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.

No comments: