Paulson regulatory shakeup looks unlikely

US Treasury secretary Hank Paulson’s long-awaited proposals to overhaul the US financial regulatory system have received a tepid response from the market, which is enthusiastic about the intent of the proposals but sceptical that they will ever be enforced.

The March 31 Blueprint for Stronger Regulatory Structure set out an ambitious plan to reduce the myriad of US regulatory agencies into just three agencies with greater jurisdiction and powers.

Market stability regulator: The Federal Reserve would be given unprecedented new powers, beyond its current commercial bank supervision remit, to gather information on and investigate the activities of investment banks, insurance firms and hedge funds “to evaluate the capital, liquidity and margin practices across the financial system and deal with systemic risk”. The Fed will also turn its attention to the derivatives market, a sector that the Treasury feels “lacks a cohesive design for clearing, settlement and novation protocols".

Prudential financial regulator: An organisation along the lines of the Office of Comptroller of the Currency (OCC) would oversee the consolidation of numerous federal bank charters into one charter and all federal bank regulators into a single entity.

Conduct of business regulator: The Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) would be merged into one organisation charged with standardising conduct of business requirements, such as disclosures, business practices, charters and licences for financial institutions, and enforcing those rules.

These three entities would replace the current patchwork of federal regulators that includes the Fed, SEC, OCC, CFTC, Federal Deposits Insurance Corporation and Office of Thrift Supervision, and will seek to harmonise practices among state-regulated financial markets, such as insurance.

The proposals have received the obligatory warm reception from US investment banks, but some dealers have raised concerns that the new regime could bring securities firms under stricter supervision and restriction by regulators. If the Fed’s March 16 decision to allow primary dealers to borrow funds directly from its discount window for the next six months, using investment grade mortgage-backed securities as collateral, are made permanent, investment banks could be forced to curb the amount of leverage they secure against their balance sheet.

“If the Fed was guaranteeing investment banks in the same way it provides commercial banks with depository insurance, the government would certainly want to have some say in the leverage these institutions are able to take onto their balance sheet,” said Jeff Rendel, president of California-based financial consultancy Rising Above Enterprises, and a former regulator with the OCC.

Rendel considers the Blueprint to be typical of the regulatory approach of taking a hachet to a problem that requires scalpel precision. “These mass shakeups of the financial system happen every decade or so. The last one was the Gramm Leech Bliley Act in 1999 and before that there was the Financial Institutions Reform Recovery and Enforcement Act, which dealt with the fallout from the savings and loan crisis. Every 10 years the regulators feel they have to do something like this,” Rendel explained.

The fact that the Blueprint makes scarce reference to mortgages has also raised questions over whether there is a need for such restructuring, and whether the existing regulatory framework, applied appropriately, could have worked to curb feckless mortgage origination practices and the selling of securities backed by poor-quality mortgage collateral.

“The problems have not occurred due to the improper application of the existing regulatory structure. Rather the configuration and arrangement of the immediate organisation has become stagnant, and has been ineffective to address the changes that have crept into the lending practices for today’s consumers. Government-sponsored enterprises did not successfully identify deficiencies in the system and did not keep pace and adapt to the changes of lending practices for proper oversight and control,” said Cameron Jones, chief compliance officer at North Carolina-based risk analytics software provider SAS.

Just as there is nothing inherently flawed in the current regulatory structure, observers suggest there might be more than a little politicking at play and that ultimately these proposals will never be implemented.

"I believe this idea will be quietly dropped. It’s a good idea but this is an election season and politics is definitely playing a part in the thinking behind this plan. There is no way that we could see an overhaul of this size being implemented until well into the next administration. We could see some quick fixes on lower interest rates for various states and new bond issuances to refinance mortgages, but any moves to combine agencies and blend various regulators I personally believe will be quietly dropped,” said Rendel.

Even if the Treasury is committed to implementing its Blueprint, the fact remains that, with just nine months left until the Bush Administration is escorted off the White House grounds, Paulson’s successor at the Treasury - Republican or Democrat - would have the authority to scrap the plan altogether. That would leave the highly contentious and divisive Sarbanes-Oxley Act as the ultimate regulatory legacy of President Bush’s eight years in office.

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