Functional regulation needs to be expanded

Functional regulation has several advantages. It provides an agency with specialized expertise to oversee the relevant financial function.

It establishes a level playing field for all firms performing the same financial function; they are all subject to the same set of regulations. In addition, a functional regulator is smaller and more nimble than a division of a large umbrella bureaucracy. Congress and the public have a better chance to evaluate the effectiveness of a government regulator as a stand-alone agency than as part of a large organization.

Congress needs to expand functional regulation in five areas.

First, it should create one federal regulator for the function of mortgage origination, oversight of which presently is scattered across federal and state agencies. At the federal level, the Federal Reserve sets the rules on mortgage lending, the Federal Trade Commission issues rules on mortgage advertising, and the Department of Housing and Urban Development acts as a backup licensing agency for mortgage lenders if they are not licensed by one of the 50 states. Congress should combine these rulemaking functions into one federal agency with a consumer protection orientation. Congress should also give that agency sufficient resources to enforce the rules on mortgage origination in conjunction with the states.

Second, Congress should allow a small number of large, global U.S. life insurers to apply for a national charter, just as banks may obtain a national charter. At present, U.S. insurance companies are chartered and regulated by the 50 states. This arrangement imposes a substantial administrative burden on large life insurers, without much benefit, as they utilize the same actuarial tables for people in all states.

With a national charter, a life insurer could simply obtain approval for its policies from the federal insurance regulator — probably a new agency — and file a notice of such policy approval with all relevant states.

Of course, the states would object to a national charter for any insurance company. Under this proposal, however, states would retain jurisdiction over all property-and-casualty insurers since they tend to be more oriented to local conditions.

States would also retain jurisdiction over the vast majority of life insurers — those that did not reach the high size requirement for a national charter.

Third, Congress should bolster regulatory coverage in the area of financial derivatives. Specifically, it should grant to the Securities and Exchange Commission or the Commodity Futures Trading Commission the broad authority to regulate all financial derivatives, including those negotiated in private markets as well as traded on public exchanges.

Whoever has this authority should move quickly to establish a centralized clearing mechanism for credit default swap contracts, which are currently negotiated in private markets, with little information available about who owns which contracts. If most CDS contracts were standardized and settled through a centralized clearing corporation, it could identify the parties to these contracts and require them to make cash deposits at the start of each contract. As market prices moved, the parties would be required to increase or decrease their cash deposits in order to limit the disruption that might be caused by the demise of any party to a CDS contract.

Several groups within and outside the United States have been approved by regulators as a clearinghouse for CDS. However, infighting among various groups who hope to have the dominant facility has precluded the successful launch of a single clearinghouse.

It would be most operationally efficient to have only one global clearinghouse for all CDS, or perhaps one for the United States and another for Europe. One centralized clearance and settlement system has dramatically lowered costs and risks for stock trading in the United States.

On the other hand, certain CDS contracts will be so customized that they cannot easily be processed through a centralized clearinghouse. To encourage financial institutions to use standardized CDS contracts, regulators should set substantially higher capital requirements for customized CDS contracts.

Fourth, Congress should strengthen functional regulation in the area of hedge funds, which are active traders and short-sellers. The assets of hedge funds have grown dramatically, from less than $250 billion in 1995 to almost $1.8 trillion at the end of 2007. During that period, the near collapse of one highly leveraged hedge fund, Long-Term Capital Management LLC, almost wreaked havoc in the bond markets. Other hedge funds have been involved more recently in major scandals, including the Bernard Madoff Ponzi scheme. Yet, neither hedge funds nor their managers are required to register with any federal agency.

Congress should require the managers of hedge funds over a certain size to register with the SEC under the Investment Advisers Act of 1940. Such registration would not limit their investment strategies, although they would be subject to SEC inspections.

In addition, Congress should require a handful of very large hedge funds to submit non-public reports with information relevant to systemic risks, such as leverage ratios and liquidity measures. However, the same registration and reporting requirements should not apply to managers of venture capital or private-equity funds, as the Department of the Treasury has proposed. These two types of funds are not run by traders or short-sellers; they acquire controlling interests through negotiated agreements in a wide range of operating companies.

Finally, Congress should enhance functional regulation by providing a consolidated regulator for any diversified financial conglomerate offering multiple financial services through regulated and unregulated subsidiaries.

The Fed already plays the role of consolidated regulator for all the parts of a diversified financial conglomerate organized under a bank holding company. However, a broad array of companies may own exempt banks — such as trust companies, credit card banks or industrial loan companies — without becoming a bank holding company. An even broader array of industrial companies may own one savings and loan association with few regulatory restrictions. As the Treasury Department has suggested, Congress should generally close these loopholes to keep industrial companies like Deere & Co. or Target Corp. from owning a bank, unless the exempt bank does not take insured deposits or it is broadly prohibited from extending any credit to the industrial company or its affiliates.

In contrast to the Fed, the SEC and the CFTC have limited jurisdiction over holding companies of registered firms. For example, the SEC had jurisdiction over only seven of the 200 affiliates of Lehman Brothers Holdings Inc.

Therefore, Congress should broaden the jurisdiction of the SEC and the CFTC to include the parent and all affiliates of any broker-dealer or commodity futures merchant if that parent or affiliate is not already supervised by a competent agency. This legislative change would ensure that transfers within the consolidated group were not manipulated to hide problems and that risky activities were not shifted to an unsupervised affiliate, without duplicating coverage of an already supervised affiliate.

For example, if a bank holding company owned a broker-dealer or mutual fund adviser that is registered with the SEC, the commission would have supervisory authority only over those entities. On the other hand, the SEC’s supervisory powers would extend to an affiliate of a SEC-registered broker if that affiliate were not regulated by the Fed or other financial agency.

From “Too Big to Save? How to Fix the U.S. Financial System” by Robert Pozen (John Wiley & Sons Inc., 2009). Mr. Pozen is chairman of MFS Investment Management.

For archived excerpts, go to InvestmentNews.com/advisersbookshelf.

Related Topics: Adviser's Bookshelf