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06.19.2009 | Legal Update

The Treasury on June 17 released a comprehensive plan to reform the financial services regulatory system in the United States.

The plan, Financial Regulatory Reform: A New Foundation, identifies causes of the current crises in the financial markets and proposes changes to the current system of financial services regulation in the United States in an effort to prevent similar events in the future. The plan was not accompanied by proposed legislation but presumably many if not all of the key elements of the proposal will be contained in legislation to be proposed in the future.

Among other things, the plan would:

• Eliminate the Office of the Comptroller of the Currency (OCC) and replace it with a new agency to be called the National Bank Supervisor (NBS);
• Eliminate the Office of Thrift Supervision (OTS) as well as the federal savings bank charter, and require federal savings banks to become national banks to be regulated, supervised and examined by the NBS;
• Promote uniformity of the regulatory framework for state-chartered banks and national banks to further minimize “arbitrage opportunities” associated with the state and national bank charters and their regulators;
• Subject systemically significant institutions to heightened regulation and supervision;
• Make the Federal Reserve a systemic risk regulator and broaden its powers to more effectively carry out that function; and
• Create a new agency to be called the Consumer Financial Protection Agency to enforce consumer protection requirements on financial institutions.

There are five broad objectives of the plan encompassing, among other things, the specific proposals summarized above. The five broad objectives, discussed in greater detail below, are to promote more effective supervision and regulation of financial firms, establish more effective supervision of financial products and markets, protect consumers and investors from financial abuse, provide the government with the tools it needs to better manage financial crises in the future, and strengthen international regulatory standards and improve international cooperation.

1.  Promoting more effective supervision and regulation of financial firms

• Eliminating the OTS and the Federal Thrift Charter

The plan calls for the elimination of the OTS and the federal thrift charter. The plan states that the rationale for federal thrifts as a specialized class of depository institution focused on residential mortgage lending no longer makes sense.  Moreover, over the past few decades, the plan states that the “powers of thrifts and banks have substantially converged.” The availability of the federal thrift charter has created “opportunities for private sector arbitrage of our financial regulatory system” and that one “clear lesson learned from the recent crisis was that competition among different government agencies responsible for regulating similar financial firms led to reduced regulation in important parts of the financial system.”

Nutter Notes: The proposals to abolish the OTS and the federal thrift charter would not directly affect any state-chartered mutual savings bank in any of the New England states or, with certain limited exceptions, any state-chartered cooperative bank. There is one Massachusetts cooperative bank the deposits of which were insured by the former Federal Savings and Loan Insurance Corporation in 1989 and which is therefore OTS-regulated at the federal level. There are also OTS-regulated cooperative banks in New Hampshire.  Although Massachusetts does not charter savings and loan associations, state-chartered savings and loan associations exist in other New England states, including Maine.  Whether the powers of banks and thrifts have “substantially converged” is arguable. Thrifts are still subject to the Qualified Thrift Lender test – requiring that at least 65% of a thrift’s assets be so-called “qualified thrift investments” – and federal thrifts remain subject to investment limits on a variety of assets including commercial and industrial loans (20% of assets) and commercial real estate loans (400% of capital).

• The National Bank Supervisor

The proposal would create the NBS, a new federal agency within Treasury, to regulate and supervise all federally chartered depository institutions other than credit unions, and all federal branches and agencies of foreign banks. This agency would take over the prudential responsibilities of the OCC and OTS.  The NBS would inherit the authority of the OCC and OTS to require reports, conduct examinations, impose and enforce prudential requirements, and conduct overall supervision.

• Regulation and Supervision of State Banks

The Federal Reserve and the FDIC would retain their respective roles in the supervision and regulation of state-chartered banks.  However, the plan states that efforts to simplify and strengthen “weak spots” in the system of federal bank supervision and regulation “will not end with the elimination of the federal thrift charter.” Although federal legislation over the past few decades has “substantially improved the uniformity of the regulatory framework” for national banks and state banks, “more work can and should be done in this area,” Treasury states.

Nutter Notes: To further minimize “arbitrage opportunities associated with the multiple remaining bank charters and supervisors,” Treasury proposes to further reduce the differences in the substantive regulation and supervisory policies applicable to national banks, state member banks, and state nonmember banks. There are no specific proposals in Treasury’s plan to further reduce the differences in the substantive regulation and supervision of national banks and state-chartered banks.

• Interstate Branching

Federal thrifts currently enjoy the unrestricted ability to branch across state lines, subject only to OTS approval. Banks do not enjoy the same broad authority.  The plan states that, although many states have enacted legislation permitting interstate branching, many other states continue to permit interstate entry only through the acquisition of an existing bank. This limitation on interstate branching “is an obstacle to interstate operations for all banks and creates special problems for community banks seeking to operate across state lines.” Treasury proposes the elimination of the remaining restrictions on interstate branching by national and state banks.

• Holding Company Regulation

The proposal states that all companies that control an insured depository institution, however organized, should be subject to consolidated supervision and regulation at the federal level by the Federal Reserve and should be subject to the nonbanking activity restrictions of the Bank Holding Company Act. The policy of “separating banking from commerce should be re-affirmed and strengthened,” according to the proposal.

• Heightened Consolidated Regulation of Systemically Significant Firms

Any financial firm whose combination of size, leverage, and interconnectedness could pose a threat to the stability of the financial system if it failed (referred to as a “Tier 1 Financial Holding Company” or “Tier 1 FHC”) would be subject to stricter consolidated supervision and regulation, regardless of whether the firm owns an insured depository institution. The Federal Reserve would have the authority and accountability for consolidated regulation and supervision of Tier 1 FHCs. Legislation to be proposed would establish criteria that the Federal Reserve would be required to consider in identifying Tier 1 FHCs. The prudential standards for Tier 1 FHCs – including capital, liquidity and risk management standards – would be stricter and more conservative than those applicable to other financial firms to account for the greater risks that their potential failure would impose on the financial system.

Nutter Notes: Functionally regulated and depository institution subsidiaries of a Tier 1 FHC would continue to be supervised and regulated primarily by their functional or bank regulator, as the case may be. However, the constraints that the Gramm-Leach-Bliley Act placed on the Federal Reserve’s ability to require reports from, examine, or impose higher prudential requirements or more stringent activity restrictions on the functionally regulated or depository institution subsidiaries of FHCs would be eliminated.

• Financial Services Oversight Council

The plan would create a Financial Services Oversight Council to facilitate information sharing and coordination, identify emerging risks, advise the Federal Reserve on the identification of firms whose failure could pose a threat to financial stability due to their combination of size, leverage, and interconnectedness, and provide a forum for resolving jurisdictional disputes between regulators. The membership of the Council would include the Secretary of the Treasury, who would serve as the Chairman; the Chairman of the Board of Governors of the Federal Reserve System; the Director of the NBS; the Director of the Consumer Financial Protection Agency, a new federal agency that Treasury proposes to establish (see summary below); the Chairman of the SEC; the Chairman of the CFTC; the Chairman of the FDIC; and the Director of the Federal Housing Finance Agency.

Nutter Notes:  S. 664, The Financial System Stabilization and Reform Act of 2009, introduced in the Senate on March 23, 2009, would take a different approach, creating an independent Financial Stability Council (FSC) comprised of the existing federal regulatory agencies with real authority to act. Among other things, the FSC would review and approve any rule issued by any federal financial regulator, review new financial products and services and recommend regulations for them to the appropriate federal financial regulator, direct each federal financial regulator to impose appropriate solvency requirements, including capital requirements and long-term debt ratios on any financial institution within its jurisdiction as the Council deems necessary to prevent systemic risk to the financial system. H.R. 1754 is a companion bill introduced in the House on March 26, 2009.  Each bill has been referred to committee.

• Requiring Hedge Funds and Other Private Pools of Capital to Register

All advisers to hedge funds and other private pools of capital, including private equity funds and venture capital funds whose assets under management exceed a certain threshold, would be required to register with the SEC under the Investment Advisers Act. The advisers would be required to report information on the funds they manage that is sufficient to assess whether any fund poses a threat to financial stability.

• Oversight of the Insurance Sector

The proposal would establish the Office of National Insurance within Treasury to gather information, develop expertise, negotiate international agreements, and coordinate policy in the insurance sector.

Nutter Notes: H.R. 1880, the National Insurance Consumer Protection Act, introduced in the House on April 2, 2009, would go significantly farther than Treasury’s proposal in regulating the business of insurance at the federal level. H.R. 1880 would establish in Treasury an Office of National Insurance (ONI), headed by a Commissioner of National Insurance (Commissioner). The bill would, among other things, authorize the Commissioner to provide for the organization, operation, and regulation of national insurance companies and national insurance agencies, including U.S. branches of non-U.S. insurers, require the Commissioner to supervise national insurers and national agencies, including chartering and licensing, provide for the conversion of state insurers to national insurers or state insurance agencies to national agencies, and vice versa, and set forth requirements governing prompt corrective action. A companion bill in the Senate has been referred to committee.

2.  Comprehensive Regulation of Financial Markets

•  Regulation and Supervision of Securitization Markets

Federal banking agencies would be required to promulgate regulations that require originators or sponsors to retain an economic interest in a material portion of the credit risk of securitized credit exposures. Regulators would promulgate additional regulations to align compensation of market participants with longer term performance of the underlying loans. The SEC would be required to continue its efforts to strengthen the regulation of credit rating agencies, including measures to promote robust policies and procedures that manage and disclose conflicts of interest, differentiate between structured and other products, and otherwise strengthen the integrity of the ratings process.

• Comprehensive Regulation of All OTC Derivatives

All over-the-counter derivatives markets, including credit default swap markets, would be subject to comprehensive regulation that addresses relevant public policy objectives such as preventing activities in those markets from posing risk to the financial system; promoting the efficiency and transparency of those markets; preventing market manipulation, fraud, and other market abuses; and ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

• Oversight of Systemically Important Payment, Clearing, and Settlement Systems

The proposal would strengthen the Federal Reserve’s authority to conduct oversight of systemically important payment, clearing and settlement systems, and activities of financial firms.

3.  Protecting Consumers and Investors from Financial Abuse

• Consumer Financial Protection Agency

The proposal would create a single federal consumer protection supervisor to protect consumers of credit, savings, payment, and other consumer financial products and services, and to regulate the providers of these products and services. The CFPA would have broad jurisdiction to protect consumers in consumer financial transactions. The CFPA would be an independent agency with sole rule-making authority for consumer financial protection statutes, as well as the ability to fill gaps through rule-making. The CFPA would have supervisory and enforcement authority and jurisdiction over all persons covered by the statutes that it implements, including both insured depository institutions and a range of other firms not previously subject to comprehensive federal supervision, and it would work with the Department of Justice to enforce the statutes under its jurisdiction in federal court. The states would have the ability to adopt and enforce stricter laws for institutions of all types, regardless of charter, and to enforce federal law concurrently with respect to institutions of all types, also regardless of charter.

• Consumer Protection Reforms

The CFPA would have authority to require that all disclosures and other communications with consumers be reasonable, balanced in their presentation of benefits, and clear and conspicuous in their identification of costs, penalties, and risks. The CFPA would define standards for “plain vanilla” products that are simple and have straightforward pricing. The CFPA would require all providers and intermediaries to offer these products prominently, alongside whatever other lawful products they choose to offer. The CFPA could also place restrictions on product terms and provider practices, if the benefits outweigh the costs, and impose appropriate duties of care on financial intermediaries.

• Investor Protection Reforms

The SEC would be given expanded authority to promote transparency in disclosures to investors. The SEC would also be given new tools to increase fairness for investors by establishing a fiduciary duty for broker-dealers offering investment advice and harmonizing the regulation of investment advisers and broker-dealers. The SEC would be required to make financial firms and public companies more accountable to their clients and investors by expanding protections for whistleblowers, expanding sanctions available for enforcement, and requiring non-binding shareholder votes on executive pay plans.

4.  Tools to Manage Financial Crises

• Resolution of Failing Bank Holding Companies, Including Tier 1 FHCs

The proposal would create a resolution regime to avoid the disorderly resolution of failing bank holding companies, including Tier 1 FHCs, if a disorderly resolution would have serious adverse effects on the financial system or the economy. The regime would supplement rather than replace, and be modeled on, the existing resolution regime for insured depository institutions under the Federal Deposit Insurance Act.

Nutter Notes:  On March 25, 2009, Treasury released proposed legislation, the Resolution Authority for Systemically Significant Financial Companies Act of 2009, to establish a new federal legal process for resolving “financial companies” the failure of which could destabilize the U.S. financial system. The bill would, among other things, create a non-Bankruptcy Code framework for managing the reorganization or liquidation of “systemically significant financial companies” and authorize financial assistance for failing SSFCs. The bill would empower Treasury to appoint the FDIC as the sole agency for resolving an SSFC, with broad power to manage the company to minimize the impact on the U.S. economy.

• Federal Reserve’s Emergency Lending Authority

The proposal would amend Section 13(3) of the Federal Reserve Act to require the prior written approval of the Secretary of the Treasury for any extensions of credit by the Federal Reserve to individuals, partnerships, or corporations in “unusual and exigent circumstances.”

5.  International Regulatory Standards and International Cooperation

• International Capital Framework

The proposal recommends that the Basel Committee on Banking Supervision (BCBS) continue to modify and improve Basel II by refining the risk weights applicable to the trading book and securitized products, introducing a supplemental leverage ratio, and improving the definition of capital by the end of 2009. The proposal also recommends that the BCBS complete an in-depth review of the Basel II framework to mitigate any pro-cyclical effects.

• Oversight of Global Financial Markets

The proposal recommends that other nations promote the standardization and improved oversight of credit derivative and other OTC derivative markets, in particular through the use of central counterparties, along the lines of the G-20 commitment, and to advance these goals through international coordination and cooperation.

Nutter Bank Report

Nutter Bank Report is a monthly electronic publication of the Banking and Financial Services Group of the law firm of Nutter McClennen & Fish LLP. Chambers and Partners, the international law firm rating service, has ranked Nutter’s Banking and Financial Services practice among the top banking practices in the nation. The Chambers and Partners review says that the “well-known and well-versed” Nutter team “excels” at corporate and regulatory banking advice. Visit the U.S. rankings at ChambersandPartners.com. The Nutter Bank Report is edited by Matthew D. Hanaghan. Assistance in the preparation of this issue was provided by Lisa M. Jentzen. The information in this publication is not legal advice. For further information, contact:

Kenneth F. Ehrlich
kehrlich@nutter.com
Tel: (617) 439-2989

Michael K. Krebs
mkrebs@nutter.com
Tel: (617) 439-2288