Congress: US needs regulatory overhaul

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WASHINGTON DC - At a US congressional hearing of the committee of oversight and government reform on October 23, speakers called for far-reaching regulatory reforms. These included demands for greater scrutiny of derivatives, increased capital charges on securitised products and the need for an all-seeing, all powerful super regulator.

Opening the hearing, committee chairman Henry Waxman said regulatory failure was the single factor linking the huge losses at American Insurance Group, the collapse of Lehman Brothers and the weaknesses of credit rating agencies.

“In each case, corporate excess and greed enriched company executives at enormous cost to shareholders and our economy. And in each case, these abuses could have been prevented if federal regulators had paid more attention and intervened with responsible regulations,” Waxman commented.

Waxman went on to claim the turmoil in financial markets, which began in the second half of 2007, had exposed as a fallacy the “market always knows best”, an idea that had been supported in Washington for too long.

He went on to criticise Alan Greenspan, who held the post of chairman of the Federal Reserve between August 1987 and January 2006, for rejecting pleas to address irresponsible lending practices in the subprime mortgage market.

In his own testimony, Greenspan said the US was “in the midst of a once in a century credit tsunami”. Although he claimed to have warned the financial sector in 2005 of the consequences of underpricing risk, Greenspan added that the crisis has turned out “to be much broader than anything I could have imagined”.

Zeroing on the subprime mortgage-backed securities (MBSs) market, Greenspan said a root cause of the crisis was that the data inputted into the models covered too short a timeframe. “Had the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today,” remarked the ex-Fed chairman.

The European Commission recently revised the Capital Requirements Directive so that bank originators of securitisation deals retain at least 5% of the transaction. Greenspan supports a similar initiative for US issuers. “In this financial environment I see no choice but to require that all securitisers retain a meaningful part of the securities they issue. This will offset in part market deficiencies stemming from the failures of counterparty supervisors.”

Nevertheless, Greenspan thought the flight-to-safety mentality already in evidence among US investors would see them shy away from riskier products including structured investment vehicles and alt-A mortgages.

Christopher Cox, chairman of the Securities and Exchange Commission, used the hearing to reiterate previous comments on the need for oversight of the credit derivatives market.

After discussing on the flaws in MBSs and rating agencies, Cox stated: “What amplified this crisis, and made it far more virulent and globally contagious, was the parallel market in credit derivatives. If the original cause was too-easy credit and bad lending, the fuel for what has become a global credit crisis was credit default swaps.”

Beyond a demand to bring the credit derivatives market under regulatory control, Cox said that improving transparency was vital. He said the SEC’s information technology office was working with the enforcement division to create a common database of trading information – including audit trails and clearing data – to identify “manipulative patterns” in the derivatives market.

While defending the SEC, Cox supported regulatory reforms such as making it statutory that regulators share surveillance information and position reporting and economic data. He also said the interconnectedness of global markets meant that the “new administration must open negotiations on a new global framework for regulations and standards”.

Meanwhile, John Snow, US Treasury secretary between 2003 and 2006, called for a comprehensive shift in focus towards leverage rather than capital. “We now know that looking solely at capital standards has proven to be inadequate. We need a new framework to stem the excessive leveraging and deleveraging that accentuates boom and bust cycles”, urged Snow.

Criticising the current fragmented regulatory regime, Snow said that the time has come to establish “one strong national regulator with the field of vision to spot excessive leverage, no matter what or where the institution is located. This change too would facilitate treating financial institutions engaged in like activities in a similar manner, and avoid regulatory arbitrage”.

Financial institutions, Cox added, need to return to fundamental risk management practices. “Those who make loans need to ask how they will be repaid and get reliable information to support loan decisions. When loans are packaged for the secondary market, originators should be required to hold on to a portion of the underlying loans”, he remarked.

Rob Davies
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