MercoPress. South Atlantic News Agency

US government proposes sweeping reforms to financial regulation

The Federal Reserve is set to play a greater role in the programmed reform

The US government is planning a major overhaul of the system of financial regulation to avoid future crises. The broad outlines of the plan were revealed on Monday by US Treasury Secretary Tim Geithner and White House economic adviser Larry Summers.

The plans will lead to tighter regulation of the biggest financial institutions and a new framework for consumer and investor protection.

But the creation of a single regulator for all banks has been abandoned.

Mr Geithner and Mr Summers said that the current system of regulation was “riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk”.

They added: “Reassuring the American people that our financial system will be better controlled, is critical to our economic recovery.”

In the biggest shake-up of financial regulation since the New Deal in the 1930s, the Obama administration is proposing giving the Federal Reserve the power to supervise any large financial institution which could threaten the financial system as a whole.

Proposals include giving the power to seize control of those institutions through an “orderly resolution mechanism” if their failure might cause a financial panic.

In the past, it was the inability of the Fed to take control of non-banking financial institutions like Lehman Brothers and Bear Stearns that led to the deepening of the crisis.

The proposals are likely to be published on Wednesday and then will have to be considered by Congress, where they could face opposition.

Some Congressional leaders are likely to be concerned about the “moral hazard” inherent in giving the Fed the power to bail out the most powerful firms, and what guarantees they should be required to give in return.

Another key stumbling block in Congress will be the role of the Fed in relation to other regulators.

Earlier plans to consolidate all regulation into a single authority have been abandoned.

Instead, the government will establish a council of regulators with broader co-ordinating authority across the system.

The confused and overlapping system of banking regulation has often been cited as one of the key reasons for the credit crunch and the spread of sub-prime lending.

But the Federal Deposit Insurance Corporation (FDIC), which regulates the smaller community banks, will retain its role after an intense lobbying campaign in Congress by its chair Sheila Bair.

The Office of the Comptroller of the Currency, part of the Treasury, will retain regulation over larger banks, but the third Federal regulator, the Office of Thrift Supervision, which regulates savings banks and some larger non-bank holding companies, is likely to be abolished.

Countrywide, the collapsed sub-prime lender fell under the Office of Thrift Supervision.

Nevertheless the new reforms will strengthen the role of the central bank, the Federal Reserve, in particular to require the larger firms to hold more capital and liquidity than smaller firms in order to “keep them safe in times of system-wide stress”.

Mr Geithner says that “in a world where the troubles of a few large firms can put the entire system at risk” such changes are necessary.

The government is planning to further regulate the market for asset-backed securities, such as residential mortgage-backed securities (RMBS) which were at the heart of the sub-prime crisis.

The ability of firms to sell off their risky mortgages to other companies “led to an erosion of lending standards that fed the housing boom and deepened the housing bust”.

So the Obama administration wants to require the originator of such securities to retain a financial interest in its performance, and plans to tighten up the amount of information the sellers of these securities are required to give, to reduce the influence of credit ratings agencies, who often gave such securities their seal of approval.

As announced earlier, there will also be tighter regulation of derivatives - financial products in which firms bet on the outcome of financial events, such as interest rate changes or defaults - and tighter regulation of the over-the-counter market for such products.

It was the failure to regulate Credit Default Swaps (CDS) which led to the biggest collapse in the financial crisis, the fall of the US insurance giant AIG.

But again, the administration has backed off from a turf war that would have resulted from its earlier proposal to merge the Securities and Exchange Commission (SEC), which regulates the stock market, with the Commodity Futures Trading Commission (CFTC), which regulates derivatives traded by many of the same firms.

Its plan to create a new consumer regulator to oversee credit cards and mortgages will still leave the SEC to regulate other consumer investment products, such as mutual funds. The hope is that the new approach will lead to a fundamental change in the behaviour of banks.

“Considerations of stability, safety, and systematic risk will have to loom larger in the planning and thinking of every financial institution,” Mr Summers said last week.

And the Obama administration is also committed to “leading the effort to improve supervision and regulation around the world” which was agreed at the G20 summit.

“Risk and leverage tend to migrate to where the constraints are weakest,” Mr Geithner told the G8 finance ministers meeting in Italy at the weekend. “We need a level playing field globally, or the effectiveness of our national safeguards against risk will be undermined.”

However, there is likely to be considerable debate about how tough the capital requirements will be for global banks, with the new Financial Stability Board likely to take up the issue during its deliberations later in the year. (BBC)