that Treasury invited public input on proposed reforms. Apparently, Treasury “published a request for public comment in the Federal Register in October.” It says that all public comments were posted on the internet. However, we have not been able to identify the URL. If you know of it, please post in the comments and we will link to it.

THE PLAN

The fact sheet divides the proposals into short, intermediate and long-term recommendations.

SHORT-TERM PROPOSALS

Short-term proposals are typically those aspects of a proposal which can be implemented quickly and are within the current powers of agencies involved.

In the case of the Paulson Plan, this would mean the proposals are within the powers of the Federal Reserve System, including the Governors of the Federal Reserve, the New York Federal Reserve Bank or the other 11 Federal Reserve banks as well as the Executive Branch (such as publishing an executive order) of the U.S. federal government. As a practical matter, the Plan can be expected to enjoy the support of G-8 and key opinion leaders in the financial and global governance community.

Key short-term proposals are:

Modernize the President’s Working Group on Financial Markets (PWG):

Create a New Federal Commission for Mortgage Origination – To evaluate, rate, and report on the adequacy of each state’s system for licensing and regulation of participants in the mortgage origination process.

  • This is a first step to asserting federal control of mortgage brokers.
  • Treasury also recommends that the Federal Reserve continue to write regulations implementing
    national mortgage lending law and also recommends clarification and enhancement of the Federal enforcement authority over these laws.
  • For our earlier post on who’s who in the housing and mortgage bubble, click here.

Clarify Liquidity Provisioning by the Federal Reserve to give the Federal Reserve the information it needs during this temporary period.

  • Future lending to non-depository institutions should be “calibrated and transparent.”
  • The Federal Reserve should have “access to sufficient information on non-depository institutions with access to Federal Reserve loans. This could include on-site examinations or other means as determined by the Federal Reserve. The most important information relates to funding and liquidity.”
  • This will “provide framework for oversight of non-depository institutions with temporary access to Fed lending while recognizing the differences between banks and non-banks.”

INTERMEDIATE-TERM PROPOSALS

Intermediate-term proposals typically take more time to implement, either because of operational considerations, budgetary considerations, or because regulatory changes are needed. As a matter of law, budget and regulatory changes require input from Congress and the public.

Transition the Thrift Charter to a national bank charter because it is no longer necessary to ensure sufficient residential mortgage loans are made available to U.S. consumers. The Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC) would merge.

  • Now that the housing bubble has burst and technology permits further centralization, there is significant excess capacity in the mortgage market and regulatory bureaucracy.
  • Banking regulation will be consolidated into the Federal Reserve so that the owners of the large banks can “self-regulate” the banking industry with less Congressional oversight.

Federal Reserve Control Over Payment Systems

  • Treasury recommends the creation of a federal charter for systemically-important payment and settlement systems. The Federal Reserve should have primary oversight responsibilities for such systems.

Create an Optional Federal Charter for Insurance

It appears that the U.S. insurance industry will be centralizing to federal from state control.

  • Treasury recommends the establishment of a federal insurance regulatory structure to provide for the creation of an Optional Federal Charter. This structure is similar to the current dual chartering system for banking.
  • An Office of National Insurance within Treasury should oversee this federal regulatory structure.
  • Treasury also recommends that, as an intermediate step, Congress establish a federal Office of Insurance Oversight within Treasury to establish a federal presence in insurance for international and regulatory issues.

Generate Unified Oversight for Future and Securities by merging the Securities and Exchange Commission (SEC) and Commodities Futures Trading Commission (CFTC) and their regulatory philosophies.

  • Now that we are in a bull market for tangibles and the PWG is heavily dependent on the futures market to manage markets, securities and commodities regulation will be integrated.

Treasury recommends the following changes to reform the SEC’s process for the securities market to prepare for the merger:

  • The adoption of core principles for exchanges and clearing agencies.
  • An expedited self-regulating organization rule approval process.
  • General exemption under Investment Company Act for already actively trading exempted products, such as exchange-traded funds, to improve the new product approval process consistent with SEC investor protection standards.
  • New Congressional legislation to expand the Investment Company Act to permit a new global investment company.

Treasury also recommends statutory changes to harmonize the regulation and oversight of broker-dealers and investment advisers offering similar services to retail investors. Treasury also recommends that investment advisers be subject to a self-regulatory regime similar to that of broker-dealers.

LONG-TERM OPTIMAL REGULATORY STRUCTURE RECOMMENDATION

Long-term changes are typically those that would require new legislation and regulations, as well as significant operational changes for public and private players in the financial system and coordination with international regulators and systems. Typically, short- and intermediate-term proposals are designed to move the existing system toward the long-term ones. My guess from reviewing the Paulson Plan is that the long-term proposals could be implemented by 2012 and beyond.

The fact sheet states that the current system of functional regulation, which maintains separate regulatory agencies across segregated functional lines of banking, insurance, securities, and futures, “is largely incompatible with today’s financial markets. Functional regulation has several fundamental problems,including the lack of a single regulator to monitor systemic risk.”

Treasury is seeking an objectives-based approach designed to address particular market failures.

Three distinct regulators would focus exclusively on financial institutions: a market stability regulator (i.e., the Federal Reserve), a new prudential financial regulator (roles of the OCC, OTS and National Credit Union Administration (CUA), and a new business conduct regulator (most roles of the CFTC and SEC, and some roles of bank regulators).

Market Stability Regulator:

  • The Federal Reserve would have the responsibility and authority to gather appropriate information, disclose information, collaborate with the other regulators on rule writing, and take corrective actions when necessary to ensure overall financial market stability. To fulfill its responsibilities to gather information, the Fed would have authority to join in examinations with the prudential and business conduct regulators.
  • This new role will replace the Fed’s more limited, traditional role as the supervisor of financial holding companies, bank holding companies, and certain state-chartered banks.
  • The Fed would have the ability to monitor risks across the financial system.

Prudential Regulator:

  • A single prudential regulator focusing on safety and soundness of firms with federal guarantees, similar to the OCC, but with appropriate authority to deal with affiliate relationship issues.
  • Prudential regulation in this context would be applied to individual firms, and it would operate like the current regulation of insured depository institutions, with capital adequacy requirements, investment limits, activity limits, and direct on-site risk management supervision.
  • The prudential regulator would oversee firms with explicit government guarantees.

Business Conduct Regulator:

  • A new business conduct regulator would monitor business conduct regulation across all types of financial firms. Business conduct regulation in this context includes key aspects of consumer protection such as rule writing for disclosures, business practices, and chartering / licensing of certain types of financial firms.
  • The new business conduct regulator subsumes most roles of the SEC/CFTC and authority over rules such as mortgage disclosure.

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