State financial regulators don’t see much good in federal overhaul plan

No topic can be more boring then a discussion of the alphabet soup of state and federal agencies that regulate the financial services industry — until something goes wrong, and there’s only one agency overseeing things in Washington, warn state regulators in reaction to a plan proposed by the Bush administration that would enhance the powers of the Federal Reserve Board.

While it is being labeled by some as the most sweeping reform of the financial services industry since the Depression, critics that the Federal Reserve – affectionately known as the Fed – would become a giant super agency, usurping the “local cop on the beat,” and would result in creating more problems than it would solve.

Indeed, they argue, the current credit meltdown set off by the subprime mortgage crisis was more the fault of the Fed then of any state regulator.

Of course that’s an oversimplification of both the proposed changes and the criticism of it, but any discussion of the mind-numbing complexity of financial regulations has to be simplified somewhat to be understood. Indeed, it is that complexity that Treasury Secretary Henry Paulson is trying to change.

And while even Paulson admits that his plan won’t be approved before the next election – and therefore probably not at all – and pundits are already pronouncing it dead on arrival, state regulators are not so sanguine. They notice that the plan reflects some longtime trends and “conventional wisdom” that have been permeating about financial regulations for quite some time – the very trends that they blame for the current crisis in the first place.

Regulatory consolidation

But let’s step back for a moment, and give you the Cliff Notes version of the Paulson plan.

According to Paulson, the nation’s financial regulatory structure developed piecemeal in response to various crises and usually aimed at one segment of the financial services industry. But that industry has become less piecemeal, as the lines between banking, insurance and securities become increasingly blurred.

Thus, what once would have been a banking problem — dubious housing loans – originated not with banks but with mortgage companies and were securitized as commodities, insured by companies out of the reach of state insurance regulators and rated by watchdogs that weren’t themselves properly watched.

In the long run, Paulson would like to create three super-agencies to deal with this situation. A market “stability regulator” – an expanded Federal Reserve that would cover the entire financial industry, not just lending, to prevent the whole thing from crashing down. It would primarily have an information-gathering role, but it would have the power to stick its nose anywhere if there is concern that there is a threat to the financial system at large.

A new “prudential financial regulator” which would set credit and underwriting standards for banks and, optionally, the insurance industry, making sure particular institutions have the money to survive.

There also would be a “conduct of business regulatory agency” – or CBRA — which would enforce regulations to protect investors and consumers.

In the shorter term, the prudential regulator would merge the Office of Thrift Supervision and the Office of the Comptroller of the Currency, which would have an increased role in regulating state chartered banks. It also would, for the first time, regulate some insurance companies – now the sole purview of the states.

The new super enforcer, the CBRA, would swallow up the Securities and Exchange Commission and the Commodity Futures Trading Commission, while mainly focusing on securities firms, but also would deal with banks and insurance companies as well.

Unenforced rules?

While the proposal still features some role for state regulators, it is clear that it would be a diminished one.

For instance, buried in the 200-plus-page proposal is the following sentence:

“CBRA’s national standards would apply to all financial services firms, whether federally or state-chartered … preempting state business conduct laws directly relating to the provision of financial services.”

And those are fighting words to Mark Connolly, director of the Bureau of Securities Regulation and head of the Corporate Finance Section of the North American Securities Administrators Association, an organization of local and state financial regulators.

Connolly was at a NASAA meeting the day Paulson released his plan and shot back, “This plan just moves the pieces around and attempts to reign in those regulators who actually have been doing something – namely, those at the state level, where industry can not necessary control the result.”

Later, back in New Hampshire, Connolly elaborated at length about what he sees as the plan’s effect, with an attempt to put it into historical context.

The plan, he said, didn’t really begin as a response to the financial meltdown that we are currently in, said Connolly. It began earlier, from critics of the current regulatory structure when the markets appeared to be doing well, and regulation seemed to be getting in the way.

The report “morphed” into “total restructuring,” in the midst of the current economic situation, which even the presumed presidential candidates are now calling a recession. But this crisis, rather than resulting in more stringent regulation is actually moving toward “regulation light,” said Connolly.

It is all part of the philosophical movement, which has been growing for years, to move to “principle-based regulation,” which is how the system works in the United Kingdom, as opposed to the U.S. system, which is based on rules.

Under the U.S. system, for instance, it is clear what an independent director is: including exactly what threshold of outside income would call that independence into question, and exactly how many independent directors are required to serve on particular committees, as opposed to the more subjective principle that corporate committees should be independent.

Connolly contends that the problem over the last eight years isn’t that there have been too many rules, but there has too little enforcement of them by understaffed federal regulators, and by allowing the lines to be blurred by various sectors of the industry, regulators have let loose whole sectors of financing that is essentially off the books of the traditional finance services industry.

“There is a lack of transparency. The subprime loans, the CDOs, the off-balance transactions, the credit derivatives — the report doesn’t talk about these. They don’t even understand most of it. The banks can’t even tell us how much they have on their balance sheets,” Connolly said.

Starved for funds

According to Connolly, so much debt was being passed around “that it was like musical chairs. As the market slowed down, and the music stopped, the larger commercial banks couldn’t unload, and they were caught with it on their books.”

It boils down, said Connolly, to two questions: “Where were the rating agencies? How did investment banks get into all these risky products?” His answer: “A whole system broke down. Before we talk about regulatory reform, we have to understand what went right and what want wrong.”

There is nothing wrong with maximizing profits, said Connolly. “But success can lead to excess. And the area that creates the excess is where regulators need to put their attention. To not do so is hurtful to the economy as shown by the mortgage meltdown.”

The way to focus regulation, however, is not to put all the regulators in one agency, especially a federal agency starved for funds.

In the same year, for instance, the SEC undertook about 500 enforcement actions, and state securities regulators undertook 10 times as many. Investors “are much more likely to find us quicker then the SEC. We are closest to the Main Street investor,” said Connolly.

Yes, there might be duplication of efforts, but “I don’t believe duplication is a bad thing. It’s a different set of eyes on a problem. Why roll everything into one super regulator? Having competing regulators is good for the market. Competition is good.”