Financial reform bill is a good start

Last updated on July 2nd, 2019 at 10:59 am

Editor’s note: Milwaukee futurist and financial expert Bob Chernow reviewed the financial reform bill that was recently approved by the U.S. Senate. As a service to the readers of BizTimes Milwaukee, his thoughts about the real-world impact of the bill are shared in this analysis.

Overall, the U.S. Senate’s “Restoring American Financial Stability” reform bill is a start in the right direction.

My guess is that the House will try to get the Senate to allow banks to hedge their own financial risks and will try to exempt auto dealers who loan money to customers for car purchases.

This would be an improvement on the Senate bill, assuming that the banks do not take advantage of the “hedging loophole” to trade for their accounts. As history has taught, several banks are no longer with us because a trader took too much risk.

One area that is not addressed as it should be is the property and casualty industry, whose spokesman, Robert Rusbuldt stated their industry “played no role in creating the crisis and poses no systemic risk to the overall economy.” Evidently he does not consider AIG to be part of his industry. If you recall, AIG set up a subsidiary in Great Britain to insure mortgage backed bond risk, but did not bother to reserve for losses. AIG was the classic “too big to fail” firm that the government has supported until it can sell itself down and pay back some of its losses.

The Office of National Insurance will, in my opinion, be a fig leaf and will show little oversight over the insurance industry at the federal level, at least until a crisis has occurred.

Regulators need independence

The Senate bill sets up a Consumer Financial Protection Bureau. It will have an independent director approved by the Senate. Its budget will be paid by the Federal Reserve Board. Depending on the term of the director, this will help to make this Bureau independent.

I do not believe that industry-dominated regulatory agencies do a good job of regulating their own industries. FINRA, the regulator of the brokerage industry, is influenced by the big players, as has, to a lesser extent, the Federal Reserve Bank (which is owned by the banks). Both organizations took a hands-off approach to enforcing basic regulations over the past several years (Eliot Spitzer was the only voice filling the void).

So, the question with this new bill is whether the regulators will be independent enough from politicians and the industries they regulate to be successful.

One step in this direction is that there is an effort for the Federal Reserve that “eliminates conflicts of interest in Reserve Bank governance” and that “the self-funded SEC will no longer be subject to the annual appropriations process.” Hopefully, this will allow the SEC investigators to do their jobs without fear that they will be fired, as has happened in the recent past.

The bill allows the Bureau to examine and enforce banks and credit unions with assets over $10 billion and all mortgage-related businesses and large non-bank financial companies. This is a good step, because too often these areas have fallen within the shadow of regulation.

The weakest part of the bill

In addressing the “next big problem,” the bill sets up a “Financial Stability Oversight Council.” It is, in my opinion, the weakest part of the bill because the Council will react to what has occurred. This Council can regulate non-bank financial companies, such as AIG, that pose a risk to the economy and it can break-up large complex companies, but a two-thirds vote is needed by all members, so it is apt to take action in a very conservative manner.

The Council will argue that the Department of Treasury will set-up an “Office of Financial Research” with a sophisticated staff, but my guess is that these will be very bright people with modest practical experience. You need a few “boys from Brooklyn” to see problems when they can be solved beforehand and not try to close the barn door after the livestock has fled! This “close-the-barn door” approach has been the history of U.S. regulation.

I recently attended the Federal Reserve Bank of Chicago’s annual three-day program on financial reform. No one, except myself, spoke about enforcement. The kind of folk who attend this excellent meeting will be the same kind who will populate this new “office.” They are smart, but their real world experience is often lacking.

The SEC will encourage whistle-blowers with rewards of 30 percent of funds recovered. This is good, but does not recognize why whistle-blowers speak out. Their motivation is not financial. They merely want to be listened to and their information acted on (and not to be harassed). Excuse my cynicism, but I do not believe that government will act on whistle-blower information.

Indeed, it is hard enough to get anyone in Washington to listen. I wrote and called Senators Russ Feingold and Herb Kohl, Congressman Jim Sensenbrenner and Congresswoman Gwen Moore, as well as other congressmen and Federal Reserve officials in 2006, regarding the upcoming sub-prime crisis. Only Congresswoman Moore followed through.

Watch the hedge funds

Hedge funds that manage over $100 million must register with the SEC as investment advisors. This is a good idea, if for no other reason than it protects investors against fraud. There were many fraudulent Ponzi schemes, but they were overshadowed by Bernie Madoff. But it is my opinion that all hedge funds should be registered with the SEC.

The federal government will regulate investment advisors with $100 million or more assets. Will the states regulate these advisors who fall below the fed authority? Clear coordination is needed so this gap is filled.

There is a portion of the bill that deals with executive compensation and corporate governance. It lets shareholders vote on executive pay and uses independent directors to hire compensation consultants. Evidently no one who wrote the bill actually has sat on a board, because “compensation” will be done as before, as directors are picked by those who run the companies. Shareholders normally support management, compensation and all. The one part of this section that makes sense is to require public companies to take back pay if “compensation” was based on “lies.”

‘Skin in the game’

Under the bill’s regulation of securitization, companies that sell mortgage-backed bonds would need to retain a 5-percent ownership. In theory, this is good. Private mortgage insurance used the “skin in the game” approach to keep banks, S&Ls and mutual savings banks honest in their underwriting because the insurance company could either pay 20 percent of the loan or could take back the property. The question here is will the “skin in the game” have the required result? A study presented at the Federal Reserve Bank of Chicago meeting showed that there were fewer defaults in packages where the underwriter held a portion of the deal.

The theory behind “skin in the game” is that loans will be made honestly if companies that make loans keep part of them.

The “reforms” on credit rating agencies is weak. We need credit agencies to help evaluate bonds; it is part of the factor of liquidity in the secondary and syndicated markets. I hope that what the bill sets up is constructive, but I worry that there will only be a few more pages of disclaimer. I have no quick fix for this problem.

The bill does not address, as far as I could determine, Fannie Mae/Freddie Mac, which are needed to provide liquidity in the mortgage market. These important agencies need to be regulated.

The bill addresses “too big to fail bailouts” by setting up a $50 billion fund to handle liquidations so that taxpayers will not be on the hook; it extends regulation over non-bank financial companies and it requires the creation of a funeral plan with stiff penalties for the failure to submit a plan, such as increased capital requirements or divestments.

This is new territory for the government with part of this plan linked to the anger of our fellow citizens. Will the $50 billion fund give permission to some banks to be irresponsible? There is a strong chance that it will.

Volcker Rule

One wise part of this section, in my opinion, is the Volcker Rule which limits proprietary trading and sponsored hedge funds. Banks in our system get the right to draw from the Federal Reserve and can leverage significantly in making loans. They should not be gambling with the “bank’s” money.

Lastly, the bill will help banks by replacing contradictory and confusing regulations. The FDIC will regulate state banks and thrifts with assets below $50 billion. The OCC will do the same for national banks and thrifts under $50 billion. The Federal Reserve will regulate all banks and thrifts with assets over $50 billion. It will be interesting to see if the hodgepodge of regulations will be streamlined and if the FDIC, OCC & Federal Reserve won’t get into turf battles.

In summary, the bill is a good start. Let us pray it works.

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