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US Financial Reform

Material Changes or More of

the Same?

Pre se n te d b y

D a vid Ta te , FR M
• Remedies for systemic risk
• Derivative activities, proprietary
trading, securitizations
• Initiative to control compensation
• Consumer Protection Agency
• Reform of Freddie Mac and Fannie
• Reforming Credit Rating Agencies
• State rights vs. federal – Preemption
issue 2
Impact of Reforms
Type of Impact
 Conclusion

• Will it prevent another • No – cannot change

economic/financial human nature,
meltdown? cannot manage all
• What impact will it complex cause and
have on financial effects
institutions viability • Less profitable, more
and profitability stable, slower
• Broader impacts: growth in the short
consumer run
protection, other • Minimal consumer
business protection /
opportunities business 3
Preventing the Next Crisis
“You can pass a law against excess, and
somewhere down the road some excess
will appear at some point from some
direction, and no one will know it at the
time, and everyone will know it in
Goldman Sachs CEO Lloyd Blankfein

US Political Process
• Both Senate and House have passed
financial reform legislation
• A joint committee is formed to reconcile
the differences
• Timing of the process is dependent on
the complexity of the issues and the
differences between the two versions
• Outcomes can be unpredictable
• Also a few regulatory initiatives have
been proposed by the bank regulators

Remedies for Preventing the Next
• Increased Monitoring
• Lender of Last Resort
• Limitation on scope of activities
• Increased transparency
• Adjusting compensation practices

Increased Monitoring: Oversight
• Creation of a systemic risk regulator
– Nine member board consisting of all
financial regulators with Sec. of
Treasury as Chairman
– Identify firms that pose systemic risk
• no free passes, hedge funds could be
• $50 billion is recommended size
– Collection and consolidation of
information on risk positions and
company interrelationships
Expanded Fed Powers
• Fed has power to force sale or
discontinuation of high risk activities
via 2/3 vote of Board of Governors
• Enforcement powers covering large
firms identified by Oversight council
• Directs Fed to develop prudential
standards for large firms covering the
following areas:
– Risk-based capital, leverage limits
– Liquidity requirements
– Risk management practices

Orderly Resolution Authority
• Create 3 judge panel with power to appoint
FDIC as receiver for troubled large firms
• Must make determination within 24 hours of
request by Secretary of Treasury - Decision
can be appealed to US Court of Appeals
• Request from Secretary of Treasury must be
supported by analysis form both the FDIC and
Board of Governors approved by 2/3 of its
– additional steps for broker/dealer operations
– insurance companies are referred to state courts
for resolution
• Study to be conducted to assess ability to
liquidate large firms under bankruptcy code
and to determine how to promote
international coordination during liquidation
of large firms 9
Key Features of Resolution

Potential for future Bailouts
– FDIC can draw on Treasury funds to conduct
– FDIC to develop procedures for use of available
• Potential for Confusion
– FDIC given power to adjust priority of unsecured
claims to minimize the loss
– FDIC given power to enforce or repudiate
contracts including derivative transactions
– Netting of exposure by counterparties
disallowed for 5 days following receivership
• Need for Retribution
– Management responsible for failure must be
– Management and BOD can be held personally 10
Lender of Last Resort
& other Systemic Risk Safeguards
• Tightens standards used by Fed for
granting loans to distressed firms
• Use of 13(3) emergency powers to
grant liquidity funds to firms (used to
support AIG)
– House bill eliminates emergency powers
– Senate bill requires development of
procedures and approval of Secretary
of Treasury
• Exempts banks from 10% concentration
limits in cases of acquisition of bank
in default
• Requirement to create “living wills” or 11
Potential Impact of Reforms
• Reforms create a cumbersome and
untested resolution process
• Unlikely to create a zen-like calm
among investors during next period
of financial turmoil
• Level of uncertainty could be even
greater during next financial crisis

Hedge Fund Reporting
• Must provide systemic risk data to SEC
– Data on assets and trading positions
– Leverage
– Counterparty risk exposure
• SEC can conduct inspections to ensure accuracy of
submitted information
• SEC can obtain information about the identity, investments,
and affairs of their clients
• Exempts “venture capital fund”, “private equity fund”, and
family offices – complete definitions to be developed by
• Requires following studies
– Determine the feasibility of hedge fund self
– Study of short-selling, esp. compliance with naked
short selling ban 13
Next Reining in
CDOs CDS Z-traunch Swaps
“You can catch more fish in murky

 Chinese proverb

new wrinkle , some innovative technique , yet they

Proprietary Trading Restrictions
Volcker Rule
• Senate Bill contains the following
– Requests a study to be performed within
one year
– Actual implementation would await
drafting of regulations
• Regulations are likely to include the
– Apply restrictions only to banks with
access to Fed Window
– Banks could still execute trades for 15
Limits on Derivative
• Standard derivative contracts moved to
• Non-standard contracts must be reported
and reviewed by systemic risk regulator
• Derivative and swap transactions must be
moved outside of the bank
– Adjustment in requirement likely during
– At minimum, change is likely to allow
activity in an affiliate under holding
• Provisions in this area take effect 180 days
from enactment – no opportunity to adjust16
Impact of Derivative
• Provides transparency on size of market
and unusually large positions
• Unanswered questions:
– Appropriate level of capitalization
– Systemic risk of large margin calls, i.e.,
AIG would still have failed based on
call for increased collateralization on
credit default swaps
– Does not eliminate the large loss
potential of asymmetric risk contracts
that accept extreme tail risk
– Limitation on access to Fed lending
powers could increase risk of contagion
and systemic risk 17
Securitization Activities
• Requirement for retention of risk was stripped out
of Senate bill in amendment process, could be
put back in during reconciliation, or could be
left up to the regulators
• FDIC proposed rule on retention of risk for
• 5% retention for 1st yr put backs
• Rating agency compensation must be partially
• Prudential rules for loans held on books will apply
to loans securitized
• Recent accounting rules create greater
transparency by requiring gross-up of exposure
for certain sercuritizations
Rules on Compensation
• Requires all companies to submit for
shareholder vote a resolution covering
any material changes In
• Mortgage brokers cannot be
compensated based on differences in
loan rates
• Regulatory initiative to create standards
designed to promote alignment of
compensation and risk management
– Stock options vs cash compensation 19
Consumer Protection
• Creates independent agency
dedicated to consumer protection
• Broad coverage: banks and credit
unions, all mortgage related
business, debt collectors, credit
• Some details still under debate
– Exemption of some small businesses?
– Independent rule-making authority?
– Source of funding?
 20
Credit Rating Agencies
• Regulated by new government office
within SEC
– Power to suspend and revoke rating
agency license by type of security
– Annual inspections conducted, which will
be made public
– Can prescribe methodology standards
• Enhance transparency and internal
– Requires separation of sales and ratings
functions 21
Other Requirements for
• Requires credit rating agency to
report any potential illegal activities
pursued by clients
• Meet standards for employee
• Studies to be conducted
– How to reduce reliance of ratings
within financial regulations
– Review alternate paradigms for
compensation of credit ratings 22
Government Sponsored
Entities (GSEs)
• Cost of supporting GSEs is political
Achilles heal for Democrats and
Obama administration
• Reform bill requires Treasury to
complete a report by Jan. 31, 2011
• Potential Options
– Smaller specialized government
agencies similar to FHA, VA
– Privatize core of operations or gradual
liquidation 23
Problems that Remain
• No clear standards for international
cooperation during times of crisis
• Most financial institutions and other large
corporations rely heavily on short-term
funding sources
• Constant innovation and complexity of
products prevents accounting industry
from developing rules to give accurate
presentation of financial status
• Short-term investor prospective eliminates
incentive for in-depth analysis required to
adequately evaluate large financial
• How do we estimate risk within individual 24
financial institutions
Potential Next Crisis
• Sovereign Debt
• Reliance on short-term funding
remains dilemma for both finance
and non-finance companies
• Difficult for China to avoid bubble
• Trade friction between slow growth
free market economies of US &
Europe versus government directed
economies of Asia esp. China.

Potential Opportunities
• If limits are imposed on GSE lending it will
provide greater opportunities for private
lending organizations
– Banks and Wall street firms could re-engage
in securitization market with lower risk
– Potential reemergence of private mortgage
insurance companies
• Enhanced opportunities for community and
regional banks due to tougher regulation
of large banks and fewer number of large
• Proprietary trading – opportunities will shift 26
to firms outside of banks – hedge funds,
Preemption of State Banking
• All federal banks charters enjoy some level of
preemption rights
– Preemption allows for more efficient operation
– Prevents state’s attorney generals from suing banks
• Defining level of preemption via court cases
– Watters vs. Wachovia – rule that operating
subsidiaries are covered by preemption
– Cuomo vs. clearinghouse – allows state attorney
generals to bring suit against national banks
• Last minute amendment to Senate Bill (Carper
– Attorney generals can sue banks, but only for
violations of regulations written by the Consumer
Financial Protection Bureau
– House members may fight to limit preemption rights
during reconciliation
– White house states publically that it wants to limit 27
preemption, but is allowing democrats to reinstate
Best Guess Result
Preemption will be preserved with
some carve out for state attorney
Language is likely to be sufficiently

ambiguous and will generate

additional legal challenges

Why did big banks and Wall
Street firm not see the dangers
of the bubble?
“We are so accustomed to disguise
ourselves to others that in the end
we become disguised to ourselves.”
 17th century author Francois de La