Republicans Can Do Financial Regulation Too

I stumbled over a fantastic find this afternoon on Fox Business' website. Apparently they got a hold of the Republicans' proposal for financial regulation. Obviously, Republicans are not known for their regulatory prowess, so I was very interested to see their take. There is some good, some bad and some ugly. I'll break it all down.

First, if you want to read the draft, you can check it out here. (Opens .pdf-like document.) It has seven main sections. Those seven manage to deal with most of the financial regulatory issues of the day.

Title 1 -- Creation of New Bankruptcy Chapter for Certain Institutions

By "certain institutions," they mean non-bank financial institutions. By non-bank financial institutions, they mean companies like AIG and its non-bank brethren. They want to create "Chapter 14" bankruptcy, specifically for those non-bank financial institutions. The idea is to make bankruptcy more efficient and smoother. I applaud the principle of favoring bankruptcy over bailout, but I cringe at the nuts and bolts.

Chapter 14 bankruptcy is essentially Chapter 11 bankruptcy, but they want to involve several regulatory bodies who can help the process along. Those institutions include the firm's functional regulator, Treasury, Federal Reserve, and Market Sustainability and Capital Adequacy Board (don't worry, we'll get to this). At first, it all sounds fine. Then, they suddenly fire a nuclear warhead at the financial markets:

Section 1407 of the new chapter exempts, upon motion of the non-bank financial institution, qualified financial derivatives contracts, such as options, swaps, and repurchase agreements, from the operation of their ordinary exclusion from the automatic stay with the approval of the Market Stability and Capital Adequacy Board or the bankruptcy Court. It further provides for a highly expedited hearing and decision on whether an exemption imposed at the time the petition is filed should remain in place or whether the Bankruptcy Code's ordinary exclusion from the automatic stay for these derivative contracts should apply. This regime will on an expedited basis balance the interests of the non-bank financial institution and its creditors in determining whether to allow the automatic stay to operate with regard to derivatives contracts.

For anyone out there who doesn't speak lawyer fluently, let me explain what that means. Usually, if a non-bank financial institution (think AIG) decides to file bankruptcy, its derivative contracts are exempt from the bankruptcy proceedings and function as usual. In a sense, they are at the top of the waterfall. Once they're all taken care of, then the creditors can have at whatever's left.

This proposal would change that. Instead, those derivative contracts would be halted and considered during the workout in bankruptcy court. That sounds like a fair idea in theory. In practice, it means financial disaster.

If derivative contracts are halted, the counterparties of those contracts will not be paid for months or years until the bankruptcy is resolved. If they don't get their money, then they can't pay other counterparties who they owe money. Those counterparties can't pay other counterparties, etc. The dominos continue to fall, along with all of America's hopes and dreams.

Since this terrible idea seems the most notable novelty of Chapter 14, I'd say we're better off without it.

Title 2 -- Market Stability and Capital Adequacy Board

As promised, this section creates a new regulatory body. It sounds to me like the Republican version of the systemic risk regulator. It isn't the Federal Reserve. It's made up of the Secretary of Treasury, the Chairman of the Federal Reserve, the Chairman of the SEC, the Chairman of the FDIC, the Chairman of the CFTC, the Chairman of the Financial Institutions Regulator (again, we'll get to this), the Director of the Federal Housing Finance Agency and five Presidential appointees.

Good. Great. Excellent. Bravo. If this group of minds can't regulate systemic risk, then no one can. It seems diverse enough to escape conflicts of interest as well -- unlike if this duty were left up to the Fed alone. So what do they actually do?

Gather industry data; review capital standard set by the functional regulators; monitor government policies which could affect market stability; and evaluate and report on systemic risks in our financial markets. Establishes a Humphrey-Hawkins style semi-annual report to Congress by the Secretary of Treasury.

I'm fine with this. I still have my doubts that a systemic risk regulator would have the foresight to prevent most unexpected economic catastrophes (because they'd still be unexpected), but I'm happy to let them try to prove me wrong.

Title 3 -- Regulatory Consolidation and Consumer Protection

That's right: Republicans care about consumers too. To keep them safe, they want to establish an umbrella bank regulator they call the Financial Institutions Regulator (FIR). Republicans would consolidate all banking regulation into this new regulator. A fairly diverse group of individuals would sit on the FIR's Board of Directors: an Independent Chairman, the head of the FIR's Federal Banking Division, the head of the FIR's State Banking Division, the Chairman of the National Credit Union Administration and the Chairman of the FDIC.

Those who believe that competition among regulators is good, commence your shouting. I think this proposed board might get past that worry, however, given its diversity. I also worry that competition between regulators can amount to banks going to Dad after Mom says, "no."

Title 4 -- Reform of the Federal Reserve

My eyes widened when I read this part. I suspect that the hand of Ron Paul may have been in this section. They want the Fed on a very short leash. Specifically:

- Grant the Government Accountability Office audit authority.
- Require the Fed to establish an explicit inflation target.
- Require the Fed to get permission from the Treasury Secretary to invoke emergency powers. Congress then gets 90-days to disapprove of that authority. It also prevents the Fed from helping any individual firm.

The audit I'm fine with. The inflation target is highly controversial. I think it isn't a bad idea, depending on how strictly they had to follow it. The Fed should have some flexibility. The emergency powers provision scares me. A lot. It essentially destroys Fed independence at a time when you want it most. The last thing the Fed needs is politics dictating how it should stabilize the market in the case of emergency. I don't think this final provision is wise.

Title 5 -- Government-Sponsored Enterprises (GSE) Reform

The gist of this section is to shrink and possibly even eliminate the GSEs, including Fannie Mae and Freddie Mac. It's a pretty reasonable plan for doing so, however, as it would be over a fairly lengthy time period (10 years for wind-down). It also establishes some new operating restrictions, which I generally like, though there is a stinker or two. I have long believed that the GSEs became entirely too large and posed way too much risk to taxpayers.

Title 6 -- Credit Rating Agency Reform

This is one of my favorite topics. Do they do better than the Treasury? Not really. The first provision I just don't understand. They amend the Securities Exchange Act of 1934 and Investment Advisers Act of 1940 by striking "nationally recognized statistical rating organization" and changing it to "nationally registered statistical rating organization." So they'd rather agencies be registered than recognized? I'm not sure if this is purely semantic, or if they mean to lower the bar for entering the rating agency business, to where any new agency would just need to register. If that's their intention, I'm on board, because competition would do the ratings industry a lot of good.

The rest of this section takes rating agency requirements out of virtually every piece of significant legislation that might contain them. I like where they're going with this, by further weakening our reliance on the rating agencies. I just worry that they haven't figured out a better standard of creditworthiness to rely on for securities like money markets.

Title 7 -- Anit-Fraud Provisions

This is a surprisingly long section. It essentially gives the SEC more power to stop fraud. All of the power seems reasonable at first glance. It involves stuff like greater penalties and consequences for fraudsters. I hate fraud, so I'm on board with additional punishment that might help deter the next Madoff.