The Hindu Business Line : US financial reforms: Reining in risk

The Obama administration has announced sweeping changes in financial regulation for the US economy in an effort to avert a crisis similar to the current one from taking place in the future.

The response to the significant overhaul has been mixed, with some sections of the market fearing that it might lead to over-regulation and curb innovation, while others believe the plan fell short of truly bold changes.

But if the Congress approves the recommendations, there are some changes the US financial system will broadly witness.

There is no dearth of committees and regulators that already oversee the financial industry. Too many cooks spoil the broth may be an adage that held true here.

Investment banks that competed with commercial banks were not regulated by bank holding company rules, and were able to take on more leverage.

Insurance companies owned insured depositories, but again were out of the purview of strict banking regulations because they did not fit the definition of bank holding companies.

Companies were able to exploit their organisational structure to choose regulators that were more lenient. The gaps in the rules between regulators allowed some institutions to take reckless bets.

The new regulations attempt to bridge these gaps.

Similar financial institutions, irrespective of their legal definition, would be subject to the same regulatory framework. The proposal grants new authority to the Federal Reserve to supervise all large financial institutions capable of imposing huge risks to the financial system. This includes insurance companies and other non-banking financial companies such as GE Capital or auto finance companies.

These institutions will be required to hold higher capital and be subject to more stringent regulations than other companies, so that the event of their failure would not impose significant costs on society.

Advisers to private equity and hedge funds have also been required to register with the Securities and Exchange Commission, bringing more institutions under supervision net.

Greater risk management

Because regulators do not necessarily consider risks to the economy as a whole and limit themselves to the subjects under their supervision, the proposal seeks to set up a Financial Services Oversight Council.

This council would monitor information from financial institutions and markets and try and head-off emerging risks. Sceptics do not see much merit in the proposal, as they believe it is short of crystal ball gazing. New risks will emerge from unfamiliar territory. But the Government believes that an early warning system must be in place.

The proposal also wishes to grant more tools to the Government to deal with future financial crises. It is, for instance, setting up a new authority that will wind down large financial institutions (other than banks, which are resolved by the Federal Deposit Insurance Corporation).

Lack of authority to effectively address the failures of non-bank holding companies forced Lehman Brothers into bankruptcy and necessitated an expensive bailout in the case of AIG.

Curbing risk appetites

The biggest take-away from the proposals is that the Government seeks to rein in the kind of reckless risk-taking that drove the economy to the brink. One positive is that it does not seek to ban any products, acknowledging that risks will arise from new ones.

But it has announced a number of measures targeting the asset-backed securities and over-the-counter derivatives markets, where lack of adequate regulation triggered the crisis.

New regulations take aim at the securitisation market, requiring that loan issuers and originators retain a financial interest, at least 5 per cent, in securitised loans.

By retaining an economic interest in these assets, regulators hope loan issuers will be more stringent in their lending practices. The regulations will also demand greater transparency in over-the-counter derivatives transactions.

Executive compensation, considered the main culprit behind excessive risk taking, will also be reined in. Shareholders will have a greater say in determining executive salaries.

A compensation Czar has already been appointed to ensure that pay is not linked to performance in a way that encourages executives to take risks.

While these measures have been welcomed, some worry that discouraging risk-taking might reduce the potential to offer innovative financial products that could benefit consumers.

Pro-consumer

An offbeat proposal is the setting up of a separate Consumer Financial Protection Agency that will primarily protect consumers from unfair trade practices such as hidden fees. These take away the powers of consumer oversight from the Federal Reserve. The CFPA would be given considerable authority to write rules for consumer protection and fill gaps in regulations regarding consumer protection.

Among other things, it will require financial intermediaries to offer plain-vanilla products alongside whatever else they offer and will ensure that communication to consumers is balanced and clearly highlights risk. With a proposal that runs 89 pages, the administration is clearly determined at tackling every cause for the current crisis to ensure that history does not repeat itself.

While some other crisis is bound to surface in the future, the hope is that regulators are better equipped to mitigate its impact the next time around.

SHANTHI VENKATARAMAN

(The author, a former BL Research Analyst, is based in New York.)

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