Systemic Risk Regulation
The current financial crisis is the natural and logical result of a failed financial regulatory system that placed an irrational faith in the ability of markets to self-correct. As a result, regulators ignored repeated warnings about the over-the-counter derivatives markets, problems with securitization and lax mortgage underwriting standards, excessive leverage in financial institutions, and the general movement of financial activity into increasingly complex and opaque forms.
1. Systemic risk is best addressed by strengthening other types of regulation.
The most important step in addressing systemic risk is to ensure the safety and soundness, fairness, transparency, and accountability of financial markets, participants, and products. If regulatory agencies perform those functions properly, then systemic risk will be far less of a problem. Congress must close loopholes in the regulatory structure to ensure that all financial products and activities are subject to appropriate oversight, provide agencies with sufficient resources to fulfill their mandates, and hold them accountable to do so. Finally, regulators must pursue their responsibilities vigorously. Policy makers should not permit the question of a new systemic risk regulator to eclipse the tasks of strengthening other forms of oversight and accountability; nor should they over-assume the existence of systemic risk.
2. A systemic risk regulator could supplement the activities of existing regulators.
In addition to the responsibilities of other regulators, one central authority should be responsible for monitoring and stemming potential systemic risks. An effective systemic risk regulator must identify and cure risks that could threaten the broader financial system, stopping institutions from creating systemic risk by growing to a certain size or complexity, becoming too interconnected, or engaging in certain activities. Regulators also must have resolution authority for non-bank financial institutions to ensure that, should an institution become systemically significant and fail, it can do so in an orderly fashion without undue impact on the broader economy.
The systemic risk regulator must have staff, resources, and expertise sufficient to monitor sources of systemic risk in institutions, products, and activities throughout the financial markets, and it must have the power to act promptly and independently. It also must be fully accountable and transparent to the public.
The current crisis has provided dramatic proof that anti-consumer and anti-investor practices create systemic risks that undermine the financial system and the broader economy. As such, the systemic risk regulator should not have the power to preempt consumer or investor protections based on the false belief, embraced by some safety and soundness regulators, that consumer and investor protections are in tension with the health of financial institutions.
3. Primary authority for systemic risk regulation may be assigned to the Federal Reserve, a new regulatory agency, or a council of regulators.
The Federal Reserve can serve as the systemic risk regulator only if it is made transparent and conflicts of interest inherent in its structure are corrected. Given that the Fed has had primary responsibility for maintaining economic and financial stability to date, some have suggested that the Fed is the most appropriate agency to act as the systemic risk regulator. This proposal raises concerns because of the Fed’s failure to mitigate the housing bubble by calling attention to the unsustainable run up in house prices and stemming the flow of deceptive loans that fed the bubble. The proposal also raises concerns because the Fed is not a true public agency; it is deeply non-transparent and has conflicts of interest built into its governance structure. At a minimum, the Fed must be reformed substantially before it could be considered as an appropriate systemic risk regulator, for example by removing bank representatives from the governance of the regional Reserve Banks.
Systemic risk could be regulated by a council composed of the heads of each relevant federal agency and representatives from state agencies. One benefit of the council of regulators is that each brings an understanding of the risks unique to the organizations and activities under his or her supervision. The council would be able to oversee all areas of the financial system with less distraction by industry- or product-specific concerns and with less risk that multiple missions, for example consumer protection and bank solvency, would lead to distraction and cause undesirable outcomes for working families. To be effective, such a council must have the authority to act without the delay of working through some other primary regulator and must have sufficient staff and other resources of it own. It also must be directly accountable for its actions and results.
A new regulatory agency could be created to oversee systemic risk. This idea is championed by those who worry that a regulatory council will prove ineffective and prone to jurisdictional disputes, but who oppose to the Fed.
Regardless of how systemic risk regulation is conducted, it cannot be viewed as substitute for proper regulation and consumer and investor protections. To the contrary, if conducted properly these other forms of oversight can forestall most of the need for systemic risk regulation.
Regulating the Shadow Markets
Financial oversight has failed to keep up with the realities of the marketplace, characterized by globalization, innovation, and the convergence of lending and investing activities. This has allowed institutions to structure complex transactions and take on risky exposures without fulfilling the regulatory requirements Congress deemed necessary to prevent a systemic financial crisis after the Great Depression. These unregulated and under-regulated activities and institutions, the “shadow financial system,” were permitted to become so intertwined with the real economy that the government has chosen to use taxpayers’ money to bail them out when they failed.
As President Obama said during the campaign, “We need to regulate institutions for what they do, not what they are.” This means that hedge funds, private equity funds, derivatives, off-balance-sheet lending vehicles, structured credit products, and other shadow markets actors and products must be subject to transparency, capital requirements, and fiduciary duties befitting their activities and risks.
Shadow market institutions and products must be subject to comprehensive oversight. We need to return to the broad, flexible jurisdiction originally provided in federal securities regulation, which allowed regulators to follow activities in the financial markets. This means ensuring that all institutions that are active in the shadow financial markets provide regular information to regulators and the public about their activities and their counterparty relationships, requiring derivatives to be traded on regulated exchanges that are transparent and impose meaningful margin requirements, and requiring money managers to provide comprehensive disclosures and to act as fiduciaries for their investors.
The opaque, over the counter derivatives market has evolved into a multi-trillion dollar casino for wealthy investors and should be eliminated altogether. Derivatives that are used for legitimate hedging purposes must be traded on open exchanges, using standardized contracts.
Unregulated pooled investment vehicles, including private equity and hedge funds, have been major participants in the shadow financial markets. Private equity and hedge funds and their managers should be subject to more stringent oversight that, at minimum, requires greater transparency, ensures that managers act in the best interest of investors, and subjects the funds to capital adequacy requirements and leverage limits.
Self-regulation is a myth. Sophisticated investors cannot and should not be relied upon to protect their own long-term financial interests or to avoid overly risky activities that can threaten the health of the financial markets and the global economy. This does not necessarily mean that all participants in the financial markets must be subject to identical regulatory requirements. But regulators must ensure a minimum level of transparency, accountability, and mandated risk management across the financial markets.
Some have suggested that certain aspects of the shadow financial markets, particularly hedge funds and derivatives such as credit default swaps, should be overseen by a systemic risk regulator instead of being subject to comprehensive regulation. This would be a terrible mistake. The shadow financial markets must be subject to comprehensive, routine oversight appropriate to the activities involved. Systemic risk regulation should function as an addition to this oversight, not a replacement for it, focusing on problems that arise from interactions among institutions regulated by different regulatory bodies or emerging risks not fully addressed by the other regulators.
A strong federal commitment to robust consumer protection is central to restoring and maintaining a sound economy. The nation’s financial crisis grew out of the proliferation of inappropriate and unsustainable lending practices that could have and should have been prevented. That failure harmed millions of American families, undermined the safety and soundness of the lending institutions themselves, and imperiled the economy as a whole. In Congress, a climate of deregulation and undue deference to industry blocked essential reforms. In the agencies, the regulators’ failure to act, despite abundant evidence of the need, highlights the inadequacies of the current regulatory regime, in which none of the many financial regulators regard consumer protection as a priority. The following reforms would fix the system’s most glaring flaws, and create a sounder foundation for the nation’s consumers and the economy.
1. Re-regulate mortgages, consumer credit, and other consumer financial products to protect consumers against the excesses of an unrestrained market.
We must return to ensuring that financial products and transactions are fair and safe instead of merely requiring information disclosures about them. We also must restore sound underwriting and realign the incentives of borrowers and lenders so that both have a common interest in fair, affordable, sustainable and understandable credit. We must reform the mortgage market, address overdraft and other abuses, and adopt a federal cap on high cost credit (a usury cap) that protects every consumer from predatory loan products such as payday loans and permits states to set lower caps. Decades-old consumer protection statutes must be updated to account for inflation and technological changes.
2. Make a strong federal commitment to consumer protection, including: an agency dedicated to consumer protection, covering all consumer financial products, a Consumer Affairs Office in the White House, and an independent government-chartered consumer organization.
The consumer financial products agency should have jurisdiction over all bank and payment products and services (including deposit products, electronic funds and payment systems), debt-related services, debt collection, and credit reporting. The agency should have a strong mandate to move away from disclosure-based “consumer protection” to the prohibition of harmful, unfair, deceptive or abusive products and practices. Its rules must be a floor, not a ceiling, on consumer protection standards. The agency should promote standard terms to enable meaningful comparison shopping (for example no-fee, binding price quotes and standard quote features to facilitate meaningful comparisons). Unlike the role that existing banking agencies have played, the consumer financial products agency should have a forward-looking mission, to prevent abusive practices before they become widespread. The agency also should be empowered to ensure fair lending compliance as a major priority, to ensure fair and equitable transactions and access to adequate, sustainable and useful credit for all, including underserved communities. The agency must have authority to obtain information and documents from regulated entities to facilitate monitoring of regulated entities’ consumer protection compliance. It also must have a robust enforcement capability, and its rules should ensure industry accountability to individual consumers.
Agency funding should be structured in a manner that provides stable, adequate resources that are not subject to political manipulation by industry, whether funding is provided through Congressional appropriations, industry assessments, filing fees, other sources, or a blend of these approaches. Its board and governance must be structured to ensure strong and effective consumer input, and a Consumer Advocate should be appointed to report semi-annually to Congress on agency effectiveness.
The consumer financial product safety agency, and each regulator’s Office of the Consumer Advocate, should have a well-resourced and easy-to-use consumer redress process, accessible online and by phone, that will respond to consumer complaints on a timely basis, stating whether the complaint appears to have merit and whether the agency will investigate and address the problem and whether it should be pursued privately.
An Office of Consumer Affairs in the White House would give consumers a voice in the Administration and provide some balance to the influence enjoyed by Wall Street. This office should have a clear mandate to weigh in on legislation, intervene as a full party in adjudicatory proceedings, and have provide in policy meetings. Its director, someone with firmly established credentials in consumer advocacy, should have direct access to the President.
A government-chartered consumer organization should be created by Congress to represent consumers’ financial services interests before regulatory, legislative, and judicial bodies. This organization could be financed through voluntary user fees such as a consumer check-off included in the monthly statements financial firms send to their customers. It would be charged with giving consumers, depositors, small investors and taxpayers their own financial reform organization to counter the power of the financial sector, and to participate fully in rulemakings, adjudications, and lobbying and other activities now dominated by the financial lobby.
3. The states must retain the ability to protect their citizens.
States have proved more nimble and effective than the federal government in reacting to emerging abuses and tailoring responses to local needs. Courts often can remedy new abuses more quickly and efficiently than legislators or regulators by applying flexible, longstanding common law principles against unreasonable, unfair, or deceptive practices. Additionally, state authorities and consumers pursuing remedies privately can add much-needed strength to federal law enforcement. Specific state laws addressing new threats also provide useful data points for federal lawmakers seeking effective models for federal legislation.
It is essential that federal consumer protection law maintains these important state roles. Federal law should set a floor not a ceiling on consumer protection, and federal enforcement efforts should complement state efforts but not displace them. Laws that promote a race to the bottom should be revised so that financial services providers do not have the ability to shop for the weakest state protections and spread those to the rest of the country. No federal agency should have authority to preempt state consumer protection law (whether statutory or common law) or prevent state enforcement of federal or state law, and federal legislators and regulatory agencies should conduct an orderly review and repeal of existing federal regulations that preempt state consumer protection law.
4. Require accountability and appropriately aligned incentives for loan originators, for Wall Street firms that package the loans, and for the investors who fund them.
Compensation terms that incent lenders and brokers to steer borrowers into higher cost or less sustainable loans than those for which they qualify should be prohibited, as should investment or other arrangements that tie the hands of loan servicers and hinder appropriate responses to problems that arise. All participants in the loan supply chain, from originator to assignee, should be held accountable for the loans they make or fund.
5. Consumers who have been damaged by abusive financial practices must have meaningful redress, which requires prohibiting practices like forced arbitration and class action bans.
Laws should be enforceable by those they are designed to protect, with meaningful remedies, against loan originators, the Wall Street firms that package the loans, and the loans’ current owners, with attorneys’ fees recoverable by prevailing claimants. Widespread abuses are frequently most efficiently addressed by groups of consumers acting together for class relief. Forced arbitration should be prohibited because it deprives consumers of access to the courts, confining them instead in unaccountable, non-reviewable, secretive forums that are often heavily biased in industry’s favor.
6. Eliminate “charter competition” among federal financial regulators, and require transparency in consumer protection regulation and enforcement so effectiveness can be evaluated.
Both the Office of the Comptroller of the Currency and the Office of Thrift Supervision failed utterly to protect consumers or the safety and soundness of regulated entities. Instead, they competed with each other to minimize consumer protection standards as a way of attracting institutions to their charters, tying their own hands and failing to fulfill their missions. Charter shopping must be eliminated so that regulators can focus on their missions without conflicts of interest. All regulators should be required to focus more on transparent, public rulemaking and enforcement actions than on non-public supervisory actions, and each should have an Office of the Consumer Advocate to report to Congress annually on the agency’s effectiveness in protecting consumers.
7. Address new risks to consumers from financial marketing practices.
Ensure that regulators address not only traditional marketing practices, but also the growing role of the Internet and online media in the provision of consumer financial services. Digital marketing practices little understood by the public—including so-called behavioral targeting—profile and track individual consumers across the Internet in order to generate financial transactions, including mortgage loans. This system is non-transparent to consumers, including how they are evaluated and what data has been collected about them. Consumer protection for financial services must reflect the realities of the contemporary marketplace, where credit applications will soon be submitted via a mobile phone, for example, and consumer dependence on the Internet for conducting financial transactions is expected to grow dramatically. Online and traditional marketing of consumer financial services should be thoroughly analyzed, and newly emergent risks—including the loss of privacy and lack of adequate privacy protection under existing banking and financial laws—must be addressed.
Mortgage Relief and the Community Reinvestment Act
One legacy of the sub-prime crisis is a deepening spiral of home foreclosures. With unemployment increasing, defaults and foreclosures are now spreading from homeowners with sub-prime loans to ordinary homeowners with conventional fixed rate mortgages that have become unaffordable due to economic hardships.
Foreclosure notices were filed on over 2 million homes in 2008, and that number is expected to increase during 2009. At the end of 2008, about 8 percent of all mortgages were delinquent; for sub-prime loans, the figure was 22 percent.
The current mortgage modification program, known as Making Home Affordable, spends $75 billion to give banks and other institutions financial incentives to modify the terms of mortgages. It excludes most homeowners whose mortgages exceed the value of their homes, as well as those who have fallen behind on their monthly payments. The New York Times reported that at most 55,000 mortgage loans had been modified under the program as of late May 2009. The number of homeowners in need of modification is well into the millions.
The portion of the Obama Administration’s program that would have compelled refinancings in some cases—authorization for bankruptcy judges to modify home mortgage terms—was defeated by the senate after fierce industry lobbying.
The federal government needs a much more robust program of mortgage relief. It could include direct government refinancing at the Treasury borrowing rate, modeled on the Home Owners Loan Corporation of the 1930s, which eventually refinanced one American mortgage in five. It also could embrace the approach first proposed by the National Community Reinvestment Coalition in February 2008, under which the federal government would use its eminent domain power to acquire both whole loans and securitized mortgages, write down their value to current market value, and pass along the savings to the homeowner in the form of an affordable mortgage.
The goal of public policy should be to maximize the number of homeowners with distressed mortgages who keep their homes. Any other approach—including the current policy—will only permit the foreclosure crisis to drag down the value of other homes and prolong the general financial and economic crisis through the ripple effects of millions of home foreclosures.
The Community Reinvestment Act
The Community Reinvestment Act (CRA) has been one of the most important tools for building wealth and revitalizing neighborhoods. CRA encourages banks to respond to a variety of needs in low- and moderate-income (LMI) communities by financing affordable rental housing, home ownership, and small business creation. It also democratizes oversight and encourages meaningful partnerships between financial institutions and LMI communities by enabling community organizations to intervene in proposed mergers or expansions and demonstrate whether banks have met the credit needs of the communities they serve.
CRA is also an antidote to the foreclosure crisis because it rewards banks for foreclosure prevention efforts such as counseling, modifying loans, and investing in funds that finance loan modification, and because it requires banks to meet the credit needs of all communities consistent with safety, soundness, and consumer protection principles. For these reasons, Congress must strengthen CRA as it applies to banks and expand CRA’s reach to non-bank financial institutions.
The CRA Modernization Act of 2009
The CRA Modernization Act of 2009, H.R. 1479, introduced by Rep. Eddie Bernice Johnson, would increase the responsiveness and accountability of banks to all communities, rural and urban. It would require CRA examinations in the great majority of geographical areas that banks serve. Currently CRA examines banks in areas where they have branches but not in areas where they lend through brokers. The bill would address racial disparities in lending by requiring CRA exams to consider lending and services to minorities in addition to LMI communities. The bill would require the reporting of race and gender of small-business borrowers as well as data regarding deposit and savings accounts. It would require the Federal Reserve Board to create a database on foreclosures and loan modifications, which would be similar in approach to Home Mortgage Disclosure Act data.
The bill would enhance the ratings system of CRA exams and require banks to submit public improvement plans, subject to public comment, when they earn low ratings in any of their service areas. It also would require federal regulatory agencies to hold more meetings and public hearings when banks merge or seek to close branches. Additionally, it would establish requirements for all affiliates and subsidiaries of banks, independent mortgage companies, mainstream credit unions, insurance companies and securities firms.
If passed, the CRA Modernization Act would leverage trillions of dollars in additional safe and sound loans and investments for America’s neighborhoods. It would help steer the country out of the current financial crisis by requiring financial institutions to invest in our people and our communities. Policy makers must strengthen these forms of citizen participation and give more emphasis to the information consumers and community organizations provide.
Civil Rights Compliance
Discriminatory Lending Was a Major Cause of the Current Crisis
Systemic discriminatory lending practices and residential segregation were major causes of the current financial crisis. The United States has never sufficiently addressed the problems and challenges of lending discrimination and redlining practices, one vestige of which is a two-tiered financial system that forces minority and low-income borrowers to pay more for financial services, receive less value for their money, and face exposure to greater risk. African-American and Latino borrowers continue to pay more for credit than Caucasian borrowers with similar credit scores and credit characteristics. Racial minorities receive a disproportionately high number of subprime, higher cost, and non-traditional mortgages and, as a result, are disproportionately losing their homes to foreclosure. It is projected that African-Americans and Latinos will lose at least $213 billion dollars as a result of the current economic downturn. These disparities are broadening the unfair and unsound wealth gap between majority and minority populations.
The current financial regulatory system fails to ensure adequate compliance with civil rights statutes or to establish a fair financial services system that serves all consumers. Agencies that oversee the financial system lack sufficient authority and accountability for enforcing fair lending laws. Further, the broad lack of oversight in the financial markets has spurred inequities by permitting market players to seek out under-regulated areas in which to target under-served populations with unfair and abusive products and practices.
Each regulatory and enforcement agency must prioritize civil rights compliance and the elimination of the current unequal, two-tiered financial system. Each program and function of the agencies must be assessed for compliance with civil rights statutes, and regulators must ensure that regulated entities have clear guidance on how to comply with civil rights statutes and regulations. They also must enhance their oversight and enforcement of civil rights compliance.
The President should re-implement the Fair Housing Council established by Executive Order 12,892, comprising the heads of relevant federal regulatory and enforcement agencies, which is tasked with ensuring that every federal program operates in compliance with the letter and spirit of the nation’s civil rights statutes. The Executive Order mandates that each federal agency, the Department of Justice and the Federal Trade Commission, work to “affirmatively further fair housing” in accordance with the Fair Housing Act.
Each agency should develop a senior position, with appropriate staff and resources, charged with ensuring compliance with civil rights statutes and working toward the broader goal of creating an equitable and fair financial system. The civil rights officer should not only assess the agencies’ programs and functions to guarantee that the agencies themselves are in compliance with civil rights statutes, but also ensure compliance by market participants and hold them accountable for noncompliance.
Agencies also must be fully transparent and accountable to the public on measures of civil rights compliance and enforcement. This includes reporting not only on their own actions but also those of market participants. In particular, the agencies must disclose any noncompliance that they identify, whether in the agencies or the private sector.
Additionally, civil rights compliance and goals must never be waived, even in the event of a crisis. While it is imperative that agencies be nimble and take quick and decisive action in the face of a crisis, their actions should not come at the expense of ensuring a fair and equitable marketplace.
Effective civil rights protections are a critical component of financial regulatory reform. They increase fairness and equity for all consumers, and they diminish the financial system’s instability.
Bankruptcy Law Is Inadequate for Systemically Significant Nonbank Institutions
The current bankruptcy regime does not work well for bank holding companies and systemically significant nonbanks institutions. The federal government has long had the power to take over and close banks and other deposit-taking institutions whose deposits are insured by the government and subject to detailed regulation. But it has no such “resolution authority” with respect to bank holding companies and non-bank financial institutions such as insurance companies, investment banks, hedge funds, private equity firms and other financial institutions.
The bankruptcy of a systemically significant non-bank can aggravate liquidity problems and destabilize financial markets, but the Bankruptcy Code’s provisions for the distribution of the assets of a bankrupt financial institution take no account of the systemic considerations that regulators can and should consider. Because the bankruptcy system was not designed for these circumstances, financial regulators may feel the need to prop up the ailing institution in order to avoid a messy and potentially destructive bankruptcy process.
The government needs new power to seize non-bank financial entities whose collapse might jeopardize the national and global financial systems. In particular, resolution authority is needed so that the Federal Deposit Insurance Corporation (FDIC) can take into conservatorship or receivership bank holding companies such as Citigroup. Current law gives FDIC no authority over bank holding companies, which is where the main mischief—and damage—occurred.
Given the potential risk from triggering acceleration clauses in credit default swap (CDS), there may be value in affording the regulator the authority to perform—as FDIC regulators do— “least cost resolution” analysis. In the case of CDS exposures, resolution authority could include a non-receivership approach. The FDIC could, for example, require the company to sell certain non-core businesses (with regulatory oversight) and disgorge troubled assets at the same time.
The Congressional Oversight Panel, the Treasury Department, and others have proposed establishing a receivership and liquidation process for systemically significant as well as other nonbank financial institutions that is similar to the resolution system for banks. Under most of these proposals, the FDIC would be empowered to appoint itself as conservator or receiver for failed or failing non-bank financial institution holding companies and their subsidiaries.
The FDIC would be charged not just with wielding resolution power but also setting standards that should limit the need to use the resolution authority. It would have responsibility over systemically important and other nonbank financial institutions and would share with Congress the responsibility for establishing resolution implementation standards. The FDIC would further have the authority to:
- Make loans to the covered financial company or any subsidiary;
Purchase assets of the covered financial company or any subsidiary;
Assume or guarantee obligations of the covered financial company or any subsidiary;
Acquire any type of equity interest or security of the covered financial company or any subsidiary;
Take a lien on any or all assets of the covered financial company or any subsidiary; and
Appoint itself as conservator or receiver of the covered financial company.
Bailouts Versus Resolution Authority
Resolution authority would be a major improvement on the current bailout strategy, which uses taxpayer funds and loans and guarantees from the Federal Reserve to prop up banks that are, by any reasonable measure, insolvent. The cost of the current strategy is that it prolongs a day of reckoning. It leaves in place seriously wounded banks incapable of serving the nation’s credit needs, which prolongs the recession and creates the risk of a Japan-type “lost decade.”
The public-private partnership model announced in late March also creates huge opportunities for conflicts of interest, with the government assuming most of the risk and private speculators appropriating most of the gain. It is unlikely to achieve its goal of increasing the market value of depressed securities because the underlying mortgages are only worth a fraction of their nominal value. The bailout process is also almost totally non-transparent.
It would be far better to enact and then use resolution authority so that banks which are effectively insolvent are taken into public receivership by a government agency with the competence and capacity to do true audits rather than hypothetical stress tests. As with resolution of smaller institutions by the FDIC, this agency would assess how large is the hole in the institution’s balance sheet, and decide what combination of public capital and bondholder losses should make up the loss. Incumbent management would be replaced, and the institution would be returned to new private ownership as soon as practical. Experience on other nations that have suffered banking collapses (Japan, Sweden) suggest that this approach of acknowledging losses and recapitalizing institutions is preferable to a policy of piecemeal bailout.
Restoring Prudential Financial System Regulation
For the last three decades, financial regulators, Congress and the executive branch have steadily pulled back the regulatory system that restrained the financial sector from acting on its own worst tendencies. The post-Depression regulatory system aimed to force disclosure of publicly relevant financial information; established limits on the use of leverage; drew bright lines between different kinds of financial activity and protected regulated commercial banking from investment bank-style risk taking; enforced meaningful limits on economic concentration, especially in the banking sector; provided meaningful consumer protections (including restrictions on usurious interest rates); and contained the financial sector so that it remained subordinate to the real economy.
This regulatory system was highly imperfect, of course, but it was not the imperfections that led to the system’s erosion and collapse. Instead, it was a concerted effort by Wall Street, which gaining momentum steadily until it reached fever pitch in the late 1990s that continued through the first half of 2008.
One of the key flaws in that system was a lack of prudential supervision by the financial regulators themselves. They failed to use their broad powers. Bank regulators were supposed to hold banks to adequate capital standards, prevent unsafe and unsound lending and maintain an adequate deposit insurance base.
With too little congressional oversight, regulators became too cozy with the banks. Worse, the Congress acceded to industry demands to reduce deposit insurance premiums and to even base them on weak “risk” standards. As a result, many banks avoided making adequate payments into the funds even as the level of risk they placed on the system grew. This worsened moral hazard.
Further, the bank regulatory system is largely outside of congressional purview because bank regulators are not paid out of congressional appropriations. Instead, regulators receive dues assessments from banks and control their budgets. In combination with entities’ ability to choose their own regulators, this creates a race to the bottom, in which banks seek the least attentive regulator that will grant them the most powers.
1. We need a simpler and more transparent financial system that is far less vulnerable to speculative abuse and systemic risk, as well as a reliable policing mechanism in order to restore the financial markets to their proper role as facilitators of the real economy. A core principle of both efforts is that any institution that creates credit (and hence risk) must be subject to prudential regulation. It does not matter whether the institution calls itself a commercial bank, an investment bank, a mortgage broker, a hedge fund or a private equity firm. There must be no category of institution that escapes supervision. As Barack Obama astutely stated in an important campaign speech on March 27, 2008, at Cooper Union in New York: “We need to regulate institutions for what they do, not for what they are.”
2. Congress needs to separate dues assessments from regulatory authority to prevent regulatory capture. The number of regulators should be reduced in any event, but the potential for charter shopping must be eliminated. Banks should pay regulatory assessments into a pool. Then, regulators should be required to submit performance and budget requests to the Congress to obtain funds from that pool for regulatory needs. All bank regulators should have their full budgets subject to Congressional oversight.
3. The inconsistencies in regulatory authority that have allowed financial services holding companies to abuse relationships between investment and insured depository banks under their control should be changed.
4. A variety of actions must be taken to improve capital standards, reduce leverage, require “skin in the game” in securitizations, and bring off-balance sheet entities onto balance sheets.
5. Regulators must limit the size of banks through prudential oversight. The deposit insurance system should be reviewed. Imposition of significantly higher premiums on larger banks and other actions to limit the size of larger, more complex financial institutions will hold those firms more accountable for their risks and temper their size. As FDIC Chair Sheila Bair has posited: “A strong case can be made for creating incentives that reduce the size and complexity of financial institutions as being bigger is not necessarily better.”
6. Give the FDIC more authority over holding companies. As Bair has testified, “Where previously the holding company served as a source of strength to the insured institution, these entities now often rely on a subsidiary depository institution for funding and liquidity, but carry on many systemically important activities outside of the bank that are managed at a holding company level or non-bank affiliate level.” This means that the FDIC needs greater authority over the actions of an entire holding company, not just a failing bank, to limit risk caused by the holding company’s actions.
7. Preemptive actions by Federal agencies and the courts restricting state enforcement authority should be reversed to reinstate the ability of state legislators, regulators, and courts to enforce federal and state laws against nationally regulated institutions and to enact stronger state-level consumer protections.
8. Each prudential regulator should issue an annual report on emerging risks so that the public will know what trends the regulators are observing.
9. The data included in public Call Reports, or statements of condition, of institutions under federal regulation should be broadened and subject to more detailed public disclosure so that the public and the Congress can better evaluate where institutions obtain their income and where their risks are changing over time.
10. Each regulator should also implement an effective complaint system that actually assists consumers and complements the efforts of the Financial Product Safety Commission.
The financial crisis began with poorly regulated loan products which posed too much risk for the consumers to whom they were sold, and ultimately to the market as a whole. While the other policy papers prepared by the coalition focus on domestic United States. regulation, many principles embodied in those papers should be extended to the debate around international re-regulation. Moreover, alongside national and international re-regulatory efforts, a strong concurrent and complementary role for provincial or state governments can provide needed early enforcement of existing standards and also develop new standards to address emerging practices before they cause widespread consumer harm or systemic risk. State and provincial legislatures are often in a unique position to spot and stop bad practices before they become universal. To ensure rapid and appropriate responses to abuses in the financial credit markets, all levels of government must be able to protect consumers and regulate financial institutions.
Also, there is a case to be made for the creation of new international financial regulatory institutions, but agreement on their exact contours and responsibilities will be difficult to achieve in the near term. Regardless of whether we create new international institutions, global rules must not interfere with national, state and local oversight. Advancing this principle requires looking at not just global regulatory bodies, but also treaties and institutions that preempt action by national and subnational governments.
Among the principles that should guide U.S. and other governments in the global arena are the following:
1. Provide an international regulatory floor.
Some existing international agreements and institutions may not be suited to preventing future financial crises. The Basel II accord, for instance, relies heavily on internal ratings-based (IRB) approaches to capital regulation that allow banks to use their own credit risk models to determine how much capital they should hold. As Federal Reserve Vice-Chairman Daniel Tarullo has written, insofar as “the IRB approaches are essentially untested, the regulators adopting them are taking at least a leap of faith and, critics fear, possibly a leap off a cliff.” Regulators must ensure that international regulatory accords do not promote destabilizing or untested banking practices and do not impinge on domestic prudential regulation. In short, international agreements should set a floor—not a ceiling—on regulatory standards, and ensure that there is no preemption of action at the national or subnational level.
2. Do not harmonize standards downward.
Business groups have long sought the convergence of accounting and other standards, which can harm consumers and investors. For instance, in August 2008, the U.S. Securities and Exchange Commission (SEC) proposed a roadmap that would permit large companies to abandon U.S. accounting standards and adopt newer, less tested European standards. The U.S. Financial Accounting Standards Board has found the European standards to be weaker, and academic studies have shown that they provide greater opportunities for earnings management (or “cooking the books”). Moreover, many experts argue that competition between standard-setters slows the race to “lowest common denominator” standards and creates efficiencies in many fields. The SEC should start with an open and transparent assessment of the strengths and weaknesses of both sets of accounting standards, especially with regard to consumer and investor protection. If there is a pressing need for convergence of one particular standard—whether in accounting or other areas—this can be done on a case-by-case basis with a pledge to raise standards, not lower them.
3. Close down tax havens.
Certain offshore tax havens, such as the Cayman Islands, Liechtenstein, Panama, Switzerland and many others, have developed local industries with the sole comparative advantage being the opportunity to profit from “regulatory arbitrage.” The consequence is a global race to the bottom that promotes deregulation at the expense of market stability. The Obama administration’s tax-haven plan is a step in the right direction. We further support the repeal of tax incentives to offshore production and investment (including deferred taxation of foreign-source income), and the call to eliminate excessive banking secrecy and push automatic tax information exchange treaties. Governments also must develop new mechanisms for international cooperation on criminal investigations of tax fraud and avoidance schemes.
4. Renegotiate—and refrain from launching disputes related to—trade and investment pacts that promote deregulation of financial services.
The United Nations Commission of Experts on the financial crisis chaired by Nobel laureate Joseph Stiglitz recently concluded that “Many bilateral and multilateral trade agreements contain commitments that restrict the ability of countries to respond to the current crisis with appropriate regulatory, structural, and macro-economic reforms and support packages.” For example, the World Trade Organization’s (WTO) Financial Services Agreement (FSA) forbid limits on financial service firms’ size, undermining remedies to the “too big to fail” problem. Such pacts can also forbid governments from re-establishing “firewalls” between commercial banking and risky investment ventures. New financial services regulations can be challenged in WTO trade tribunals, which prioritize commerce above all other concerns. Similar provisions exist in agreements ranging from the proposed U.S.-Panama trade agreement to bilateral investment treaties, where private investors—including subsidiaries of U.S. corporations—have standing to challenge government actions for cash compensation.
In the short term, the United States must refrain from trade and investment suits regarding governments’ responses to the financial crisis, especially against developing nations, and call on corporations and other nations to do likewise. (Deutsche Bank and Citigroup, for instance, are launching a case against Sri Lanka’s policies on oil derivatives. Argentina and the Czech Republic have also experienced successful investor-state cases on financial re-regulation.) In the longer term, existing and prospective pacts that contain deregulatory obligations and constraints on oversight must be renegotiated so that policymakers can implement the consensus call to address the crisis in the manner they see fit without the threat of trade suits.
5. Avoid regulatory arbitrage.
The elimination of capital controls due to International Monetary Fund (IMF) structural adjustment mandates in the 1980s and 1990s—combined with the WTO General Agreement on Trade in Services rules, which locks in their removal—has blocked a major tool used by governments to prevent regulatory arbitrage. When some governments increase oversight of risky, under-regulated products and activities, there is a serious risk that those products and activities will simply move to jurisdictions with weak oversight. To prevent this, governments should consider the reinstatement of capitol controls as nations such as China, India, and Chile have done to avoid financial contagion in past crises. The United States should exercise its votes at the IMF and other international financial institutions to ensure that countries have the flexibility to adopt robust financial regulatory rules, including capital controls.
In addition, the shadow financial markets must be subject to an international regulatory floor that includes, at minimum, comprehensive consumer and investor protection, public disclosure requirements, and safety and soundness regulation.
6. Implement transparency and other governance reforms of international bodies.
A growing international consensus rightly supports reform of the governance, accountability, and transparency of the WTO, the IMF, and other institutions and agreements that play major roles in the global financial system. In addition, international regulatory institutions with authority over financial services, such as the Financial Stability Board and the International Organization of Securities Commissions should be reviewed to ensure they are operating in an open, transparent and democratic fashion. International standard setting institutions with authority over financial services, such as the International Accounting Standards Board, should be reformed to ensure their independence from industry financing and direction.
 Adapted from Rob Weissman & James Donahue, Essential Information & Consumer Education Foundation, Sold Out: How Wall Street and Washington Betrayed America (2009) at 14-02.
 Adapted from Bob Kuttner, Demos, Financial Regulation After the Fall (2009) at 5.
 Sheila C. Bair, Chairman, FDIC, “Regulating and Resolving Institutions Considered “‘Too Big To Fail,’” before the Committee on Banking, Housing, and Urban Affairs, United States Senate, May 6, 2009.
 Daniel K. Tarullo, Banking on Basel: The Future of International Financial Regulation (Washington, DC: Peterson Institute, 2008), at 6.
Financial Accounting Standards Board, The IASC-U.S. Comparison Project: A Report on the Similarities and Differences Between IASC Standards and U.S. GAAP, 2d Ed., Oct. 1999, available at http://126.96.36.199 /intl/iascpg2d.shtml.
 Teri Yohn, Associate Professor, Indiana University, “International Accounting standards: Opportunities, Challenges and Global Convergence Issues,” before the Banking, Housing and Urban Affairs Committee, United States Senate, Oct. 24, 2007.
Shyam Sunder, Professor, Yale School of Management, Financial Times, Sept. 18, 2008.
Preliminary Draft of the Full Report of the Commission of Experts of the President of the UN General Assembly on Reforms of the International Monetary and Financial System, May 21, 2009, available at http://www.un.org/ga/president/63/interactive/financialcrisis/PreliminaryReport210509.pdf, at 87.
 A prudential measures exception can be raised when a financial service regulatory policy is challenged, but it contains a loophole that undermines its usefulness: It applies to policies that do not have the effect of limiting foreign firms’ access.
 Luke Eric Peterson, “Deutsche Bank files ICSID claim against Sri Lanka,” Investment Arbitration Reporter, Vol. 2, No. 6, Apr. 2, 2009; “Czech Republic to pay Dutch firm Saluka $181 Million,” Investment Arbitration Reporter, Vol. 1, No. 4, July 1, 2008; Luke Eric Peterson, “Legal Tango,” FDI Magazine, Aug. 1, 2005.