Monday, March 31, 2008

John Mauldin email.

How To Fix It
By Michael E. Lewitt

"This disposition to admire, and almost to worship, the rich and the powerful, and to despise, or, at least, to neglect, persons of poor and mean condition, though necessary both to establish and to maintain the distinction of ranks and the order of society, is, at the same time, the great and most universal cause of the corruption of our moral sentiments."

Adam Smith, The Theory of Moral Sentiments (1759)
Twelve Basis Points

One way of measuring how perilously close the U.S. financial system came to melting down in mid-March 2008 is to look at how low the rate on one-month Treasury bills fell at the depths of the crisis. That number is 12 basis points. 0.12%. The three-month Treasury bill rate, which our friend Jim Bianco of the highly respected Bianco Research points out is the "risk-free" rate for many models such as the capital asset pricing model, the arbitrage risk pricing model and the Black-Scholes pricing model, fell to a 50-year low of 56 basis points on Tuesday, March 25. 0.56%. As Mr. Bianco pointed out, these bills were yielding less than Japanese 3-month financial bills for the first time since July 14, 1993.

And it's not as though the Japanese economy is flourishing. In fact, quite the opposite is occurring as Japan continues to struggle with the aftermath of its lost decade (which is stretching into lost decades). Hilary Clinton, who looks increasingly unlikely to lead her party in the upcoming Presidential election, is definitely onto something when she warns that "[w ]e may be drifting into a Japanese-like situation. I don't think we can work our way out of the problems we're in for the broad-based economy through monetary policy alone. Japan tried that and tried and tried that."1 The structural problems ailing the U.S. economy are severe. They derive from bad economic policies and bad political values.

American Capitalism In Need of Repair2

We all know Adam Smith as the author of the bible of capitalism, The Wealth of Nations (1776). But he first wrote what is arguably a far more important book, The Theory of Moral Sentiments, from which the quote that heads this month's newsletter is drawn. America is rushing headlong into the 21st century without a proper understanding of what economic policies and financial tools are going to be required to prosper in a changing world. For more than two decades, the United States economy has favored financial speculation over production. Over the past century, our legal system had developed an increasingly outmoded concept of fiduciary duty that privileges short-term, single-firm interests over the kind of long-term, society-wide interests that could lead to prolonged prosperity. The current meltdown in the financial markets is a symptom of a serious disease that is eating away at the stability of our most important institutions. What we are witnessing might well be the end of American financial hegemony, which is the result of a burgeoning global economy. The current crisis in financial markets gives us an opportunity to evaluate how we can better prepare ourselves to deal with a borderless world.

In spite of claims to the contrary, the American economy has become increasingly unstable in recent decades. This phenomenon picked up momentum in recent years as financial markets focused on trading derivative financial instruments rather than cash stocks and bonds. Paradoxically, the very financial instruments designed to manage risk increase mark volatility. As the distance separating lenders and borrowers as well managers and stockholders increased, debacles such as the Enron and WorldCom frauds earlier this decade and, more recently, the subprime mortgage and structured credit meltdown of today became more common. By effectively reducing all financial instruments and measures of financial value to "one's and zero's" - by digitalizing value - Wall Street removed crucial checks and balances on financial behavior, which ultimately remains a human activity. The growing use of quantitative trading models led to a market dominated by traders directing money into companies about which they know little or nothing. This leveling of all economic values to indistinguishable signs did untold damage to economic actors' ability to distinguish valuable assets from worthless ones.

In addition, unstoppable economic and historical trends such as globalization caused a shift of jobs and factories to geographic locations with lower labor and materials costs, resulting in a transformation of the U.S. economy from one that manufactures goods to one that traffics in intangible items. The result has been a shift from investing in activities that add to the productive capacity of the country to transactions and activities that are merely speculative in nature, i.e., that merely spawn more money but not more physical or capital assets. This shift from a tangible to an intangible economic base was accompanied by a change in the way in which businesses are financed. At the same time as the business base became increasingly intangible, so did the financial base. Equity was replaced by debt, and cash securities were replaced by derivatives. Much of the new financial architecture is now constructed outside the purview of the Federal Reserve and other regulators, allowing economic actors to avoid margin requirements and other limits on leverage that can prevent systemic threats. The new foundations of corporate finance can vaporize in the blink of a trader's eye. These trends have enormous policy consequences for the United States and our future standard of living.

The fiduciary law that governs our business culture reaches back to the 15th century and requires those who are entrusted with managing our largest corporations or pools of money to act in the best interests of their shareholders or clients. But the evolution of fiduciary law has developed into a mode of thinking that privileges short-term, single-company results over long- term, society-wide results. Consequently, fiduciaries are driven by a logic that dictates a focus on the short-term, which can be more accurately predicted than the long-term. But there is something deeper at work in this mindset. Fiduciary thought privileges form over substance, procedure over justice. Decisions that serve a single corporation's shareholders may cause significant harm to a wider array of interests. The entire concept of fiduciary duty must be rethought if capitalism is going to flourish in a borderless, digitalized world. Instead of a narrow focus on the interests of a single firm's shareholders, the fiduciaries of our large business enterprises are going to have to widen their arc of concern to a wider group of constituencies. Without such a broadening of focus, narrow interests will continue to place the entire system in jeopardy because of the networked nature of today's financial markets.

Some Specific Recommendations for Financial Reform

Nano-scopic interest rates are a sign of just how corrupted our financial system has grown from the twin diseases of leverage and greed. The collapse of Bear Stearns was an all-too predictable byproduct of a system that refuses to look itself in the mirror. The bailout of Bear was an obnoxious necessity in view of the fact that the firm was too interconnected as a Wall Street counterparty and prime broker to be permitted to fail. Its collapse would have placed many hedge funds and other financial firms at risk.3 So instead of being able to allow the firm to enter bankruptcy as a just dessert for its failure to properly manage the risks inherent in its business, the Federal Reserve and Treasury Department had to place the interests of the financial system first. The time to ask about moral hazard is not when the system is about the implode - the appropriate time for such questions is much earlier, when the seeds of destruction that lead to the necessity to bail out players that act in ways that threaten long-term systemic stability are being sown. Such questioning, and the requisite action to avoid future problems, requires degrees of forethought and forthrightness for which the power players on Wall Street and in Washington have little tolerance. Even when we skirt complete systemic collapse - and make no mistake about it, we have come as close to such an event as anyone should dare imagine - those with a stake in the game continuing are working behind the scenes to protect their interests.

The Bush Administration, under the intellectual leadership of Treasury Secretary Henry Paulson, has proposed a broad reorganization of financial industry regulation. Unfortunately, this plan merely addresses form over substance and does little or nothing to address the underlying problems that are eating away at the system like a cancer. If reform ultimately follows the path proposed by Mr. Paulson and goes no farther to outlaw the reckless practices that place the system at risk in order to line the pockets of a privileged few, we will have sadly learned nothing from the current crisis. The system is infected by deep, inbred flaws that are rendering it increasingly unstable. Free-market capitalism as practiced on Wall Street and in The City has run amok. If the current crisis, and the recurring crises of the last twenty years, tell us anything, it is that market solutions are insufficient to protect the system from the greed and fear that drive markets. If the deep structural cracks in the system are not addressed and corrected, the markets may not survive the next near-death experience.

This is not a time to mince words. As the poet William Blake wrote, "Opposition is true friendship." At the risk of offending many of our readers, here are HCM's thoughts on how to reform the financial system.

Financial Industry Regulation: There is too little, not too much, financial industry regulation. The problem with our current regulatory regime is that too many of our current regulations serve little or no purpose (for example, the pages of meaningless disclosure in Wall Street research reports that nobody reads and are often longer than the research reports themselves) or are enforced in a capricious and arbitrary manner by unqualified regulators and overzealous prosecutors. This breeds disrespect for the law and resentment among the regulated. As a result, we have a system of laws, not values, a system that privileges form over substance, process over justice. We are never going to have a sound regulatory system until we raise the compensation levels for those who are charged with insuring that millionaires are following the rules.

HCM often hears the argument that too much regulation will force business offshore and render the U.S. financial industry less competitive. Our response to that argument is that institutions and fiduciaries in the end will gravitate to the system with the strongest and wisest regulatory protections. Moreover, we should be pushing the most reckless practices out of our markets and into other markets. We should be creating global competition over best regulatory practices, not worst ones.

Wall Street Compensation: The financial incentive system that governs Wall Street - and by "Wall Street," we mean the investment and commercial banks, private equity firms and hedge funds - requires dramatic rethinking. As compensation is meted out today on Wall Street, too much is paid to too few for doing too little of value for society. Too much capital is allowed to exit investment banks in the form of annual cash compensation. Executive compensation should be calculated based on multiple years of performance and subject to high water marks and claw backs in the event one year's profits from a transaction or a specific activity are lost in later years when that activity turns out to have been fraudulent or flawed. The subprime mortgage business is a case in point. Why should bankers be permitted to retain bonuses earned with respect to the closing of subprime mortgage CDOs that subsequently led to losses for their firms and investors? Compensation should be based on a longer-term view of value-added. Furthermore, regulators should permit firms to maintain reserve accounts and make other arrangements to facilitate a more nuanced compensation structure with adequate disclosure to keep investors fully informed.

Private equity managers and hedge fund managers should not be compensated based on returns attributable to inflation or the market. Their performance fees should be subject to a hurdle rate that is based on annual inflation rates and the applicable asset class performance (equity market performance in the case of private equity firms, for instance) to insure that investors are really paying fees for performance, not for fortuity.

Private Equity: The private equity business has resulted in the overleveraging of American business. One result is that many businesses are short-changing capital expenditures and research and development in order to service debt. Despite the statistics promulgated by self-serving, private equity-financed industry groups, it is irrefutable that companies would have more money to contribute to the productive stock of the economy if they were devoting less money to servicing their enormous debts. We will look back at the private equity boom as a phenomenon that damaged the American economy and impaired America's competitive position in the world.

The private equity boom is the quintessential example of what the economist Hyman Minsky termed "speculative finance" and, in its most extreme form, "Ponzi finance."4 Private equity deals add little or nothing to the productive capacity or capital base of the economy. Instead, they merely create debts that have to be serviced and divert cash to the activity of servicing debt rather than creating jobs or funding new projects or research. In 50 years, it is going to be clear that the U.S. economy has paid a terrible price for this.

Private equity managers' (and hedge fund managers') "carried interests" should be taxed at ordinary tax rates, not at the capital gains rate. Such earnings are nothing other than compensation, not earnings on risk capital.5 The arguments that private equity firms have tried to promote on Capitol Hill that such a taxation regime would reduce risk-taking are completely unsupportable from a factual standpoint. Henry Kravis and Stephen Schwarzman are not going to stop doing deals because they have to pay taxes at the same rate as their chauffeurs. These arguments are also the most cynical kind of politicking that insults the intelligence of every American. If politicians want to be held in even lower regard than they already are, supporting these arguments is a good way to go.

Finally, private equity firms should not be permitted to go public. The discipline of the markets - i.e. 50 percent or more declines in the price of private equity firms' stocks such as The Blackstone Group (BX) and Fortress Investment Group (FIG) - is inadequate to police the abuses of such transactions. These firms are hopelessly and terminally conflicted between their fiduciary obligations to their limited partners and their fiduciary obligations to their shareholders. The fact that investors are willing to ignore the mind-boggling hypocrisy of IPOs of businesses that are built on the premise that public ownership is economically inefficient is a tribute to the insatiable greed that has consumed investors. That greed has not only corrupted investors' moral sentiments, as Adam Smith wrote more than two centuries ago, it has crippled their common sense.

Financial Institution Leverage: Allowing investment banks to be leveraged to the tune of 30 to 1 is the equivalent of playing Russian roulette with 5 of the 6 chambers of the gun loaded. If one adds the off-balance sheet liabilities to this leverage, you might as well fill the 6th chamber with a bullet and pull the trigger. If this continues, the odds of a systemic crisis more severe than the one we are experiencing are near 100%. An absolute leverage limit should be imposed on investment banks and other financial institutions.6 Some will argue that limiting financial institution leverage will render these businesses less profitable and less competitive with non-U.S. companies. HCM's response is - "so what?" Perhaps less profitable investment banks will result in more of America's talented students becoming scientists, engineers, doctors and teachers instead of investment bankers and mortgage traders. What would be so terrible about that?

Off balance sheet entities should be outlawed immediately, plain and simple. If first Enron and now the SIVs haven't taught us the necessary lessons about hidden liabilities, the system probably doesn't deserve to survive. Speaking as someone with extensive knowledge of these off-balance sheet entities, it would not be difficult to render them extinct relatively easily. It would be doing the world a favor.

Tying this issue to the compensation question in the financial industry, if investment banks want to leverage themselves 30 to 1, their executives should be required to retain 97 percent of their compensation in their firms in the form of equity capital. The way it stands now, the ratio between capital retained and cash out is much lower (perhaps 1:1) and effectively creates a "heads-I-win, tails-you-lose" culture. For institutions that play a central role as financial counterparties and lenders, this is an unacceptable risk-sharing arrangement for society to bear. These institutions need to understand that they have responsibilities to the system, not just to their own shareholders and employees. Sure, Jimmy Cayne sold stock once worth $1.2 billion for only $61 million, but he also took out hundreds of millions of dollars in cash compensation over the years. Nobody can argue that his incentives were anything but grossly asymmetric, which may explain his ability to keep his job while demonstrating a much greater understanding of the strategies of the game of bridge than of the balance sheet risks his firm was undertaking.

Hedge Fund Leverage: Allowing unregulated entities such as hedge funds to be leveraged 10 to 1 or 15 to 1 would be laughable if it wasn't so dangerous. Prime brokers continue to be suckers for big names and big clients (and especially for big name clients). As a result, they often extend credit to parties who are not qualified to employ it prudently. HCM has expressed its view on more than one occasion that fixed income strategies that require excessive amounts of leverage do not make sense and have never made sense. We would refer anybody who disagrees with us to the recent collapses of Sowood Capital Management, LP, Peloton Partners LLP and Carlyle Capital Corp. Each of these firms reportedly employed high amounts of leverage (reportedly more than 15x) in their strategies. An absolute leverage limitation should be placed on hedge funds immediately. Since the prime brokers don't seem to want to impose such a limitation, the Federal Reserve should do so with its new powers. If investors can't generate decent returns without employing grotesque amounts of leverage, they should find another profession.

We recently read7 that John Meriwether of Long Term Capital Management infamy is at risk of blowing up a hedge fund that was leveraged 14.9 to 1 as of the end of February (and is reportedly down 28 percent year-to-date). The fund in question, Mr. Meriwether's Relative Value Opportunity Fund, reportedly has earned about 7 percent per annum since inception in 1999 through February 2008 (according to The Wall Street Journal) despite the use of generous amounts of leverage. According to the Journal article, Mr. Meriwether, like many hedge funds, charges a 2 percent management fee and 20 percent performance fee for managing his fund. We really don't mean to pick on Mr. Meriwether. Everybody is entitled to a second chance. But one would hope that an individual whose firm almost cratered the entire financial system in 1998 would have learned from his mistakes. Any way you slice it, 15x leverage is imprudent. It may look prudent compared to the 100x leverage employed at Long Term Capital Management a decade ago, but that is like saying 2 degrees below zero isn't cold because it isn't 30 degrees below zero.

Of course, the real question is why hedge fund investors are still willing to risk their money in such highly leveraged strategies. HCM has been asking that question for years but has yet to hear a satisfactory explanation. But since the market won't impose the type of discipline that is necessary to protect the system from boom and bust cycles, it is time for the regulators to step in.

Quantitative Strategies: Quantitative investing has not only introduced an unhealthy amount of volatility into the markets, but has contributed to a larger trend in the financial markets that divorces the investment process from the concept of fundamental value. HCM would defy the quants to explain in any degree of detail what the companies in their portfolios do. This is another type of investing activity, like private equity, that does little or nothing to provide capital to increase the productive capacity or physical stock of the economy. In fact, quantitative investment strategies are the quintessential "hot money." Enslaved by their computer models, they trade in and out of positions at the blink of an eye. When things go wrong, they blame everybody but themselves. Being a quant means never having to say you're sorry.

At some point, society has to figure out that the way an investor earns his money is even more important than the amount of money he makes. This is why human beings were vested with moral sentiments, so they could distinguish the quality of human conduct from the quantity of its results. Until that happens, we will continue to extol the types of investment activity that contribute little to our world. HCM would respectfully propose that a new school of "ethical investing" be adopted that takes into account how particular kinds of investments contribute to the economy. On this basis, quantitative strategies would be eliminated from consideration.

Short Selling: Short selling is an absolutely legitimate way to invest or hedge a portfolio. The SEC made a major error when it repealed the downtick rule last year. The repeal of this rule increased downside volatility exponentially and contributed to the ability of quantitative and other computer-driven selling to push the market lower based on technical rather than fundamental investment considerations. The SEC should reinstitute the downtick rule immediately.
Financial Triage

The magnitude of the unprecedented steps that the Federal Reserve and U.S. Treasury have had to take to bail out the U.S. financial system speaks to the depth of the problems we are facing. We may have left some steps out, but by our account the following is a list of the extraordinary actions that the U.S. central bank has been required to take to address the current crisis.

Since last summer, the Fed has cut interest rates by 300 basis points. The result? Mortgage rates have barely budged, but they are finally starting to move lower. Unfortunately, this comes too late for many homeowners who are losing their homes.

On December 12, 2007, the Federal Reserve created the Term Auction Facility (TAF) whereby the Fed will auction term funds to depository institutions against a wide variety of collateral that can be used to secure loans at the discount window. On March 7, 2008, the Federal Reserve increased the size of the TAF to $100 billion and initiated a series of term repurchase transactions that were expected to cumulate to $100 billion. As with the TAF auction sizes, the Fed said it would increase the size of these term repo operations if necessary. No doubt these facilities will need to be increased.

On March 11, 2008, the Federal Reserve created a $200 billion Term Securities Lending Facility (TSLF) whereby primary dealers could borrow Treasury securities for a period of up to 28 days using as collateral federal agency debt, federal agency residential mortgage backed securities (MBS) and non-agency AAA/Aaa-rated private-label residential MBS.

On March 17, 2008, the Federal Reserve opened up the discount window to the investment banks, which are not subject to the same regulatory limitations as the commercial banks that have traditionally had access to the window.

The Federal Reserve made a $29 billion line of credit available to JP Morgan Chase in connection with its takeover of Bear Stearns.

The Office of Federal Housing Enterprise Oversight (OFHEO) announced on March 19 that it would reduce excess capital requirements for Fannie Mae and Freddie Mac by one-third, from 30 percent to 20 percent. This is calculated to permit these two entities to add another $200 billion of mortgages to their existing $1.4 trillion portfolios (on an equity base of less than $70 billion). The two agencies shortly thereafter announced that they were authorized to raise an additional $5-10 billion of equity capital each, which would still leave them grossly leveraged by HCM's count.

The Federal Housing Finance Board announced that it would increase the limit on Federal Home Loan Banks' MBS (mortgage backed securities) investment authority from 300 percent of capital to 600 percent of capital for two years. This is estimated to enable these institutions to purchase another $200 billion of this paper.
While these moves were probably necessary to save the system from complete collapse, it is abundantly clear that these drastic steps are going to have enormous negative long-term effects on the U.S. economy. Among those effects will be higher future inflation and an extension of the high levels of leverage in the system that pushed the economy to the precipice this time. Does anybody really think it's a good idea to have Federal Home Loan Banks buy more MBS paper? Or for Fannie and Freddie to leverage their balance sheets further? All of these actions are going to have to be unwound at some point, which means that the day of reckoning is simply being delayed.8 It is clear that the authorities are engaged in a desperate attempt at economic triage that bodes poorly for the future economic health and stability of the United States. Looked at in this context, it is difficult to argue against those who believe in long-term U.S. dollar weakness. If you want to look at the end of American economic hegemony, just look at the list of desperate actions taken by U.S. financial authorities above. It is a sad commentary on how the greed and short-sighted actions and policies of U.S. politicians and businessmen have inflicted permanent damage on our economy.

There is a way out, but it will not be easy. The way out is to accompany the drastic steps taken by the Federal Reserve and Treasury with a comprehensive regulatory revolution that addresses the flaws embedded in the system. HCM does not use the word "revolution" loosely, but nothing less than a drastic rethinking of our current system accompanies by action to change it is going to be required if we are to strengthen the global economic system for the challenges to come.

Michael E. Lewitt

Ten Fundamental Issues in Reforming Financial Regulation and Supervision in a World of Financial Innovation and Globalization

Nouriel Roubini | Mar 31, 2008
Today U.S. Treasury Secretary Hank Paulson presented his proposals for a reform of the system of supervision and regulation of financial markets following the most severe – still ongoing – financial crisis in the U.S. since the Great Depression. And soon the Draghi Commission within the Financial Stability Forum will report its conclusions and proposals for reform of the financial system to the G7 Finance Ministers.

To understand whether the U.S. Treasury proposals make sense one should first analyze what are the problems that an increasingly complex and globalized financial system face and what are the shortcomings of the current system of financial regulation and supervision, in the U.S. and around the world. Only a detailed consideration of such problems and shortcomings can lead to the recognition of the appropriate reforms of the system.So, let us consider in more detail such problems and shortcomings of the financial system and of its regime of regulation and supervision.

They can be summarized in ten points or issues…

First, the system of compensation of bankers and operators in the financial system is flawed as a source of moral hazard in the form of gambling for redemption. The typical agency problems between financial firms’ shareholders and the firms’ managers/bankers/traders are exacerbated by the way the latter are compensated: since a large fraction of such compensation is in the form of bonuses tied to short-term profits and since such bonuses are one-sided (positive in good times and, at most zero, when returns are poor) managers/bankers/traders have a huge incentive to take larger risks than warranted by the goal of shareholders’ value maximization. The potential solutions to this gambling for redemption bias are varied: restricted stock that has to be maintained for a number of years; or a pool of cumulated bonuses that is not cashed out yearly but that can grow or shrink depending on the medium terms returns to particular investments.

But even leaving aside the problem of how to change such compensation in a highly competitive labor market talent in the financial sector, it is not obvious that the suggested solutions would fully work: for example in the case of Bear Stearns about 30% of the firm was owned by its employees and such employees had restricted stock. However this system of compensation did not prevent Bear Stearns from making reckless investment that eventually made it insolvent. Possibly this was the case because the individual compensation was not tied to the individual investment/lending decision. Still, compensation of bankers/traders should be considered as a crucial factor that distorts lending and investment decisions in financial markets.

Second, the current models of securitization (the “originate and distribute” model) has serious flaws as it reduces the incentive for the originator of the claims to monitor the creditworthiness of the borrower. In the securitization food chain for U.S. mortgages every intermediary in the chain was making a fee and eventually transferring the credit risk to those least able to understand it. The mortgage broker, the home appraiser, the bank originating the mortgages and repackaging them into MBSs, the investment bank repackaging the MBSs into CDOs, CDOs of CDOs and even CDO cubed, the credit rating agencies giving their AAA blessing to such toxic instruments: each of these intermediaries was earning income from charging fees for their step of the intermediation process and transferring the credit risk down the line.

One possible solution to this lack of incentive to undertake a proper monitoring of the borrower would be to force the originating bank and the investment bank intermediaries to hold some of the credit risk, for example in the form of their holding some part of the equity tranche in the CDOs or holding some of the MBS that they originate. But it is not obvious that such solutions would fully resolve the moral hazard problems faced by financial intermediaries. In fact, while the securitization process implied a partial transfer of the credit risk from the mortgage originators and the managers of the CDOs to final investors the reality is that banks and other financial institutions maintained a significant exposure to mortgages, MBS and CDOs. Indeed in the US about 47% of all the assets of major banks are real estate related; and the figure for smaller banks is closer to 67%. I.e. the model of “originate and distribute” securitization did not fully transfer the credit risk of mortgages to capital market investors: banks and broker dealers (say Bear Stearns) did keep in a variety of forms a significant fraction of that credit risk. Indeed, if that credit risk had been fully transferred such banks and other financial intermediaries would have not suffered the hundreds of billions of dollars of losses that they have recognized so far and that they will have to recognized in the future.

Thus, excessive risk taking and gambling for redemption did occur in spite of the fact that financial institutions were holding part of the credit risk. So proposing that such institutions hold some of that risk – rather than try to transfer it all – does not seem to be a solution that will resolve fully the problems deriving from the wrong set of financial incentives faced by bankers and the poor risk management by financial institutions. If the fundamental problem is one of the moral hazard deriving from the way that bankers are compensated forcing financial institutions to hold more of the credit risk will not resolve the problem that led in the first place to the poor monitoring of the creditworthiness of the borrowers and to poor underwriting standards.

Third, the regulation and supervision of banks and the lighter – on in some cases such as that of hedge funds non-existent – regulation and supervision of non-bank financial institutions has led to significant regulatory arbitrage: i.e. the transfer of a large fraction of financial intermediation to non-bank financial institutions such as broker dealers, hedge funds, money market funds, SIVs, conduits, etc.

The problems with this financial innovation are twofold: first, some of the institutions in this shadow banking system (or shadow financial system) are systemically important. Two, most of these institutions are at risk of bank-like runs on their liabilities as they borrow in short and liquid ways, they are highly leveraged and they invest in longer and more illiquid ways.

The risk of runs is significantly prevented for banks by the existence of deposit insurance and by the lender of last resort support that the central bank can provide. Publicly provided deposit insurance is generally not warranted for non-bank financial institutions as the protection of small investors/depositors - who don’t have the expertise to monitor the lending/investment decisions of banks - is not generally an issue for such non banks. But as the recent Bear Stearns episode as well as the run on and collapse of other components of the shadow financial system suggest bank-like runs on non-banks can occur and are more likely to occur more often if such institutions do not properly manage their liquidity and credit risks.

While provision of lender of last resort to non-bank institutions that are not systemically important is not warranted such support may be warranted for the few institutions that are systemically important. And indeed the recent Fed actions - $30 billion rescue of Bear Stearns, and two new facilities that allow non-bank primary dealers to access the Fed ‘s discount window and to swap their illiquid MBS products for safe Treasuries – imply that the lender of last resort support of the Fed has been now extended to systemically important non-bank institutions. Thus, the same regulation and supervision that is applied to banks should also be applied to these systemically important financial firms, not just in periods of turmoil (as recommended by Hank Paulson) but on a more permanent basis.

But if these institutions should be regulated like banks because they are systemically important and receive the Fed’s lender of last resort support one cannot have a system where the regulation and supervision of a subset of non-bank financial institutions is different depending on whether the institution is systemically important or not. Otherwise regulatory arbitrage will lead financial intermediation to move from banks and systemically important broker dealers to more lightly regulated smaller broker dealers and other non-bank financial institutions.

Thus, while the safety net of the Fed and other central banks should remain restricted to banks/depository institutions and to – subject to some constructive ambiguity - systemically important non-bank firms, the regulatory and supervisory framework should be similar for banks and non-bank financial institutions: regulatory capital, type of supervision, liquidity ratios, compliance and disclosure standards, etc, should be similar for banks and other financial institutions. Otherwise regulatory arbitrage will shift financial intermediation and risks to other more lightly regulated institutions.

For example, the loophole that allowed SIVs and conduits to operate with little supervision and no capital standard under the pretense that these were off-balance sheet units – while the sponsoring bank was providing large credit enhancements and systematic liquidity lines that made these units de facto on-balance sheet assets and liabilities – was deeply flawed. Unless these and a whole host of other special purpose vehicles are regulated and supervised as if they were on-balance sheet units this type of regulatory arbitrage will lead again to the disaster that SIVs created.

Moreover, a comprehensive supervisory and regulatory regime that covers both banks and non-bank would also allow a better monitoring and assessment of systemic financial risks that at the moment are not properly supervised. Providing both regulators/supervisors as well as investors and the reporting and disclosure of information that allows an assessment of systemic financial risks will be essential.

Poor liquidity risk management and the risk of bank-like runs on non-bank financial institutions has been shown as a severe problem in the shadow financial system: the entire SIV/conduit regime has recently collapsed given the roll-off of their ABCP liabilities; hedge funds and private equity funds collapsed because of risky investments and redemptions or roll-off of short term credits; money market funds whose NAV fell below par had to be rescued to avoid a run on them; Bear Stearns collapsed because of poor credit/investment choices but also because of a sudden run on its liquidity. While banks have are fundamentally maturity-mismatched given their reliance on short-term deposits there is no reason for non-bank financial institutions to run large liquidity/rollover risk especially as they do not have deposit insurance and no access – apart from the systemically important ones - to the central banks’ lender of last resort support.

Thus, an essential element of the common regulation of all non-bank financial institutions should be a greater emphasis given to the management of liquidity risk. Such firms should be asked to significantly lengthen the maturity and duration of their liabilities in order to reduce their liquidity risk. A firm that makes money only because it borrows very short, has little capital, leverages a lot and lends long and in illiquid ways is reckless in its risk management. It should certainly disclose fully to supervisors and to investors the liquidity and other risks that it is undertaking. But it should also be required to reduce its liquidity risk with a variety of tools provides it with a greater liquidity buffer.

Fourth, most regulatory and supervisory regimes have moved in the direction of emphasizing self-regulation and market discipline rather than rigid regulations. One of the arguments in favor of this market discipline approach is that financial innovation is always one or more steps ahead of regulation; thus, one need to design a regime that does not rely on rigid rules that would be easily avoidable via financial innovation.

This market discipline approach is behind the reliance on “principles” rather than “rigid” rules, the reliance on internal models of risk assessment and management in determining how much capital a firm needs, the reliance on rating agencies assessments of creditworthiness, and a key element of the philosophy behind the Basel II agreement. But this model based on market discipline has been proven vastly flawed given that the way bankers are compensated and the risk-transfer incentives provided by the “originate and distribute” model implies that internal risk managers are effectively ignored in good times when “the music plays and you gotta dance”; similarly the conflicts of interests of rating agencies lead to mis-ratings of new and exotic financial instruments.

Thus, while reliance on principles is useful to deal with financial innovation and regulatory arbitrage a more robust set of rules that go with the grain of principle-based regulation and supervision is necessary. Strict reliance on market discipline has been proven wrong in a world where bankers are improperly compensated, agency problems lead to poor monitoring of lending, a flawed transfer of credit risk to those least able to understand it and manage it, and where regulatory arbitrage is rampant.

Fifth, even before being fully implemented the Basel II agreement has shown its flaws: capital adequacy ratios that pro-cyclical and thus inductive of credit booms in good times and credit busts in bad times; low emphasis on liquidity risk management; excessively low capital ratios given the risks faced by banks; excessive reliance on internal risk management models; excessive importance given to the rating agencies. These are serious shortcomings of the new capital regime for large internationally active banks and depository institutions.

How to reform Basel II given the current severe financial crisis is not an easy task; but the urgency of this reform is undeniable. Particular importance should be given to: measures that would reduce the pro-cyclicality of capital standards that is a source of boom and busts in credit cycles; and to measures to increase – rather than decrease - the overall amount of capital held by financial institutions as recent history suggests that most financial institutions were vastly undercapitalized given the kind of market, liquidity, credit and operational risks that they were facing in an increasingly globalized financial system.

Sixth, by now the conflicts of interest and informational problems that led the rating agencies to rate – or better mis-rate – many MBS and CDO and other ABS products as highly rated are well known and recognized. With a large fraction of their revenues and profits coming from the rating of complex structured finance products and the consulting and modeling services provided to the issuers of such complex and exotic instruments it is clear that rating agencies are ripe with conflicts of interests. Add to this the flaws of a system where competition in this rating market is limited given the regulatory barriers to entry and the semi-official role that rating agencies have, in general and in Basel II in particular; the potential biases of a system where rating agencies are paid by issuers rather than the investors; the informational problems of raters that know little about the underlying risks of new complex and exotic instruments.

What are the potential solutions to these conflicts of interest and other problems? Open up competitions in the rating agency business; drop the semi-official role that rating agencies have in Basel II and in the investment decisions of asset managers; forbid activities (such as consulting or modeling) that cause conflicts of interest; drop the reliance on ratings paid by issuers rather than by investors (the free riding problem of having investors pay for ratings can be solved by pooling the investors’ resources in a pool that can be used to collectively purchase the ratings). Certainly rating agencies have lost a lot of their reputation in this ABS ratings fiasco; and only serious and credible reforms – not just cosmetic changes – will be required to restore their credibility in the rating business.

Seventh, there are fundamental accounting issues on how to value securities, especially in periods of market volatility and illiquidity when the fundamental long term value of the asset differs from its market price. The current “fair value” approach to valuation stresses the use of mark-to-market valuation where, as much as possible, market prices should be used to value assets, whether they are illiquid or not.

There are two possible situations where mark to market accounting may distort valuations: first, when there are bubbles and the market value may be above fundamental value; second, when bubbles burst and, because of market illiquidity, asset prices are potentially below fundamental value. The latter case has become a concern in the latest episode of market turmoil as mark-to-market accounting may force excessive writedowns and margin calls that may lead to further fire sales of illiquid assets that, in turn, could cause a cascading fall in asset prices well below long term fundamentals. However, mark to market accounting may also create serious distortions during bubbles when its use may lead to excessive leverage as high valuation allow investors to borrow more and leverage more and feed even further the asset bubble. In either case, mark to market accounting leads to pro-cyclical capital bank capital requirement given the way that the Basel II capital accord is designed.

The shortcomings of mark-to-market valuation are known but the main issue is whether one can find an alternative that is not subject to gaming by financial institutions. Some have suggested the use of historical cost to value assets (where assets are booked at the price at which they were bought); others propose the use of a discounted cash flow (DCF) model where long run fundamentals – cash flows – would have a greater role. However, historical cost does not seem to be an appropriate way to value assets. The use of a DCF model may seem more appealing but it is not without flaws either. How to properly estimate future cash flows? Which discount rate to apply to such cash flows? How to avoid a situation where those using this model to value asset subjectively game the model to achieve the valuations that they want as the value of the asset in a DCF model strongly depend on assumptions about future cash flows and the appropriate discount factor? Possibly mark-to-market may be a better approach when securities are held in a trading portfolio while DCF may be a more appropriate approach when such securities as held as a long term investment, i.e. until maturity. But the risk of a DCF approach is that different firms will value very differently identical assets and that firms will use any approach different from mark-to-market to manipulate their financial results.

The other difficult problem that one has to consider is that any suspension of mark-to-market accounting in periods of volatility would reduce – rather than enhance – investors’ confidence in financial institutions. Part of the recent turmoil and increase in risk aversion can be seen as an investors’ backlash against an opaque and non-transparent financial system where investors cannot properly know what is the size of the losses experienced by financial institutions and who is holding the toxic waste. Mark-to-market accounting at least imposes some discipline and transparency; moving away from it may further reduce the confidence of investors as it would lead to even less transparency.

Some suggest that the problem is not mark-to-market accounting but the pro-cyclical capital requirements of Basel II; that is correct. But even without such pro-cyclical distortions there is a risk that financial institutions – not just banks - would retrench leverage and credit too much and too fast during periods of turmoil when they become more risk averse. Thus, the issue remains open of whether there are forms of regulatory forbearance - that are not destructive of confidence - that can be used in periods of turmoil in order to avoid a cascading and destructive fall in asset prices. But certainly solutions should be symmetric, i.e applied both during periods of rising asset prices and bubbles (when market prices are above fundamentals) and when such bubbles go bust (and asset prices may fall below fundamentals). But so far there is no clear and sensible alternative to mark-to-market accounting.

Eighth, the recent financial markets crisis and turmoil has been partly caused by the fact that the – over the last few years – financial markets have become less transparent and more opaque in many different dimensions. The development of news exotic and illiquid financial instruments that are hard to value and price; the development of increasingly complex derivative instruments; the fact that many of these instruments trade over the counter rather than in an exchange; the fact that there is little information and disclosure about such instruments and who is holding them; the fact that many new financial institutions are opaque and with little or no regulation (hedge funds, private equity, SIV and other off-balance sheet special purpose vehicles) have all contributed to a lack of financial market transparency and increased opacity of such markets.

But private financial markets cannot function properly unless there is enough information, reporting and disclosure both to market participants and to relevant regulators and supervisors. How much reporting and disclosure - and to whom - is appropriate is a difficult question. But it is clear that for the last few years financial market have become excessively opaque in ways that are destructive of investors’ confidence. When investors cannot prices appropriately complex new securities, when investors cannot properly assess the overall losses faced by financial institutions and when they cannot know who is holding toxic waste securities risk (that can be priced) turns into generalized uncertainty (that cannot be priced) and the outcome is an excessive increase in risk aversion, lack of trust and confidence in counterparties and a massive seizure of liquidity in financial markets. Greater transparency and information – including the use of fair value accounting (that, in spite of its shortcomings, is still the best way to value assets) – as well as prompt recognition by financial institutions of their exposures and losses are essential to restore the investors’ confidence in financial markets.

Some specific ideas on how to make new complex and exotic financial instruments more liquid and easier to price would be to make such instrument more standardized and have them traded in clearing house-based exchanges rather than over the counter. The benefits of standardization are clear as such standardization would allow to compare securities with similar characteristics and would thus improve their liquidity. Moreover, instruments that are exchange-traded through a clearing house would have much lower counterparty risk, would be subject to appropriate margin requirements and would be appropriately marked-to-market on a daily basis.

Ninth, what are the appropriate institutions of financial regulation and supervision and the system of such regulation and supervision in a world of financial innovation and globalization? There are many alternative models that have different pros and cons.

An increasingly popular model is the one of a unique and centralized financial regulator and supervisor, as in the case of the UK’s FSA where all financial policies – for banks, securities firms, other financial institutions, insurance companies, etc. – are under one umbrella. Another model is the US one where you have more than half a dozen or more of financial regulators and supervisors at the federal level and another layer of them at the state level. While some have argued that the US system because it foster beneficial competition about the best practices among different regulators the shortcoming of the US system, an incoherent set of overlapping regulators and a race to the bottom – rather than to the top – in terms of excessively deregulatory competition, have now become clear. One overall financial regulator may be too little but sixty plus of them is obviously way too many. A streamlining of such institutions and concentration of most regulatory and supervisory activities among a smaller number of institutions is certainly necessary.

Further, whether supervisory and regulatory power over banks – and possibly other systemically important financial institutions – should be kept within the central bank (as in the US) or whether it should be given to another regulator (as in the case of the UK FSA) is a difficult and controversial issue. Some worry that taking such powers away from the central bank – while maintaining its role as the lender of last resort - would reduce the ability of the central bank to oversee financial vulnerabilities in specific institutions and in the overall financial system (systemic risk). But as long as there is a proper exchange of information between the regulator and supervisor of banks and of other financial institutions and the central bank these informational issues can be properly managed. The UK debacle over Northern Rock was caused not by the existence of a single financial authority (the FSA) but rather – in part – by the lack of coordination and proper information exchange between the FSA, the Bank of England and the UK Treasury. Thus, the UK model of a single financial regulator/supervisor is – in principle – superior to a model where such powers are fragmented among many and different institutions. But proper coordination and information exchange is essential to make this system work.

Tenth, and finally, reforms of financial regulation and supervision cannot be done only at the national level as regulatory arbitrage may lead financial intermediation to move to jurisdictions with a lighter – and less appropriate - regulatory approach. Indeed, the recent US debate on reforming capital markets was driven – before the current market turmoil – by the concerns that a tighter regulatory approach in the U.S. (say the Sarbanes-Oxley legislation) was leading to a competitive slippage of New York relative to London in the provision of financial services.

In a world of financial globalization, mobile capital and lack of capital controls capital and financial intermediation may move to more lightly regulated shores. While the idea of a global financial regulator – or a global financial “sheriff” – is for the time being a bit far-fetched a much stronger degree of coordination of financial regulation and supervision policies is necessary to avoid a race to the bottom in financial regulation and supervision and to prevent excessive regulatory arbitrage. Such international coordination of financial policies is currently occurring on a very limited scale and will have to be seriously enhanced over time. Certainly within the Eurozone a system where bank supervision and regulation occurs only at the national level while only the ECB would be able to provide lender of last resort support in the case of a systemic banking crisis or when a major systemically important cross-border institution gets into trouble is an untested model. Over time financial supervision and regulation within the Eurozone will have to move from the national level to a Eurozone-wide level.

Finally, how do the U.S. Secretary Paulson proposals for the reform of the financial system compare with the principles and ideas for optimal financial regulation and supervision discussed above? An appropriate answer requires a detailed discussion that will be provided in the near future in this forum. But in brief summary, such proposals - while representing a step forward – have many shortcomings and they overemphasize the role of self-regulation, market discipline and reliance on principles rather than rules that have miserably failed to deliver an appropriate regulation and supervision of the financial system. Given that we are still in the midst of the worst U.S. financial crisis since the Great Depression, a crisis that has shaken the foundations of modern financial capitalism, the current US Treasury proposals have significant shortcomings that don’t address the core and structural financial risks and vulnerabilities that the current crisis has revealed.

Let the litigation begin!

Schiffrin Barroway Topaz & Kessler, LLP Files First ERISA Fiduciary Breach Class Action on Behalf of Participants and Beneficiaries of the Bear Stearns Companies, Inc. Employee Stock Ownership Plan Against the Bear Stearns Companies, Inc. and Other Plan Fi

RADNOR, Pa., March 27 /PRNewswire/ -- The following statement was
issued today by the law firm of Schiffrin Barroway Topaz & Kessler, LLP:

Notice is hereby given that the law firm of Schiffrin Barroway Topaz &
Kessler, LLP ("SBTK") has filed the first lawsuit of its kind on behalf of
participants and beneficiaries of The Bear Stearns Companies, Inc. Employee
Stock Ownership Plan (the "Plan"), in the United States District Court for
the Southern District of New York, alleging violations of the Employee
Retirement Income Security Act ("ERISA"), the federal law governing
employee benefit plans. The lawsuit seeks to recover, on behalf of the Plan
and its aggrieved participants, losses in connection with the unprecedented
devaluation of The Bear Stearns Companies, Inc. ("Bear Stearns") common
stock (NYSE: BSC) held by Plan participants between December 14, 2006 and
the present (the "Class Period").

This case epitomizes the danger of concentrating hundreds of millions
of "retirement eggs" in one basket - employer stock - even for employees of
an institution like Bear Stearns. Plaintiff alleges that Bear Stearns, like
too many others, has inflicted long-term harm on its most precious resource
- its workers.

Pursuant to ERISA, the defendants-fiduciaries of the Plan-were
obligated to ensure that the Plan's assets were prudently invested. The
Complaint alleges that the defendants utterly failed to fulfill their
fiduciary duties and, as a result, the Plan's participants have suffered
tremendous losses to their retirement savings.

The Complaint generally alleges that Bear Stearns and certain of its
officers and directors allowed the imprudent investment of the Plan's
assets/participants' retirement savings in Bear Stearns equity throughout
the Class Period, despite the fact that they clearly knew or should have
known that such investment was imprudent due to, among other things, (a)
the Company's failure to disclose material adverse facts about its
financial well- being including its ability to continue as a going concern;
(b) the foreseeable deleterious consequences to the Company resulting from
its substantial entrenchment in the subprime mortgage market; (c) the fact
that, as a consequence of the above, the Company's stock price was
artificially inflated; and (d) the fact that heavy investment of retirement
savings in Company stock would therefore result in significant losses to
the Plan, and consequently, to its participants.

Specifically, Plaintiff's complaint alleges that Bear Stearns stock was
an inherently imprudent Plan investment vehicle because the Company: (1)
was grossly over-exposed to the potential for substantial losses as
conditions in the subprime industry deteriorated; (2) actively concealed
the ominous dangers it faced; (3) failed to take accurate and timely
write-downs for losses resulting from the collapse of the subprime market;
and that the (4) Company's statements about its financial well-being and
future business prospects were lacking in any reasonable basis when made.

As noted above, this case is brought on behalf of the Plan and its
participants. Proposed class actions have also been brought against Bear
Stearns regarding violations of the federal securities laws by the
company's public shareholders.

SBTK specializes in complex class action litigation, representing
investors, employees and consumers in class actions pending in state and
federal courts throughout the United States. SBTK has substantial
experience and success in this specialized area of pension law, with one of
the preeminent and largest legal departments dedicated to ERISA breach of
fiduciary duty class action litigation in the country. The firm has been
named lead or co-lead counsel in numerous directly analogous ERISA class
cases - including successful actions on behalf of ESOP and/or 401(k)
savings plans sponsored by companies such as AOL/Time Warner,
Bristol-Myers, and Polaroid.

If you are a current or former employee of Bear Stearns, or a
subsidiary of Bear Stearns, who held Bear Stearns stock through the Plan
during the Class Period, and you wish to discuss this action or have any
questions concerning this notice or your rights or interests with respect
to these matters, please contact Schiffrin Barroway Topaz & Kessler, LLP
(Edward W. Ciolko, Esq. or Richard A. Maniskas, Esq.) toll free at
1-888-299-7706 or 1-610-667-7706, or via e-mail at

For more information about Schiffrin Barroway Topaz & Kessler, please

CONTACT: Schiffrin Barroway Topaz & Kessler, LLP
Edward W. Ciolko, Esq.
Richard A. Maniskas, Esq.
280 King of Prussia Road
Radnor, PA 19087
1-888-299-7706 (toll free) or 1-610-667-7706
Or by e-mail at

As Jobs Vanish and Prices Rise, Food Stamp Use Nears Record

Published: March 31, 2008
Driven by a painful mix of layoffs and rising food and fuel prices, the number of Americans receiving food stamps is projected to reach 28 million in the coming year, the highest level since the aid program began in the 1960s.

Barometer of Tougher Times
The number of recipients, who must have near-poverty incomes to qualify for benefits averaging $100 a month per family member, has fluctuated over the years along with economic conditions, eligibility rules, enlistment drives and natural disasters like Hurricane Katrina, which led to a spike in the South.

But recent rises in many states appear to be resulting mainly from the economic slowdown, officials and experts say, as well as inflation in prices of basic goods that leave more families feeling pinched. Citing expected growth in unemployment, the Congressional Budget Office this month projected a continued increase in the monthly number of recipients in the next fiscal year, starting Oct. 1 — to 28 million, up from 27.8 million in 2008, and 26.5 million in 2007.

The percentage of Americans receiving food stamps was higher after a recession in the 1990s, but actual numbers are expected to be higher this year.

Federal benefit costs are projected to rise to $36 billion in the 2009 fiscal year from $34 billion this year.

“People sign up for food stamps when they lose their jobs, or their wages go down because their hours are cut,” said Stacy Dean, director of food stamp policy at the Center on Budget and Policy Priorities in Washington, who noted that 14 states saw their rolls reach record numbers by last December.

One example is Michigan, where one in eight residents now receives food stamps. “Our caseload has more than doubled since 2000, and we’re at an all-time record level,” said Maureen Sorbet, spokeswoman for the Michigan Department of Human Services.

The climb in food stamp recipients there has been relentless, through economic upturns and downturns, reflecting a steady loss of industrial jobs that has pushed recipient levels to new highs in Ohio and Illinois as well.

“We’ve had poverty here for a good while,” Ms. Sorbet said. Contributing to the rise, she added, Michigan, like many other states, has also worked to make more low-end workers aware of their eligibility, and a switch from coupons to electronic debit cards has reduced the stigma.

Some states have experienced more recent surges. From December 2006 to December 2007, more than 40 states saw recipient numbers rise, and in several — Arizona, Florida, Maryland, Nevada, North Dakota and Rhode Island — the one-year growth was 10 percent or more.

In Rhode Island, the number of recipients climbed by 18 percent over the last two years, to more than 84,000 as of February, or about 8.4 percent of the population. This is the highest total in the last dozen years or more, said Bob McDonough, the state’s administrator of family and adult services, and reflects both a strong enlistment effort and an upward creep in unemployment.

In New York, a program to promote enrollment increased food stamp rolls earlier in the decade, but the current climb in applications appears in part to reflect economic hardship, said Michael Hayes, spokesman for the Office of Temporary and Disability Assistance. The additional 67,000 clients added from July 2007 to January of this year brought total recipients to 1.86 million, about one in 10 New Yorkers.

Nutrition and poverty experts praise food stamps as a vital safety net that helped eliminate the severe malnutrition seen in the country as recently as the 1960s. But they also express concern about what they called the gradual erosion of their value.

Food stamps are an entitlement program, with eligibility guidelines set by Congress and the federal government paying for benefits while states pay most administrative costs.

Eligibility is determined by a complex formula, but basically recipients must have few assets and incomes below 130 percent of the poverty line, or less than $27,560 for a family of four.

As a share of the national population, food stamp use was highest in 1994, after several years of poor economic growth, with an average of 27.5 million recipients per month from a lower total of residents. The numbers plummeted in the late 1990s as the economy grew and legal immigrants and certain others were excluded.

But access by legal immigrants has been partly restored and, in the current decade, the federal and state governments have used advertising and other measures to inform people of their eligibility and have often simplified application procedures.

Because they spend a higher share of their incomes on basic needs like food and fuel, low-income Americans have been hit hard by soaring gasoline and heating costs and jumps in the prices of staples like milk, eggs and bread.

At the same time, average family incomes among the bottom fifth of the population have been stagnant or have declined in recent years at levels around $15,500, said Jared Bernstein, an economist at the Economic Policy Institute in Washington.

The benefit levels, which can amount to many hundreds of dollars for families with several children, are adjusted each June according to the price of a bare-bones “thrifty food plan,” as calculated by the Department of Agriculture. Because food prices have risen by about 5 percent this year, benefit levels will rise similarly in June — months after the increase in costs for consumers.

Advocates worry more about the small but steady decline in real benefits since 1996, when the “standard deduction” for living costs, which is subtracted from family income to determine eligibility and benefit levels, was frozen. If that deduction had continued to rise with inflation, the average mother with two children would be receiving an additional $37 a month, according to the private Center on Budget and Policy Priorities.

Both houses of Congress have passed bills that would index the deduction to the cost of living, but the measures are part of broader agriculture bills that appear unlikely to pass this year because of disagreements with the White House over farm policy.

Another important federal nutrition program known as WIC, for women, infants and children, is struggling with rising prices of milk and cheese, and growing enrollment.

The program, for households with incomes no higher than 185 percent of the federal poverty level, provides healthy food and nutrition counseling to 8.5 million pregnant women, and children through the age of 4. WIC is not an entitlement like food stamps, and for the fiscal year starting in October, Congress may have to approve a large increase over its current budget of $6 billion if states are to avoid waiting lists for needy mothers and babies.

US credit crunch hits education as banks abandon student loans

How will I finance college?
Suzy Jagger in New York
One of America’s leading banking associations has given warning that the United States faces a growing educational apartheid as some lenders withdraw from student loans amid new evidence that the credit crisis has spread across all types of borrowing.

In the past fortnight, some banks, including HSBC, have pulled out of the $85 billion (£42 billion) a year US student loans market, fuelling anxiety that the turmoil that hit debt markets on Wall Street last summer is spilling over into the wider economy and making credit more difficult to secure for ordinary American households.

In the US, many undergraduates take out a federal guaranteed loan and top up their financial needs with a private loan from lenders such as Bank of America, JPMorgan Chase and Citi-group. In the academic year 2005-06, $17 billion in private student loans was used to finance higher education.

Banks have become reluctant to offer private student loans because worsening credit conditions have meant that they cannot package up the loans and sell them on.

Although the brightest students who win places at America’s rich Ivy League universities will be affected less because of generous bursaries - which do not have to be repaid – less able students applying to other institutions are expected to face difficulty in securing private loans to fund their study. At one end of the field is Harvard University, with $34 billion of endowments, and at the other are many community colleges and low-tier universities with limited resources.

Joe Belew, president of the Consumer Bankers’ Association, said: “Some of the banks are getting out. Part of the reason is that Congress has cut the fees they could charge, making some loans pretty much unprofitable. But part of the reason is that they can’t securitise the debt. The problems they have had with mortgage-backed debt – it’s the same thing at play in student lending.

“We have talked to some of the banks about this. It’s a painful decision to pull out because of the nature of the clientele – everyone wants to be in the business of helping people get ahead, but at the end of the day you still have to deliver value to shareholders. At the moment, it’s a fine line between hanging in there and pulling out. It’s a murky situation.

“If the overall market is contracting, then those students with poor credit scores or without the rich uncle co-signers [loan guarantor] may have real problems funding themselves.”

Last week, Iowa Student Loan said that it would soon stop offering private loans altogether. The group, which made 29,000 student loans last year, said: “This is really a reaction to the economy’s recent situation, the sub-prime market in particular.”

Within the past fortnight, Montana Higher Education Student Assistance Corp said that a lack of appetite for buying debt such as student loans had led to its interest costs to finance such borrowing rising by a tenth, or $3.4 million, since the beginning of February.

Several members of Congress have urged the Bush Administration to stabilise the market after the National Association of Independent Colleges and Universities gave warning that student loans have become far harder and costlier to obtain since the credit crisis.

Last October, as the credit crisis on Wall Street was gathering pace, Washington introduced legislation limiting the returns that banks could extract from student loans.

Concern over funding for students is also spreading to Ivy League institutions. The University of Pennsylvania’s head of financial aid, William Schilling, has just written to banks demanding assurances they will continue to offer student loans.

Speaking to The Times, Dr Schilling said: “We want the banks to tell us whether they will continue to offer [federal] loans and private loans for the next academic year. The key thing is not just whether they will lend at all, but what the terms will be.”

Dr Schilling said that although some of the loans are guaranteed by Washington and are therefore “very low risk”, the market for them “has just gone away”.

Brace for $1 Trillion Writedown of `Yertle the Turtle' Debt

Review by James Pressley
March 31 (Bloomberg) -- Be it ever so devalued, $1 trillion is a lot of dough.

That's roughly on a par with the Russian economy. More than double the market value of Exxon Mobil Corp. About nine times the combined wealth of Warren Buffett and Bill Gates.

Yet $1 trillion is the amount of defaults and writedowns Americans will likely witness before they emerge at the far side of the bursting credit bubble, estimates Charles R. Morris in his shrewd primer, ``The Trillion Dollar Meltdown.'' That calculation assumes an orderly unwinding, which he doesn't expect.

``The sad truth,'' he writes, ``is that subprime is just the first big boulder in an avalanche of asset writedowns that will rattle on through much of 2008.''

Expect the landslide to cascade through high-yield bonds, commercial mortgages, leveraged loans, credit cards and -- the big unknown -- credit-default swaps, Morris says. The notional value for those swaps, which are meant to insure bondholders against default, covered about $45 trillion in portfolios as of mid-2007, up from some $1 trillion in 2001, he writes.

Morris can't be dismissed as a crank. A lawyer, former banker and author of 10 other books, he knows a thing or two about the complex instruments that have spread toxic debt throughout the credit system. He once ran a company that made software for creating and analyzing securitized asset pools. Yet he writes with tight clarity and blistering pace.

The financial innovations of the past 25 years have done some good, Morris notes. Collateralized mortgage obligations, invented in 1983, saved homeowners $17 billion a year by the mid-1990s, according to one study.

Slicing and Dicing

CMOs transformed the business by slicing pools of mortgages into different bonds for different risk appetites. Top-tier bonds had the first claim on all cash flows and paid commensurately low yields. The bottom tier was the first to absorb all the losses; it paid yields resembling those on junk bonds.

What began as a good thing, though, soon spawned a bewildering array of new asset classes that spread throughout the financial system, marbling balance sheets with what Morris calls inflated valuations, hidden debt and ``phony triple-A ratings.'' The more the quants fine-tuned the upper tranches of CMOs and other collateralized debt obligations, the more dangerous the bottom slices grew. Bankers began calling it ``toxic waste.''

Guess where the toxins wound up? That's right: Credit hedge funds are now the weakest link in the chain, Morris says. Their equity stands at some $750 billion and is so massively leveraged that ``most funds could not survive even a 1 percent to 2 percent payoff demand on their default swap guarantees,'' he writes.

`Utter Thrombosis'

Morris sketches a scenario in which hedge fund counterparty defaults would ripple through default swap markets, triggering writedowns of insured portfolios, demands for collateral, and a rush to grab cash from defaulting guarantors. The credit system would suffer ``an utter thrombosis,'' he says, making the subprime crisis ``look like a walk in the park.''

As bankers and regulators try to prop up the ``Yertle the Turtle-like unstable tower of debt,'' Morris points to two previous episodes of lost market confidence.

The first was the 1970s inflationary trauma that prompted investors to suck money out of the stocks and bonds that finance business. Confidence returned only after Fed chief Paul Volcker slew runaway inflation by ratcheting up interest rates.

The other precedent is the popped 1980s Japanese asset bubble. In that case, politicians and finance executives tried to paper over their troubles. Two decades later, Japan still hasn't recovered, Morris writes.

We should be as bold as Volcker, he suggests: Face the scale of the mess, take a $1 trillion writedown and shore up regulatory measures. His recommendations include forcing loan originators to retain the first losses; requiring prime brokers to stop lending to hedge funds that don't disclose their balance sheets; and bringing the trading of credit derivatives onto exchanges.

What he fears is that the U.S. will instead follow the Japanese precedent, seeking to ``downplay and to conceal. Continuing on that course will be a path to disaster.''

``The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash'' is from PublicAffairs (194 pages, $22.95).

(James Pressley writes for Bloomberg News. The opinions expressed are his own.)

To contact the writer of this review: James Pressley in Brussels at

Sunday, March 30, 2008

NAA Reveals Biggest Ad Revenue Plunge in More Than 50 Years

Huge Decline in Ads.
By Jennifer Saba

Published: March 28, 2008 12:55 PM ET
NEW YORK The newspaper industry has experienced the worst drop in advertising revenue in more than 50 years.

According to new data released by the Newspaper Association of America, total print advertising revenue in 2007 plunged 9.4% to $42 billion compared to 2006 -- the most severe percent decline since the association started measuring advertising expenditures in 1950.

The drop-off points to an economic slowdown on top of the secular challenges faced by the industry. The second worst decline in advertising revenue occurred in 2001 when it fell 9.0%.

Total advertising revenue in 2007 -- including online revenue -- decreased 7.9% to $45.3 billion compared to the prior year.

There are signs that online revenue is beginning to slow as well. Internet ad revenue in 2007 grew 18.8% to $3.2 billion compared to 2006. In 2006, online ad revenue had soared 31.4% to $2.6 billion. In 2005, it jumped 31.4% to $2 billion.

As newspaper Web sites generate more advertising revenue, the growth rate naturally slows.

The NAA reported that online revenue now represents 7.5% of total newspaper ad revenue in 2007 compared to 5.7% in 2006.

That growth could not stave off the losses in the print however. National print advertising revenue dropped 6.7% to $7 billion last year. Retail slipped 5% to $21 billion. Classified plunged 16.5% to $14.1 billion.

"Even with the near-term challenges posed to print media by a more fragmented information environment and the economic headwinds facing all advertising media, newspapers publishers are continuing to drive strong revenue growth from their increasingly robust Web platforms," John Sturm, president and CEO of the NAA, said in a statement.

Not yet time for a bail-out of banks (FT)

Published: March 28 2008 19:49 | Last updated: March 28 2008 19:49
The “credit crunch” is nearly eight months old, yet shows little sign of easing. It has already forced the US Federal Reserve to slash its benchmark interest rate by 3 percentage points. It has driven central banks to make huge injections of liquidity into markets. Yet this activity has failed to give confidence to markets. So has the time come for a fiscal bail-out? The short answer is: no.

“The heart of the problem is not in the real economy; it is in the financial sector itself,” argued Mervyn King, governor of the Bank of England this week. “It stems from an ‘overhang’ on banks’ balance sheets of assets in which markets have closed ... That has created uncertainty about the strength of banks’ financial positions.”

Inevitably, banks are now unwilling to extend credit. So spreads between official interest rates and the rates at which banks will lend to one another are unusually high. Worse, these spreads have again been rising in recent months.

The many signs of frozen lending are, in turn, creating a lobby for the “something must be done” school. The most plausible “something” is an injection of public money into the mortgage market or, heaven forbid, the financial industry itself.

Such an infusion is to be contemplated only in the direst circumstances. This is not now close to being the case in any affected country. Moreover, the extent of the losses to be tackled will only be known when asset prices stop falling. For this very reason, that point should be reached as soon as possible. Governments should, therefore, avoid trying to support the housing market, but allow it to adjust, instead. Only then will the value of outstanding mortgage-backed securities, and of the institutions that hold them, be known.

So what should be done now? Central banks must use monetary policy to avoid the risk of economic collapse. They should also try to make illiquid securities less so, while leaving credit risk with their holders. Where adequate room for manoeuvre exists, fiscal policy should support monetary policy.

Governments can also help by facilitating renegotiation of mortgages. The principal aim is to avoid unnecessary and costly foreclosures. Finally, regulators should be willing to let institutions operate with somewhat inadequate capital for a while, provided they have clear plans to rectify the situation.

Does this mean that a fiscal bail-out should be ruled out under all circumstances? No. If the financial system were to be so damaged that it proved impossible to sustain aggregate demand, the public sector would have to step in. But it should do so only over the dead bodies of shareholders and management. Those who caused the crisis must not be rescued by taxpayers from the results of their copious follies.

In the meantime, we must understand one point: the hangover from the party will endure a long while.

Saturday, March 29, 2008

Paulson's Executive Summary: Liar's Poker

I. Executive Summary
The mission of the Department of the Treasury (“Treasury”) focuses on promoting economic
growth and stability in the United States. Critical to this mission is a sound and competitive
financial services industry grounded in robust consumer protection and stable and innovative
Financial institutions play an essential role in the U.S. economy by providing a means for
consumers and businesses to save for the future, to protect and hedge against risks, and to
access funding for consumption or organize capital for new investment opportunities. A
number of different types of financial institutions provide financial services in the United
States: commercial banks and other insured depository institutions, insurers, companies
engaged in securities and futures transactions, finance companies, and specialized companies
established by the government. Together, these institutions and the markets in which they act
underpin economic activity through the intermediation of funds between providers and users
of capital.
This intermediation function is accomplished in a number of ways. For example, insured
depository institutions provide a vehicle to allocate the savings of individuals. Similarly,
securities companies facilitate the transfer of capital among all types of investors and
investment opportunities. Insurers assist in the financial intermediation process by providing
a means for individuals, companies, and other financial institutions to protect assets from
various types of losses. Overall, financial institutions serve a vitally important function in the
U.S. economy by allowing capital to seek out its most productive uses in an efficient matter.
Given the economic significance of the U.S. financial services sector, Treasury considers the
structure of its regulation worthy of examination and reexamination.
Treasury began this current study of regulatory structure after convening a conference on
capital markets competitiveness in March 2007. Conference participants, including current
and former policymakers and industry leaders, noted that while functioning well, the U.S.
regulatory structure is not optimal for promoting a competitive financial services sector
leading the world and supporting continued economic innovation at home and abroad.
Following this conference, Treasury launched a major effort to collect views on how to
improve the financial services regulatory structure.
In this report, Treasury presents a series of “short-term” and “intermediate-term”
recommendations that could immediately improve and reform the U.S. regulatory structure.
The short-term recommendations focus on taking action now to improve regulatory
coordination and oversight in the wake of recent events in the credit and mortgage markets.
The intermediate recommendations focus on eliminating some of the duplication of the U.S.
regulatory system, but more importantly try to modernize the regulatory structure applicable
to certain sectors in the financial services industry (banking, insurance, securities, and
futures) within the current framework.
Treasury also presents a conceptual model for an “optimal” regulatory framework. This
structure, an objectives-based regulatory approach, with a distinct regulator focused on one of
three objectives—market stability regulation, safety and soundness regulation associated with
government guarantees, and business conduct regulation—can better react to the pace of
market developments and encourage innovation and entrepreneurialism within a context of
enhanced regulation. This model is intended to begin a discussion about rethinking the
current regulatory structure and its goals. It is not intended to be viewed as altering regulatory
authorities within the current regulatory framework. Treasury views the presentation of a
tangible model for an optimal structure as essential to its mission to promote economic
growth and stability and fully recognizes that this is a first step on a long path to reforming
financial services regulation.
The current regulatory framework for financial institutions is based on a structure that
developed many years ago. The regulatory basis for depository institutions evolved gradually
in response to a series of financial crises and other important social, economic, and political
events: Congress established the national bank charter in 1863 during the Civil War, the
Federal Reserve System in 1913 in response to various episodes of financial instability, and
the federal deposit insurance system and specialized insured depository charters (e.g., thrifts
and credit unions) during the Great Depression. Changes were made to the regulatory system
for insured depository institutions in the intervening years in response to other financial
crises (e.g., the thrift crises of the 1980s) or as enhancements (e.g., the Gramm-Leach-Bliley
Act of 1999 (“GLB Act”)); but, for the most part the underlying structure resembles what
existed in the 1930s. Similarly, the bifurcation between securities and futures regulation, was
largely established over 70 years ago when the two industries were clearly distinct.
In addition to the federal role for financial institution regulation, the tradition of federalism
preserved a role for state authorities in certain markets. This is especially true in the
insurance market, which states have regulated with limited federal involvement for over 135
years. However, state authority over depository institutions and securities companies has
diminished over the years. In some cases there is a cooperative arrangement between federal
and state officials, while in other cases tensions remain as to the level of state authority. In
contrast, futures are regulated solely at the federal level.
Historically, the regulatory structure for financial institutions has served the United States
well. Financial markets in the United States have developed into world class centers of
capital and have led financial innovation. Due to its sheer dominance in the global capital
markets, the U.S. financial services industry for decades has been able to manage the
inefficiencies in its regulatory structure and still maintain its leadership position. Now,
however, maturing foreign financial markets and their ability to provide alternate sources of
capital and financial innovation in a more efficient and modern regulatory system are
pressuring the U.S. financial services industry and its regulatory structure. The United States
can no longer rely on the strength of its historical position to retain its preeminence in the
global markets. Treasury believes it must ensure that the U.S. regulatory structure does not
inhibit the continued growth and stability of the U.S.
financial services industry and the economy as a whole. Accordingly, Treasury has
undertaken an analysis to improve this regulatory structure.
Over the past forty years, a number of Administrations have presented important
recommendations for financial services regulatory reforms.
Most previous studies have
focused almost exclusively on the regulation of depository institutions as opposed to a
broader scope of financial institutions. These studies served important functions, helping
shape the legislative landscape in the wake of their release. For example, two reports,
Blueprint for Reform: The Report of the Task Group on Regulation of Financial Services
(1984) and Modernizing the Financial System: Recommendations for Safer, More
Competitive Banks (1991), laid the foundation for many of the changes adopted in the GLB
In addition to these prior studies, similar efforts abroad inform this Treasury report. For
example, more than a decade ago, the United Kingdom conducted an analysis of its financial
services regulatory structure, and as a result made fundamental changes creating a tri-partite
system composed of the central bank (i.e., Bank of England), the finance ministry (i.e., H.M.
Treasury), and the national financial regulatory agency for all financial services (i.e.,
Financial Services Authority). Each institution has well-defined, complementary roles, and
many have judged this structure as having enhanced the competitiveness of the U.K.
Australia and the Netherlands adopted another regulatory approach, the “Twin Peaks” model,
emphasizing regulation by objective: One financial regulatory agency is responsible for
prudential regulation of relevant financial institutions, and a separate and distinct regulatory
agency is responsible for business conduct and consumer protection issues. These
international efforts reinforce the importance of revisiting the U.S. regulatory structure.
The Need for Review
Market conditions today provide a pertinent backdrop for this report’s release, reinforcing the
direct relationship between strong consumer protection and market stability on the one hand
and capital markets competitiveness on the other and highlighting the need for examining the
U.S. regulatory structure.
Prompting this Treasury report is the recognition that the capital markets and the financial
services industry have evolved significantly over the past decade. These developments, while
providing benefits to both domestic and global economic growth, have also exposed the
financial markets to new challenges.
Globalization of the capital markets is a significant development. Foreign economies are
maturing into market-based economies, contributing to global economic growth and stability
and providing a deep and liquid source of capital outside the United States. Unlike the United
States, these markets often benefit from recently created or newly
See Appendix B for background on prior Executive Branch studies.
developing regulatory structures, more adaptive to the complexity and increasing pace of
innovation. At the same time, the increasing interconnectedness of the global capital markets
poses new challenges: an event in one jurisdiction may ripple through to other jurisdictions.
In addition, improvements in information technology and information flows have led to
innovative, risk-diversifying, and often sophisticated financial products and trading
strategies. However, the complexity intrinsic to some of these innovations may inhibit
investors and other market participants from properly evaluating their risks. For instance,
securitization allows the holders of the assets being securitized better risk management
opportunities and a new source of capital funding; investors can purchase products with
reduced transactions costs and at targeted risk levels. Yet, market participants may not fully
understand the risks these products pose.
The growing institutionalization of the capital markets has provided markets with liquidity,
pricing efficiency, and risk dispersion and encouraged product innovation and complexity. At
the same time, these institutions can employ significant degrees of leverage and more
correlated trading strategies with the potential for broad market disruptions. Finally, the
convergence of financial services providers and financial products has increased over the past
decade. Financial intermediaries and trading platforms are converging. Financial products
may have insurance, banking, securities, and futures components.
These developments are pressuring the U.S. regulatory structure, exposing regulatory gaps as
well as redundancies, and compelling market participants to do business in other jurisdictions
with more efficient regulation. The U.S. regulatory structure reflects a system, much of it
created over seventy years ago, grappling to keep pace with market evolutions and, facing
increasing difficulties, at times, in preventing and anticipating financial crises.
Largely incompatible with these market developments is the current system of functional
regulation, which maintains separate regulatory agencies across segregated functional lines of
financial services, such as banking, insurance, securities, and futures. A functional approach
to regulation exhibits several inadequacies, the most significant being the fact that no single
regulator possesses all of the information and authority necessary to monitor systemic risk, or
the potential that events associated with financial institutions may trigger broad dislocation or
a series of defaults that affect the financial system so significantly that the real economy is
adversely affected. In addition, the inability of any regulator to take coordinated action
throughout the financial system makes it more difficult to address problems related to
financial market stability.
Second, in the face of increasing convergence of financial services providers and their
products, jurisdictional disputes arise between and among the functional regulators, often
hindering the introduction of new products, slowing innovation, and compelling migration of
financial services and products to more adaptive foreign markets. Examples of recent inter-
agency disputes include: the prolonged process surrounding the
development of U.S. Basel II capital rules, the characterization of a financial product as a
security or a futures contract, and the scope of banks’ insurance sales.
Finally, a functional system also results in duplication of certain common activities across
regulators. While some degree of specialization might be important for the regulation of
financial institutions, many aspects of financial regulation and consumer protection
regulation have common themes. For example, although key measures of financial health
have different terminology in banking and insurance—capital and surplus respectively—they
both serve a similar function of ensuring the financial strength and ability of financial
institutions to meet their obligations. Similarly, while there are specific differences across
institutions, the goal of most consumer protection regulation is to ensure consumers receive
adequate information regarding the terms of financial transactions and industry complies with
appropriate sales practices.
Treasury has developed each and every recommendation in this report in the spirit of
promoting market stability and consumer protection. Following is a brief summary of these
Short-Term Recommendations
This section describes recommendations designed to be implemented immediately in the
wake of recent events in the credit and mortgage markets to strengthen and enhance market
stability and business conduct regulation. Treasury views these recommendations as a useful
transition to the intermediate-term recommendations and the proposed optimal regulatory
structure model. However, each recommendation stands on its own merits.
President’s Working Group on Financial Markets
In the aftermath of the 1987 stock market decline an Executive Order established the
President’s Working Group on Financial Markets (“PWG”). The PWG includes the heads of
Treasury, the Federal Reserve, the Securities and Exchange Commission (“SEC”), and the
Commodity Futures Trading Commission (“CFTC”) and is chaired by the Secretary of
Treasury. The PWG was instructed to report on the major issues raised by that stock market
decline and on other recommendations that should be implemented to enhance market
integrity and maintain investor confidence. Since its creation in 1988, the PWG has remained
an effective and useful inter-agency coordinator for financial market regulation and policy
Treasury recommends the modernization of the current PWG Executive Order in four
different respects to enhance the PWG’s effectiveness as a coordinator of financial regulatory
First, the PWG should continue to serve as an ongoing inter-agency body to promote
coordination and communication for financial policy. But the PWG’s focus should be
broadened to include the entire financial sector, rather than solely financial markets.
Second, the PWG should facilitate better inter-agency coordination and communication in
four distinct areas: mitigating systemic risk to the financial system, enhancing financial
market integrity, promoting consumer and investor protection, and supporting capital markets
efficiency and competitiveness.
Third, the PWG’s membership should be expanded to include the heads of the Office of the
Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”),
and the Office of Thrift Supervision (“OTS”). Similarly, the PWG should have the ability to
engage in consultation efforts, as might be appropriate, with other domestic or international
regulatory and supervisory bodies.
Finally, it should be made clear that the PWG should have the ability to issue reports or other
documents to the President and others, as appropriate, through its role as the coordinator for
financial regulatory policy.
Mortgage Origination
The high levels of delinquencies, defaults, and foreclosures among subprime borrowers in
2007 and 2008 have highlighted gaps in the U.S. oversight system for mortgage origination.
In recent years mortgage brokers and lenders with no federal supervision originated a
substantial portion of all mortgages and over 50 percent of subprime mortgages in the United
States. These mortgage originators are subject to uneven degrees of state level oversight (and
in some cases limited or no oversight).
However, the weaknesses in mortgage origination are not entirely at the state level. Federally
insured depository institutions and their affiliates originated, purchased, or distributed some
problematic subprime loans. There has also been some debate as to whether the OTS, the
Federal Reserve, the Federal Trade Commission (“FTC”), state regulators, or some
combination of all four oversees the affiliates of federally insured depository institutions.
To address gaps in mortgage origination oversight, Treasury’s recommendation has three
First, a new federal commission, the Mortgage Origination Commission (“MOC”), should be
created. The President should appoint a Director for the MOC for a four to six-year term. The
Director would chair a six-person board comprised of the principals (or their designees) of
the Federal Reserve, the OCC, the OTS, the FDIC, the National Credit Union Administration,
and the Conference of State Bank Supervisors. Federal legislation should set forth (or provide
authority to the MOC to develop) uniform minimum licensing qualification standards for
state mortgage market participants. These should include personal conduct and disciplinary
history, minimum educational requirements,
testing criteria and procedures, and appropriate license revocation standards. The MOC
would also evaluate, rate, and report on the adequacy of each state’s system for licensing and
regulation of participants in the mortgage origination process. These evaluations would grade
the overall adequacy of a state system by descriptive categories indicative of a system’s
strength or weakness. These evaluations could provide further information regarding whether
mortgages originated in a state should be viewed cautiously before being securitized. The
public nature of these evaluations should provide strong incentives for states to address
weaknesses and strengthen their own systems.
Second, the authority to draft regulations for national mortgage lending laws should continue
to be the sole responsibility of the Federal Reserve. Given its existing role, experience, and
expertise in implementing the Truth in Lending Act (“TILA”) provisions affecting mortgage
transactions, the Federal Reserve should retain the sole authority to write regulations
implementing TILA in this area.
Finally, enforcement authority for federal laws should be clarified and enhanced. For
mortgage originators that are affiliates of depository institutions within a federally regulated
holding company, mortgage lending compliance and enforcement must be clarified. Any
lingering issues concerning the authority of the Federal Reserve (as bank holding company
regulator), the OTS (as thrift holding company regulator), or state supervisory agencies in
conjunction with the holding company regulator to examine and enforce federal mortgage
laws with respect to those affiliates must be addressed. For independent mortgage originators,
the sector of the industry responsible for origination of the majority of subprime loans in
recent years, it is essential that states have clear authority to enforce federal mortgage laws
including the TILA provisions governing mortgage transactions.
Liquidity Provisioning by the Federal Reserve
The disruptions in credit markets in 2007 and 2008 have required the Federal Reserve to
address some of the fundamental issues associated with the discount window and the overall
provision of liquidity to the financial system. The Federal Reserve has considered alternative
ways to provide liquidity to the financial system, including overall liquidity issues associated
with non-depository institutions. The Federal Reserve has used its authority for the first time
since the 1930s to provide access to the discount window to non-depository institutions.
The Federal Reserve’s recent actions reflect the fundamentally different nature of the market
stability function in today’s financial markets compared to those of the past. The Federal
Reserve has balanced the difficult tradeoffs associated with preserving market stability and
considering issues associated with expanding the safety net.
Given the increased importance of non-depository institutions to overall market stability,
Treasury is recommending the consideration of two issues. First, the current temporary
liquidity provisioning process during those rare circumstances when market stability is
threatened should be enhanced to ensure that: the process is calibrated and transparent;
appropriate conditions are attached to lending; and information flows to the Federal Reserve
through on-site examination or other means as determined by the Federal Reserve are
adequate. Key to this information flow is a focus on liquidity and funding issues. Second, the
PWG should consider broader regulatory issues associated with providing discount window
access to non-depository institutions.
Intermediate-Term Recommendations
This section describes additional recommendations designed to be implemented in the
intermediate term to increase the efficiency of financial regulation. Some of these
recommendations can be accomplished relatively soon; consensus on others will be difficult
to obtain in the near term.
Thrift Charter
In 1933 Congress established the federal savings association charter (often referred to as the
federal thrift charter) in response to the Great Depression. The federal thrift charter originally
focused on providing a stable source of funding for residential mortgage lending. Over time
federal thrift lending authority has expanded beyond residential mortgages. For example,
Congress broadened federal thrifts’ investment authority in the 1980s and permitted the
inclusion of non-mortgage assets to meet the qualified-thrift lender test in 1996.
In addition, the role of federal thrifts as a dominant source of mortgage funding has
diminished greatly in recent years. The increased residential mortgage activity of
government-sponsored enterprises (“GSEs”) and commercial banks, as well as the general
development of the mortgage-backed securities market, has driven this shift.
Treasury recommends phasing out and transitioning the federal thrift charter to the national
bank charter as the thrift charter is no longer necessary to ensure sufficient residential
mortgage loans are made available to U.S. consumers. With the elimination of the federal
thrift charter the OTS would be closed and its operations would be assumed by the OCC.
This transition should take place over a two-year period.
Federal Supervision of State-Chartered Banks
State-chartered banks with federal deposit insurance are currently subject to both state and
federal supervision. If the state-chartered bank is a member of the Federal Reserve System,
the Federal Reserve administers federal oversight. Otherwise, the FDIC oversees state-
chartered banks.
The direct federal supervision of state-chartered banks should be rationalized. One approach
would be to place all such banking examination responsibilities for state-chartered banks with
federal deposit insurance with the Federal Reserve.
Another approach would be to place all such bank examination responsibilities for state-
chartered banks with federal deposit insurance with the FDIC.
Any such shift of supervisory authority for state-chartered banks with federal deposit
insurance from the Federal Reserve to the FDIC or vice versa raises a number of issues
regarding the overall structure of the Federal Reserve System. To further consider this issue,
Treasury recommends a study, one that examines the evolving role of Federal Reserve
Banks, to make a definitive proposal regarding the appropriate federal supervisor of state-
chartered banks.
Payment and Settlement Systems Oversight
Payment and settlement systems are the mechanisms used to transfer funds and financial
instruments between financial institutions and between financial institutions and their
customers. Payment and settlement systems play a fundamental and important role in the
economy by providing a range of mechanisms through which financial institutions can easily
settle transactions. The United States has various payment and settlement systems, including
large-value and retail payment and settlement systems, as well as settlement systems for
securities and other financial instruments.
In the United States major payment and settlement systems are generally not subject to any
uniform, specifically designed, and overarching regulatory system. Moreover, there is no
defined category within financial regulation focused on payment and settlement systems. As
a result, regulation of major payment and settlement systems is idiosyncratic, reflecting
choices made by payment and settlement systems based on options available at some
previous time.
To address the issue of payment and settlement system oversight, a federal charter for
systemically important payment and settlement systems should be created and should
incorporate federal preemption. The Federal Reserve should have primary oversight
responsibilities for such payment and settlement systems, should have discretion to designate
a payment and settlement system as systemically important, and should have a full range of
authority to establish regulatory standards.
For over 135 years, states have primarily regulated insurance with little direct federal
involvement. While a state-based regulatory system for insurance may have been appropriate
over some portion of U.S. history, changes in the insurance marketplace have increasingly
put strains on the system.
Much like other financial services, over time the business of providing insurance has moved
to a more national focus even within the state-based regulatory structure. The inherent nature
of a state-based regulatory system makes the process of developing national products
cumbersome and more costly, directly impacting the competitiveness of U.S. insurers.
There are a number of potential inefficiencies associated with the state-based insurance
regulatory system. Even with the efforts of the National Association of Insurance
Commissioners (“NAIC”) to foster greater uniformity through the development of model
laws and other coordination efforts, the ultimate authority still rests with individual states.
For insurers operating on a national basis, this means not only being subject to licensing
requirements and regulatory examinations in all states where the insurer operates, but also
operating under different laws in each state.
In addition to a more national focus today, the insurance marketplace operates globally with
many significant foreign participants. A state-based regulatory system creates increasing
tensions in such a global marketplace, both in the ability of U.S.-based firms to compete
abroad and in allowing greater participation of foreign firms in U.S. markets.
To address these issues in the near term, Treasury recommends establishing an optional
federal charter (“OFC”) for insurers within the current structure. An OFC structure should
provide for a system of federal chartering, licensing, regulation, and supervision for insurers,
reinsurers, and insurance producers (i.e., agents and brokers). It would also provide that the
current state-based regulation of insurance would continue for those not electing to be
regulated at the national level. States would not have jurisdiction over those electing to be
federally regulated. However, insurers holding an OFC could still be subject to some
continued compliance with other state laws, such as state tax laws, compulsory coverage for
workers’ compensation and individual auto insurance, as well as the requirements to
participate in state mandatory residual risk mechanisms and guarantee funds.
An OFC would be issued to specify the lines of insurance that each national insurer would be
permitted to sell, solicit, negotiate, and underwrite. For example, an OFC for life insurance
could also include annuities, disability income insurance, long-term care insurance, and
funding agreements. On the other hand, an OFC for property and casualty insurance could
include liability insurance, surety bonds, automobile insurance, homeowners, and other
specified lines of business. However, since the nature of the business of life insurers is very
different from that of property and casualty insurers, no OFC would authorize an insurer to
hold a license as both a life insurer and a property and casualty insurer.
The establishment of an OFC should incorporate a number of fundamental regulatory
concepts. For example, the OFC should ensure safety and soundness, enhance competition in
national and international markets, increase efficiency in a number of ways, including the
elimination of price controls, promote more rapid technological change, encourage product
innovation, reduce regulatory costs, and provide consumer protection.
Treasury also recommends the establishment of the Office of National Insurance (“ONI”)
within Treasury to regulate those engaged in the business of insurance pursuant to an OFC.
The Commissioner of National Insurance would head ONI and would have
specified regulatory, supervisory, enforcement, and rehabilitative powers to oversee the
organization, incorporation, operation, regulation, and supervision of national insurers and
national agencies.
While an OFC offers the best opportunity to develop a modern and comprehensive system of
insurance regulation in the short term, Treasury acknowledges that the OFC debate in
Congress is difficult and ongoing. At the same time, Treasury believes that some aspects of
the insurance segment and its regulatory regime require immediate attention. In particular,
Treasury recommends that Congress establish an Office of Insurance Oversight (“OIO”)
within Treasury. The OIO through its insurance oversight would be able to focus
immediately on key areas of federal interest in the insurance sector.
The OIO should be established to accomplish two main purposes. First, the OIO should
exercise newly granted statutory authority to address international regulatory issues, such as
reinsurance collateral. Therefore, the OIO would become the lead regulatory voice in the
promotion of international insurance regulatory policy for the United States (in consultation
with the NAIC), and it would be granted the authority to recognize international regulatory
bodies for specific insurance purposes. The OIO would also have authority to ensure that the
NAIC and state insurance regulators achieved the uniform implementation of the declared
U.S. international insurance policy goals. Second, the OIO would serve as an advisor to the
Secretary of Treasury on major domestic and international policy issues. Once Congress
passes significant insurance regulatory reform, the OIO could be incorporated into the OFC
Futures and Securities
The realities of the current marketplace have significantly diminished, if not entirely
eliminated, the original reason for the regulatory bifurcation between the futures and
securities markets. These markets were truly distinct in the 1930s at the time of the enactment
of the Commodity Exchange Act and the federal securities laws. This bifurcation operated
effectively until the 1970s when futures trading soon expanded beyond agricultural
commodities to encompass the rise and eventual dominance on non-agricultural
Product and market participant convergence, market linkages, and globalization have
rendered regulatory bifurcation of the futures and securities markets untenable, potentially
harmful, and inefficient. To address this issue, the CFTC and the SEC should be merged to
provide unified oversight and regulation of the futures and securities industries.
An oft-cited argument against the merger of the CFTC and the SEC is the potential loss of
the CFTC’s principles-based regulatory philosophy. Treasury would like to preserve the
market benefits achieved in the futures area. Accordingly, Treasury recommends that the
SEC undertake a number of specific actions, within its current regulatory structure and under
its current authority, to modernize the SEC’s regulatory approach to
accomplish a more seamless merger of the agencies. These recommendations would reflect
rapidly evolving market dynamics. These steps include the following:

• The SEC should use its exemptive authority to adopt core principles to apply to securities
clearing agencies and exchanges. These core principles should be modeled after the core
principles adopted for futures exchanges and clearing organizations under the
Commodity Futures Modernization Act (“CFMA”). By imbuing the SEC with a
regulatory regime more conducive to the modern marketplace, a merger between the
agencies will proceed more smoothly.

• The SEC should issue a rule to update and streamline the self-regulatory organization
(“SRO”) rulemaking process to recognize the market and product innovations of the past
two decades. The SEC should consider streamlining and expediting the SRO rule
approval process, including a firm time limit for the SEC to publish SRO rule filings and
more clearly defining and expanding the type of rules deemed effective upon filing,
including trading rules and administrative rules. The SEC should also consider
streamlining the approval for any securities products common to the marketplace as the
agency did in a 1998 rulemaking vis-à-vis certain derivatives securities products. An
updated, streamlined, and expedited approval process will allow U.S. securities firms to
remain competitive with the over-the-counter markets and international institutions and
increase product innovation and investor choice.

• The SEC should undertake a general exemptive rulemaking under the Investment Company
Act of 1940 (“Investment Company Act”), consistent with investor protection, to permit
the trading of those products already actively trading in the U.S. or foreign jurisdictions.
Treasury also recommends that the SEC propose to Congress legislation that would
expand the Investment Company Act by permitting registration of a new “global”
investment company.

These steps should help modernize the SEC’s regulation prior to the merger of the CFTC and
the SEC. Legislation merging the CFTC and the SEC should not only call for a structural
merger, but also a process to merge regulatory philosophies and to harmonize securities and
futures regulations and statutes. The merger plan should also address certain key aspects:

• Concurrent with the merger, the new agency should adopt overarching regulatory principles
focusing on investor protection, market integrity, and overall financial system risk
reduction. This will help meld the regulatory philosophies of the agencies. Legislation
calling for a merger should task the PWG with drafting these principles.

• Consistent with structure of the CFMA, all clearing agency and market SROs should be
permitted by statute to self-certify all rulemakings (except those involving corporate
listing and market conduct standards), which then become effective upon filing. The SEC
would retain its right to abrogate the rulemakings at any time. By


limiting self-certified SRO rule changes to non-retail investor related rules, investor
protection will be preserved.

• Several differences between futures regulation and federal securities regulation would need
to be harmonized. These include rules involving margin, segregation, insider trading,
insurance coverage for broker-dealer insolvency, customer suitability, short sales, SRO
mergers, implied private rights of action, the SRO rulemaking approval process, and the
agency’s funding mechanism. Due to the complexities and nuances of the differences in
futures and securities regulation, legislation should establish a joint CFTC-SEC staff task
force with equal agency representation with the mandate to harmonize these differences.
In addition, the task force should be charged with recommending the structure of the
merged agency, including its offices and divisions.

Finally, there has also been a continued convergence of the services provided by broker-
dealers and investment advisers within the securities industry. These entities operate under a
statutory regime reflecting the brokerage and investment advisory industries as they existed
decades ago. Accordingly, Treasury recommends statutory changes to harmonize the
regulation and oversight of broker-dealers and investment advisers offering similar services
to retail investors. In that vein, the establishment of a self-regulatory framework for the
investment advisory industry would enhance investor protection and be more cost-effective
than direct SEC regulation. Thus, to effectuate this statutory harmonization, Treasury
recommends that investment advisers be subject to a self-regulatory regime similar to that of
Long-Term Optimal Regulatory Structure
While there are many possible options to reform and strengthen the regulation of financial
institutions in the United States, Treasury considered four broad conceptual options in this
review. First, the United States could maintain the current approach of the GLB Act that is
broadly based on functional regulation divided by historical industry segments of banking,
insurance, securities, and futures. Second, the United States could move to a more functional-
based system regulating the activities of financial services firms as opposed to industry
segments. Third, the United States could move to a single regulator for all financial services
as adopted in the United Kingdom. Finally, the United States could move to an objectives-
based regulatory approach focusing on the goals of regulation as adopted in Australia and the
After evaluating these options, Treasury believes that an objectives-based regulatory
approach would represent the optimal regulatory structure for the future. An objectives-based
approach is designed to focus on the goals of regulation in terms of addressing particular
market failures. Such an evaluation leads to a regulatory structure focusing on three key

• Market stability regulation to address overall conditions of financial market stability
that could impact the real economy;


• Prudential financial regulation to address issues of limited market discipline caused by
government guarantees; and

• Business conduct regulation (linked to consumer protection regulation) to address
standards for business practices.

More closely linking the regulatory objectives of market stability regulation, prudential
financial regulation, and business conduct regulation to regulatory structure greatly improves
regulatory efficiency. In particular, a major advantage of objectives-based regulation is that
regulatory responsibilities are consolidated in areas where natural synergies take place, as
opposed to the current approach of dividing these responsibilities among individual
regulators. For example, a dedicated market stability regulator with the appropriate mandate
and authority can focus broadly on issues that can impact market stability across all types of
financial institutions. Prudential financial regulation housed within one regulatory body can
focus on common elements of risk management across financial institutions. A dedicated
business conduct regulator leads to greater consistency in the treatment of products,
eliminates disputes among regulatory agencies, and reduces gaps in regulation and
In comparison to other regulatory structures, an objectives-based approach is better able to
adjust to changes in the financial landscape than a structure like the current U.S. system
focused on industry segments. An objectives-based approach also allows for a clearer focus
on particular goals in comparison to a structure that consolidates all types of regulation in one
regulatory body. Finally, clear regulatory dividing lines by objective also have the most
potential for establishing the greatest levels of market discipline because financial regulation
can be more clearly targeted at the types of institutions for which prudential regulation is
most appropriate.
In the optimal structure three distinct regulators would focus exclusively on financial
institutions: a market stability regulator, a prudential financial regulator, and a business
conduct regulator. The optimal structure also describes the roles of two other key authorities,
the federal insurance guarantor and the corporate finance regulator.
The optimal structure also sets forth a structure rationalizing the chartering of financial
institutions. The optimal structure would establish a federal insured depository institution
(“FIDI”) charter for all depository institutions with federal deposit insurance; a federal
insurance institution (“FII”) charter for insurers offering retail products where some type of
government guarantee is present; and a federal financial services provider (“FFSP”) charter
for all other types of financial services providers. The market stability regulator would have
various authorities over all three types of federally chartered institutions. A new prudential
regulator, the Prudential Financial Regulatory Agency (“PFRA”), would be responsible for
the financial regulation of FIDIs and FIIs. A new business conduct regulator, the Conduct of
Business Regulatory Agency (“CBRA”), would be responsible for business conduct
regulation, including consumer protection issues, across all types of firms, including the three
types of federally chartered institutions. More detail regarding the responsibilities of these
regulators follows.
Market Stability Regulator – The Federal Reserve
The market stability regulator should be responsible for overall issues of financial market
stability. The Federal Reserve should assume this role in the optimal framework given its
traditional central bank role of promoting overall macroeconomic stability. As is the case
today, important elements of the Federal Reserve’s market stability role would be conducted
through the implementation of monetary policy and the provision of liquidity to the financial
system. In addition, the Federal Reserve should be provided with a different, yet critically
important regulatory role and broad powers focusing on the overall financial system and the
three types of federally chartered institutions (i.e., FIIs, FIDIs, or FFSPs). Finally, the Federal
Reserve should oversee the payment and settlement system.
In terms of its recast regulatory role focusing on systemic risk, the Federal Reserve should
have the responsibility and authority to gather appropriate information, disclose information,
collaborate with the other regulators on rule writing, and take corrective actions when
necessary in the interest of overall financial market stability. This new role would replace its
traditional role as a supervisor of certain banks and all bank holding companies.
Treasury recognizes the need for enhanced regulatory authority to deal with systemic risk.
The Federal Reserve’s responsibilities would be broad, important, and difficult to undertake.
In a dynamic market economy it is impossible to fully eliminate instability through
regulation. At a fundamental level, the root causes of market instability are difficult to
predict, and past history may be a poor predictor of future episodes of instability. However,
the Federal Reserve’s enhanced regulatory authority along with clear regulatory
responsibilities would complement and attempt to focus market discipline to limit systemic

A number of key long-term issues should be considered in establishing this new framework.
First, in order to perform this critical role, the Federal Reserve must have detailed
information about the business operations of PFRA- and CBRA-regulated financial
institutions and their respective holding companies. Such information will be important in
evaluating issues that can have an impact on overall financial market stability.
The other regulators should be required to share all financial reports and examination reports
with the Federal Reserve as requested. Working jointly with PFRA, the Federal
Treasury notes that the PWG, the Federal Reserve Bank of New York, and the OCC have previously
stated that market discipline is the most effective tool to limit systemic risk. See Agreement among PWG
and U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of Capital (Feb. 2007).
ACT 34-35 (Nov. 1999).
Reserve should also have the ability to develop additional information-reporting requirements
on issues important to overall market stability.
The Federal Reserve should also have the authority to develop information-reporting
requirements for FFSPs and for holding companies with federally chartered financial
institution affiliates. In terms of holding company reporting requirements, such reporting
should include a requirement to consolidate financial institutions onto the balance sheet of
the overall holding company and at the segmented level of combined federally chartered
financial institutions. Such information-reporting requirements could also include detailed
reports on overall risk management practices.
As an additional information-gathering tool, the Federal Reserve should also have the
authority to participate in PFRA and CBRA examinations of federally chartered entities, and
to initiate such examinations targeted on practices important to market stability. Targeted
examinations of a PFRA- or CBRA-supervised entity should occur only if the information
the Federal Reserve needs is not available from PFRA or CBRA and should be coordinated
with PFRA and CBRA.
Based on the information-gathering tools described above, the Federal Reserve should
publish broad aggregates or peer group information about financial exposures that are
important to overall market stability. Disseminating such information to the public could
highlight areas of risk exposure that market participants should be monitoring. The Federal
Reserve should also be able to mandate additional public disclosures for federally chartered
financial institutions that are publicly traded or for a publicly traded company controlling
such an institution.
Second, the type of information described above will be vitally important in performing the
market stability role and in better harnessing market forces. However, the Federal Reserve
should also have authority to provide input into the development of regulatory policy and to
undertake corrective actions related to enhancing market stability. With respect to regulatory
policy, PFRA and CBRA should be required to consult with the Federal Reserve prior to
adopting or modifying regulations affecting market stability, including capital requirements
for PFRA-regulated institutions and chartering requirements for CBRA-regulated institutions,
and supervisory guidance regarding areas important to market stability (e.g., liquidity risk
management, contingency funding plans, and counterparty risk management).
With regard to corrective actions, if after analyzing the information described above the
Federal Reserve determines that certain risk exposures pose an overall risk to the financial
system or the broader economy, the Federal Reserve should have authority to require
corrective actions to address current risks or to constrain future risk-taking. For example, the
Federal Reserve could use this corrective action authority to require financial institutions to
limit or more carefully monitor risk exposures to certain asset classes or to certain types of
counterparties or address liquidity and funding issues.
The Federal Reserve’s authority to require corrective actions should be limited to instances
where overall financial market stability was threatened. The focus of the market stability
regulator’s corrective actions should wherever possible be broadly based across particular
institutions or across asset classes. Such actions should be coordinated and implemented with
the appropriate regulatory agency to the fullest extent possible. But the Federal Reserve
would have residual authority to enforce compliance with its requirements under this
Third, the Federal Reserve’s current lender of last resort function should continue through the
discount window. A primary function of the discount window is to serve as a complementary
tool of monetary policy by making short-term credit available to insured depository
institutions to address liquidity issues. The historic focus of Federal Reserve discount
window lending reflects the relative importance of banks as financial intermediaries and a
desire to limit the spread of the federal safety net. However, banks’ somewhat diminished
role and the increased role of other types of financial institutions in overall financial
intermediation may have reduced the effectiveness of this traditional tool in achieving market
To address the limited effectiveness of discount window lending over time, a distinction
could be made between “normal” discount window lending and “market stability” discount
window lending. Access to normal discount window funding for FIDIs—including
borrowing under the primary, secondary, and seasonal credit programs—could continue to
operate much as it does today. All FIDIs would have access to normal discount window
funding, which would continue to serve as a complementary tool of monetary policy by
providing a mechanism to smooth out short-term volatility in reserves, and providing some
degree of liquidity to FIDIs. Current Federal Reserve discount window policies regarding
collateral, above market pricing, and maturity should remain in place. With such policies in
place, normal discount window funding would likely be used infrequently.
In addition, the Federal Reserve should have the ability to undertake market stability discount
window lending. Such lending would expand the Federal Reserve’s lender of last resort
function to include non-FIDIs. A sufficiently high threshold for invoking market stability
discount window lending (i.e., overall threat to financial system stability) should be
established. Market stability discount window lending should be focused wherever possible
on broad types of institutions as opposed to individual institutions. In addition, market
stability discount window lending would have to be supported by Federal Reserve authority
to collect information from and conduct examinations of borrowing firms in order to protect
the Federal Reserve (and thereby the taxpayer).
Prudential Financial Regulator
The optimal structure should establish a new prudential financial regulator, PFRA. PFRA
should focus on financial institutions with some type of explicit government guarantees
associated with their business operations. Most prominent examples of this type of
government guarantee in the United States would include federal deposit
insurance and state-established insurance guarantee funds. Although protecting consumers
and helping to maintain confidence in the financial system, explicit government guarantees
often erode market discipline, creating the potential for moral hazard and a clear need for
prudential regulation. Prudential regulation in this context should be applied to individual
firms, and it should operate like the current regulation of insured depository institutions, with
capital adequacy requirements, investment limits, activity limits, and direct on-site risk
management supervision. PFRA would assume the roles of current federal prudential
regulators, such as the OCC and the OTS.
A number of key long-term issues should be considered in establishing the new prudential
regulatory framework. First, the optimal structure should establish a new FIDI charter. The
FIDI charter would consolidate the national bank, federal savings association, and federal
credit union charters and should be available to all corporate forms, including stock, mutual,
and cooperative ownership structures. A FIDI charter should provide “field” preemption over
state laws to reflect the national nature of financial services. In addition, to obtain federal
deposit insurance a financial institution would have to obtain a FIDI charter. PFRA’s
prudential regulation and oversight should accompany the provision of federal deposit
insurance. The goal of establishing a FIDI charter is to create a level playing field among all
types of depository institutions where competition can take place on an economic basis rather
than on the basis of regulatory differences.
Activity limits should be imposed on FIDIs to serve the traditional prudential function of
limiting risk to the deposit insurance fund. A starting place could be the activities that are
currently permissible for national banks.
PFRA’s regulation regarding affiliates should be based primarily at the individual FIDI level.
Extending PFRA’s direct oversight authority to the holding company should be limited as
long as PFRA has an appropriate set of tools to protect a FIDI from affiliate relationships. At
a minimum, PFRA should be provided the same set of tools that exists today at the individual
bank level to protect a FIDI from potential risks associated with affiliate relationships. In
addition, consideration should be given to strengthen further PFRA’s authority in terms of
limiting transactions with affiliates or requiring financial support from affiliates. PFRA
should be able to monitor and examine the holding company and the FIDI’s affiliates in order
to ensure the effective implementation of these protections. With these added protections in
place, from the perspective of protecting a FIDI, activity restrictions on affiliate relationships
are much less important.
Holding company regulation was designed to protect the assets of the insured depository
institution and to prevent the affiliate structure from threatening the assets of the insured
institution. However, some view holding company supervision as way to protect against
systemic risk. The optimal structure decouples those two regulatory objectives as the blurring
of these objectives is ineffective and confusing. Therefore, PFRA will focus on the original
intent of holding company supervision, protecting the assets of the insured depository
institution; and a new market stability regulator will focus on broader systemic risk issues.
Second, to address the inefficiencies in the state-based insurance regulatory system, the
optimal structure should establish a new FII charter. Similar to the FIDI charter, a FII charter
should apply to insurers offering retail products where some type of government guarantee is
present. In terms of a government guarantee, in the long run a uniform and consistent
federally established guarantee structure, the Federal Insurance Guarantee Fund (“FIGF”),
could accompany a system of federal oversight, although the existing state-level guarantee
system could remain in place. PFRA would be responsible for the financial regulation of FIIs
under the same structure as FIDIs.
Finally, some consideration should focus on including GSEs within the traditional prudential
regulatory framework. Given the market misperception that the federal government stands
behind the GSEs’ obligations, one implication of the optimal structure is that PFRA should
not regulate the GSEs. Nonetheless, given that the federal government has charged the GSEs
with a specific mission, some type of prudential regulation would be necessary to ensure that
they can accomplish that mission. To address these challenging issues, in the near term, a
separate regulator should conduct prudential oversight of the GSEs and the market stability
regulator should have the same ability to evaluate the GSEs as it has for other federally
chartered institutions.
Business Conduct Regulator
The optimal structure should establish a new business conduct regulator, CBRA. CBRA
should monitor business conduct regulation across all types of financial firms, including FIIs,
FIDIs, and FFSPs. Business conduct regulation in this context includes key aspects of
consumer protection such as disclosures, business practices, and chartering and licensing of
certain types of financial firms. One agency responsible for all financial products should
bring greater consistency to areas of business conduct regulation where overlapping
requirements currently exist. The business conduct regulator’s chartering and licensing
function should be different than the prudential regulator’s financial oversight
responsibilities. More specifically, the focus of the business conduct regulator should be on
providing appropriate standards for firms to be able to enter the financial services industry
and sell their products and services to customers.
A number of key long-term issues should be considered in establishing the new business
conduct regulatory framework.
First, as part of CBRA’s regulatory function, CBRA would be responsible for the chartering
and licensing of a wide range of financial firms. To implement the chartering function, the
optimal structure should establish a new FFSP charter for all financial services providers that
are not FIDIs or FIIs. The FFSP charter should be flexible enough to incorporate a wide
range of financial services providers, such as broker-dealers, hedge funds, private equity
funds, venture capital funds, and mutual funds. The establishment of a FFSP charter would
result in the creation of appropriate national standards, in terms of financial capacity,
expertise, and other requirements, that must be satisfied to enter the business of providing
financial services. For example, these standards would resemble
the net capital requirements for broker-dealers for that type of FFSP charter. In addition to
meeting appropriate financial requirements to obtain a FFSP charter, these firms would also
have to remain in compliance with appropriate standards and provide regular updates on
financial conditions to CBRA, the Federal Reserve, and the public as part of their standard
public disclosures. CBRA would also oversee and regulate the business conduct of FIDIs and
Second, the optimal structure should clearly specify the types of business conduct issues
where CBRA would have oversight authority. In terms of FIDIs’ banking and lending,
CBRA should have oversight responsibilities in three broad categories: disclosure, sales and
marketing practices (including laws and regulations addressing unfair and deceptive
practices), and anti-discrimination laws. Similar to banking and lending, CBRA should have
the authority to regulate FIIs’ insurance business conduct issues associated with disclosures,
business practices, and discrimination. CBRA’s main areas of authority would include
disclosure issues related to policy forms, unfair trade practices, and claims handling
In term of business conduct issues for FFSPs, such as securities and futures firms and their
markets, CBRA’s focus would include operational ability, professional conduct, testing and
training, fraud and manipulation, and duties to customers (e.g., best execution and investor
Third, CBRA’s responsibilities for business conduct regulation in the optimal structure would
be very broad. CBRA’s responsibilities would take the place of those of the Federal Reserve
and other insured depository institution regulators, state insurance regulators, most aspects of
the SEC’s and the CFTC’s responsibilities, and some aspect of the FTC’s role.
Given the breadth and scope of CBRA’s responsibilities, some aspect of self-regulation
should form an important component of implementation. Given its significance and
effectiveness in the futures and securities industry, the SRO model should be preserved. That
model could be considered for other areas, or the structure could allow for certain
modifications, such as maintaining rule writing authority with CRBA, while relying on an
SRO model for compliance and enforcement.
Finally, the proper role of state authorities should be established in the optimal structure.
CBRA would be responsible for setting national standards for a wide range of business
conduct laws across all types of financial services providers. CBRA’s national standards
would apply to all financial services firms, whether federally or state-chartered. In addition,
field preemption would be provided to FIDIs, FIIs, and FFSPs, preempting state business
conduct laws directly relating to the provision of financial services.
In the optimal structure, states would still retain clear authority to enact laws and take
enforcement actions against state-chartered financial service providers. In considering the
future role of the states vis-à-vis federally chartered institutions, the optimal structure seeks
to acknowledge the existing national market for financial products, while at the
same time preserving an appropriate role for state authorities to respond to local conditions.
Two options should be considered to accomplish that goal. First, state authorities could be
given a formalized role in CBRA’s rulemaking process as a means of utilizing their extensive
local experience. Second, states could also play a role in monitoring compliance and
Federal Insurance Guarantee Corporation
The FDIC should be reconstituted as the Federal Insurance Guarantee Corporation (“FIGC”)
to administer not only deposit insurance, but also the FIGF (if one is created and valid
reasons to leave this at the state level exist as discussed in the report). The FIGC should
function primarily as an insurer in the optimal structure. Much as the FDIC operates today,
the FIGC would have the authority to set risk-based premiums, charge ex-post assessments,
act as a receiver for failed FIDIs or FIIs, and maintain some back-up examination authority
over those institutions. The FIGC will not possess any additional direct regulatory authority.
Corporate Finance Regulator
The corporate finance regulator should have responsibility for general issues related to
corporate oversight in public securities markets. These responsibilities should include the
SEC’s current responsibilities over corporate disclosures, corporate governance, accounting
oversight, and other similar issues. As discussed above, CBRA would assume the SEC’s
current business conduct regulatory and enforcement authority over financial institutions.
The United States has the strongest and most liquid capital markets in the world. This
strength is due in no small part to the U.S. financial services industry regulatory structure,
which promotes consumer protection and market stability. However, recent market
developments have pressured this regulatory structure, revealing regulatory gaps and
redundancies. These regulatory inefficiencies may serve to detract from U.S. capital markets
In order to ensure the United States maintains its preeminence in the global capital markets,
Treasury sets forth the aforementioned recommendations to improve the regulatory structure
governing financial institutions. Treasury has designed a path to move from the current
functional regulatory approach to an objectives-based regulatory regime through a series of
specific recommendations. The short-term recommendations focus on immediate reforms
responding to the current events in the mortgage and credit markets. The intermediate
recommendations focus on modernizing the current regulatory structure within the current
functional system.
The short-term and intermediate recommendations will drive the evolution of the U.S.
regulatory structure towards the optimal regulatory framework, an objectives-based regime
directly linking the regulatory objectives of market stability regulation, prudential financial
regulation, and business conduct regulation to the regulatory structure. Such a framework
best promotes consumer protection and stable and innovative markets.