ALERT: Reg Reform - HFSC Wraps Up "Addressing the Need for Comprehensive Regulatory Reform" - *Cumulative* Recap

On March 26, 2009, the HFSC has wrapped up its hearing "Addressing the Need for Comprehensive Regulatory Reform" at which Geithner laid out the Administration's 40,000 foot plans with respect to regulatory reform in preparation for next week's G20 summit in London. In his testimony, Geithner indicated that the Administration was approaching the regulatory reform issue in a four step process including: systemic risk, consumer and investor protection, eliminating gaps in our regulatory structure, and international coordination. Within the context of that first issue of systemic risk, Geithner's testimony sets forth a six-step process: (1) creation of a single (yet to be determined) independent regulator for systemically important firms; (2) establishment of higher standards on capital and risk management for systemically important firms; (3) registration of all hedge fund advisors with assets above a given threshold; (4) OTC derivatives market oversight, protections and disclosure; (5) new requirements for money market funds; and (6) creation of a resolution authority for non-bank institutions.

Key issues raised included systemic risk regulator, preventing "too big to fail," regulation of hedge funds, regulation of derivatives, insurance company regulation, money market fund regulation, consumer protection, creation of a resolution authority, taxpayer burden of government intervention, unintended consequences, among other issues further discussed below. To some extent, the hearing raised more questions than answers about the Administration's plans for regulatory reform, as questions such as whether the Federal Reserve or FDIC, or other entity, should take on role of systemic risk regulator remain open for debate.

I. Opening Statements

Key issues raised in opening statements included (1) restricting excessive leverage; (2) resolution process; (3) hedge funds; (4) insurance companies; and (5) unintended consequences. To recap:

(1) Policy Needed to Restrict Excessive Leverage, to Impose Rules on Curtailing Abuses of Value-Added Innovations. Chairman Frank (D-MA) expressed support for increasing the authority of some entity or entities in the government to restrict excessive leverage. He acknowledged that allowing a “too big to fail” entity to fail without intervention would create magnifying effect, yet indicated his preference of prevent entities from getting too big to fail in the first place. Chairman Frank said he believes securitization and CDOs, credit default swaps, are a set of innovations that have added great value to magnify the value of value; however there were problems that there were no rules to allow the society to get the benefit of value-added innovations while curtailing the abuses.

(2) Support for Need for Resolution Process, But Criticism of Treasury’s Proposal as Using Taxpayer Money and Giving Too Much Discretion to FDIC and Federal Reserve. Ranking Member Bachus (R-AL) criticized that the taxpayer is continuing to get the bill for bailouts of “too big to fail” entities. He indicated that regulators must strive for a system where institutions can succeed or fail without having systemic consequences on the whole system; he supports creating a new regime to resolve or liquidate non-bank financial institutions. However, he criticized the Administration’s proposal for a resolution entity because (1) it would use taxpayer funds as perpetuating moral hazard; and (2) the proposal would give the FDIC and Federal Reserve too much discretion on determining whether to unwind an institution or save the institution.

(3) Including Hedge Funds and Private Pools of Capital in Resolution Authority. Rep. Kanjorski (D-PA) praised establishment of resolution authority to prepare us for calamities down the road. Rep. Kanjorski raised “shadow system” issue and noted that Congress must include hedge fund and private pools of capital in the resolution authority.

(4) Insurance Companies. Rep. Kanjorski (D-PA) said that insurance is a piece of the puzzle to complete picture, and he is interested in how resolution authority will work in this market.

(5) Unintended Consequences. Rep. Garrett (R-NJ) cautioned that we need to avoid unintended consequences of a resolution entity that is not carefully crafted. He indicated potential of moral hazard being institutionalized by designating certain entities as systemically significant.

II. Recap of Q+A Issues:

Key issues raised in Q+A included: (1) insurance companies; (2) FDIC role in resolution authority; (3) taxpayer burden; (4) PPIP questions; (5) credit default swaps and OTC derivatives; (6) money market mutual funds; (7) capital requirements for hedge funds; (8) consumer protection; (9) too big to fail; (10) floorplan financing/ autos (11) who to be systemic risk regulator and (12) hedge funds and systemic risk. To recap:

(1) Insurance Companies. Rep. Scott (D-GA) noted that it is not insurance that caused the problem, and that insurance companies have already been regulated by the states. Geithner said we need effective consolidated supervision over entities that pose a systemic risk; but that does not mean that we should take away the power of state regulators. Rep. Royce ( ) asked whether it would make sense to have a single federal regulator for insurers as opposed to state system. However, he ran out of time to receive answer to this question and Chairman Frank instructed Geithner to submit an answer in writing. Rep. Kanjorski (D-PA) asked whether Treasury will have a position on the federal treatment on insurance companies, and if so when and what are likely parameters of that question? Geithner said he would come back soon with complicated questions; he said there is a good case for optional federal charter but he needs to get back. Rep. Kanjorksi asked if there is anyone at Treasury designated to talk about insurance question. Geithner said that there is a team working on this and other issues, but there are still vacancies left to be filled. Chairman Frank (D-MA) asked if Geithner could also get back in writing or further consider whether there is any difference on how to deal with life insurance and one hand, and property and casualty insurance on the other.

(2) FDIC Role in Resolution Authority. Rep. Scott (D-GA) asked where in the federal government the power should rest to seize non-bank entities? Geithner said his model would substantially rely on the FDIC to implement this regime; however for checks and balances the action would require a majority of Fed Reserve, President, and other checks to make sure the FDIC alone does not have too much discretion.

(3) Taxpayer Cost for Resolution Authority. Ranking Member Bachus (R-AL) noted that legislation would authorize the FDIC to spend an unlimited amount (“such sums as necessary”) of money to unwind a failing non-bank institution under the resolution authority legislation? Geithner said we would need to look at how costs are shared in the system; Geithner further indicated that it may be cheaper for the taxpayer for the government to take this action to prevent failure than the alternative.

(4) PPIP – Public-Private Investment Partnership - Leverage Ratio, Valuation of Assets, Transparency : (1) Leverage Ratio. Rep. Campbell (R-CA) asked why the PPIP has a 6 to 1 ratio, which he said encourages more risk taking a leverage, and perhaps moves the problem from bank to nonbank entities. Geithner said the leverage was suggested by the FDIC; this is substantially less leverage than banks run with today. Rep. Marchant (R-TX) expressed general support for a PPIP, but expressed concern that investors have enough skin in the game under the model with the leverage ratio. Geithner said he has same concern that investors have enough skin in the game, but that he thinks this is a better way of protecting taxpayers. (2) Valuation of Assets: Further, Rep.Marchant (R-TX) expressed concern about valuation of assets in PPIP, and potential gaps in prices between bids and asks. He asked whether there is enough TARP money to plug the hole of potential gaps, and whether Treasury would allow there to be a response time between the bank and the FDIC? Geithner noted that there would be a six month window. Rep. Marchant (R-TX) asked whether the FDIC will have an ability to say that a given sale in the PPIP can not take place (e.g. because the FDIC cannot bare the loss?) Geithner said that this would require more thought from the FDIC and he would be glad to follow up; he side-stepped and noted generally that the FDIC would try to work out the balance in this case. Chairman Frank (D-MA) noted this is an important point and that this calls for the further consultation with other agencies, and that this will be subject of a further hearing. (3) Transparency. Rep. Klein (D-FL) further commented on the need for an open, competitive bidding process.

(5)_ Credit Default Swaps and OTC Derivatives. Rep. Lance (R-NJ) asked whether regulation would be needed or Congressional legislation. Geithner noted the need for legislation to strengthen the framework for regulation of credit default swaps and OTC derivatives, and further noted that his hope is for a global structure so we do not have a balkanized system at the global level such as we have had in the U.S.

(6) Money Market Mutual Funds. Rep. Lance (R-NJ) asked whether issue will be discussed in London. Geithner said that he was not sure how specifically proposals will be discussed, but that he will be working with colleagues on this issue on global level.

(7) Capital Requirements for Hedge Funds. Rep. Ellison (D- MI) asked how a capital adequacy regime would work for hedge funds? Geithner clarified that Treasury does not intend to impose a capital adequacy regime for hedge funds. Rather, he said that Treasury wants hedge funds to register with the SEC, and that if a hedge fund is determined to be systemically significant, that then they would be folded into systemic risk regime.

(8) Financial Products Safety Board / Consumer Protection. Rep. Ellison (D- MI) asked what Treasury thinks of Professor Warren’s “Financial Products Safety Board” (note: also the subject of Schumer proposed legislation). Geithner said he thinks this is an interesting proposal and it is something Treasury is looking at.

(9) “Too Big to Fail”. Rep. Klein (D-FL) remarked on “nauseating” concept of “too big to fail” and referenced anti-trust laws which he indicated have not been enforced as much as they could have been. Rep. Klein asked how to avoid organizations from getting to too big to fail category? Geithner responded we are a nation of 8000 to 9000 banks – and that these organizations should have access to capital on same terms that large institutions do. Geithner indicated he wants to hold the large institutions to stronger rules on leverage, and he underscored caps on shares of deposits that any single institution can have in the United States.

(10) Floorplan Financing/Autos. Rep. Donnelly (D-Indiana) noted the problem of auto dealers getting floor plan financing. Geithner said Treasury is working on this issue and in the next few days could work on what is possible and what is not.

(11) Who to Be Systemic Risk Regulator. Secretary Geithner noted that the Treasury is not the appropriate entity for systemic risk regulator, however he did not clarify whether for example the Federal Reserve or FDIC or entity should assume that role. Secretary Geithner noted the need for appropriate checks and balances so that any one government entity would not become too powerful.