Wash Over of Recalcitrant Boards by the Rise in Financial Regulation

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Financial Regulators: Who They Are and What They Do

Federal and state governments have a myriad of agencies in place that regulate and oversee financial markets and companies. These agencies each have a specific range of duties and responsibilities that enable them to act independently of each other while they work to accomplish similar objectives. Although opinions vary on the efficiency, effectiveness and even the need for some of these agencies, they were each designed with specific goals and will most likely be around for some time. With that in mind, the following article is a complete review of each regulatory body.

Federal Reserve Board

The Federal Reserve Board (FRB) is one of the most recognized of all the regulatory bodies. As such, the “Fed” often gets blamed for economic downfalls or heralded for stimulating the economy. It is responsible for influencing money, liquidity and overall credit conditions. Its main tool for implementing monetary policy is its open market operations, which control the purchase and sale of U.S. Treasury securities and federal agency securities. Purchases and sales can change the quantity of reserves or influence the federal funds rate – the interest rate at which depository institutions lend balances to other depository institutions overnight. The Board also supervises and regulates the banking system to provide overall stability to the financial system. The Federal Open Market Committee (FOMC) determines the actions of the Fed. (To learn more, see our tutorial on the Federal Reserve.)

Federal Deposit Insurance Corporation

The Federal Deposit Insurance Corporation (FDIC) was created by the Glass-Steagall Act of 1933 to provide insurance on deposits to guarantee the safety of checking and savings deposits at banks. Its mandate is to protect up to $250,000 per depositor. The catalyst for creating the FDIC was the run on banks during the Great Depression of the 1920s. (For background reading, see The History Of The FDIC.)

Office of the Comptroller of the Currency

One of the oldest federal agencies, the Office of the Comptroller of the Currency (OCC) was established in 1863 by the National Currency Act. Its main purpose is to supervise, regulate and provide charters to banks operating in the U.S. to ensure the soundness of the overall banking system. This supervision enables banks to compete and provide efficient banking and financial services.

Office of Thrift Supervision

The Office of Thrift Supervision (OTS) was established in 1989 by the Department of Treasury through the Financial Institutions Reform, Recovery and Enforcement Act of 1989. It is funded solely by the institutions it regulates. The OTS is similar to the OCC except that it regulates federal savings associations, also known as thrifts or savings and loans.

Commodity Futures Trading Commission

The Commodity Futures Trading Commission (CFTC) was created in 1974 as an independent authority to regulate commodity futures and options markets and to provide for competitive and efficient market trading. It also seeks to protect participants from market manipulation, investigates abusive trading practices and fraud, and maintains fluid processes for clearing. The CFTC has evolved since 1974 and in 2000, the Commodity Futures Modernization Act of 2000 was passed. This changed the landscape of the agency by creating a joint process with the Securities and Exchange Commission (SEC) to regulate single-stock futures. (Read Futures Fundamentals for a basic explanation of how the futures market works.)

Financial Industry Regulatory Authority

The Financial Industry Regulatory Authority (FINRA) was created in 2007 from its predecessor, the National Association of Securities Dealers (NASD). FINRA is considered a self-regulatory organization (SRO) and was originally created as an outcome of the Securities Exchange Act of 1934. FINRA oversees all firms that are in the securities business with the public. It is also responsible for training financial services professionals, licensing and testing agents, and overseeing the mediation and arbitration processes for disputes between customers and brokers. (For more insight, see Who’s Looking Out For Investors?)

State Bank Regulators

State bank regulators operate similarly to the OCC, but at the state level for state-chartered banks. Their oversight works in conjunction with the Federal Reserve and the FDIC.

State Insurance Regulators

State regulators monitor, review and oversee how the insurance industry conducts business in their states. Their duties include protecting consumers, conducting criminal investigations and enforcing legal actions. They also provide licensing and authority certificates, which require applicants to submit details of their operations. (For a directory of specific state agencies visit www.insuranceusa.com.)

State Securities Regulators

These agencies augment FINRA and the SEC for matters associated with regulation in the state’s securities business. They provide registrations for investment advisors who are not required to register with the SEC and enforce legal actions with those advisors.

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Securities and Exchange Commission

The SEC acts independently of the U.S. government and was established by the Securities Exchange Act of 1934. One of the most comprehensive and powerful agencies, the SEC enforces the federal securities laws and regulates the majority of the securities industry. Its regulatory coverage includes the U.S. stock exchanges, options markets and options exchanges as well as all other electronic exchanges and other electronic securities markets. It also regulates investment advisors who are not covered by the state regulatory agencies. (To learn more, read The Treasury And The Federal Reserve, Policing The Securities Market: An Overview Of The SEC and Are Your Bank Deposits Insured?)

Conclusion

All of these government agencies seek to regulate and protect those who participate in the respective industries they govern. Their areas of coverage often overlap; but while their policies may vary, federal agencies usually supersede state agencies. However, this does not mean that state agencies wield less power, as their responsibilities and authorities are far-reaching.

Understanding the regulation of the banking, securities and insurance industry can be confusing. While most people will never deal directly with these agencies, they will affect their lives at some time. This is especially true of the Federal Reserve, which has a strong hand in influencing liquidity, interest rates and credit markets.

China’s Restructuring of Financial Regulation Is Good News for Reform

One of China’s toughest and longstanding economic challenges has been the need to slow runaway credit growth, much of it fueled by speculative investments that do not contribute to the real economy. After years of uncertainty over possible reforms of the financial regulatory system, the National People’s Congress moved on March 13 to merge the banking and insurance regulators and delegate more policymaking authority to the central bank (People’s Bank of China, or PBOC). It was a welcome step that will help address the credit problem by setting up a more function-based rather than organization-based regulatory system. The plan should also improve coordination among regulators and delineate clearer divisions of responsibility between them.

Evolution of China’s Fragmented Regulatory Landscape

The current structure is sometimes called “one bank and three commissions.” It has been in place since 2003, when the China Banking Regulatory Commission (CBRC) was carved out of the PBOC. The creation of the CBRC was the culmination of a decade-long process that created the China Securities Regulatory Commission (CSRC) in 1992 and the China Insurance Regulatory Commission (CIRC) in 1998. In the early 2000s China’s banks were reeling from a mountain of bad loans that required enormous bailouts to keep them in business, and looming entry of foreign competition opened up by China’s accession to the World Trade Organization (WTO). Banks and their regulators needed modernization. Specialized, professional regulators for what were then far more clearly distinct businesses—banks, insurance, and securities companies—seemed to be part of the answer.

But the specialized regulation approach has been flawed by serious shortcomings. The rise of shadow banking, especially after 2008, has produced firms and products that often blur the lines between banking, insurance, and securities. The siloed supervisory structure made it virtually impossible to effectively regulate these hybrid institutions that often managed to fall between jurisdictions. The central bank is “first among equals” in this structure, but it does not have authority over the three commissions to coordinate regulatory efforts and handle a constantly changing, more complex financial sector. Fragmentation also made it difficult to take a systemic, macroprudential approach to regulation—one that takes different areas of the financial system and their linkages into account.

China Streamlines Regulation by Focusing on Function Rather than Company Type

The government has debated various reform ideas for years, including proposals (eventually rejected) to merge the regulatory functions into a single “super regulator.” Instead of trying to merge four organizations with so many competing interests, government officials came up with a compromise. In November 2020, they created the Financial Stability and Development Committee directly under the State Council, headed by a vice premier more highly ranked than the heads of the regulatory agencies and the PBOC. The role of the new committee is to coordinate overall strategy for the financial sector and formulate policy at a high level.

The new reorganization will streamline policymaking and implementation below the committee level. Instead of separate regulators for each type of company (insurance, banking, etc.), separate regulators will oversee policy formulation and its day-to-day implementation, which includes monitoring compliance. The PBOC will take over the legislative and rulemaking functions of the CBRC and CIRC, a significant increase in power. Since the new combined banking and insurance regulator will be only an implementer of policy—no longer also formulating it—there will be two (the central bank and the securities regulatory commission) rather than four ministry-level policymaking bodies. The result is fewer overlapping, unclear jurisdictions. The overall push for deleveraging and reduction of financial risk is now more credible because financial firms will find it harder to shop for lighter touch regulation by shuffling the same economic functions to a different type of company.

Financial crises throughout history have taught us that destabilizing conflicts of interest tend to arise when a single regulatory body is responsible both for the system and for the oversight and soundness of individual institutions. Regulators can be afraid to undertake urgently needed tightening of their system-wide policies like interest rates and capital requirements if they know that some financial institutions they are responsible for overseeing will fail as a result, because the blame will be placed squarely on their shoulders. Conversely, a regulator may fail to crack down on a reckless bank flouting the rules if it fears doing so could threaten the stability of the system. The new structure in China attenuates the contradiction by housing these functions in separate institutions, which better aligns their incentives.

Integrating Faltering Regulator Parallels US Example

Though it may seem novel to integrate banking and insurance, it is generally accepted by policymakers and academics globally that both bank depositors and insurance policyholders should be protected from risk in a similar way, through heavy regulation around risk taking and capital adequacy. Securities regulation tends instead to focus on transparency and proper functioning of markets, where customers realize they are taking on risk if investments go south.

The combination of the CIRC and the CBRC follows examples from outside China and is in many ways like the 2020 absorption of the Office of Thrift Supervision (OTS) into the Office of the Controller of the Currency (OCC) in the United States. The OTS is widely cited as an example of “regulatory capture,” when an agency becomes the cheerleader rather than a referee for the industry it is supposed to regulate. Financial institutions engaged in jurisdiction shopping, reorganizing as thrifts under the OTS to get lighter regulatory burdens. The results in the financial crisis were disastrous, as many of them failed and taxpayers shouldered their losses.

In China, the CIRC started deregulating insurance in 2002, when it allowed insurance companies to invest in many new types of assets and issue short-term insurance policies that resembled risky investments. In late 2020 it liberalized further, unleashing a massive offshore buying spree by the giant, politically connected Anbang, among other companies. Like most booms, this frenzy created serious problems. In April 2020, the CIRC’s chairman was investigated for corruption and removed from his post. The government is still cleaning up the mess created by the regulatory capture, including recently taking control of Anbang, which owns the Waldorf Astoria in New York and a broad range of other offshore assets. Its buying spree appears to have brought it to the brink of bankruptcy. Like the OTS, the troubled CIRC is effectively being eliminated and its functions handed to a stronger regulator. As in the United States, the merger process is sure to be an acrimonious process with wrangling over posts and turf that takes years to complete.

Uncertainties Ahead

But many questions remain. One is how this reorganization will change relations between financial regulatory authorities at the local and national levels. Under-resourced local officials have been primarily responsible for the day-to-day regulation of financial institutions in their jurisdictions, implementing policies determined by regulators like the CBRC in Beijing. The national reorganization may further centralize authority at the national level to prevent a different type of jurisdiction shopping, in which financial firms choose to locate where local governments are pliant. Another question is the future of the CSRC, which remains independent for now but exists next to a much more powerful central bank. It is also unclear how the reorganization will affect the financial technology firms that have grown to become the world’s largest, thanks partly to the space granted them by poorly coordinated regulators.

Overall, these reforms are good news for financial stability in China.

The problem with financial regulation

Regulation should not be about de-risking; it should be about funnelling risk to where it can be best absorbed

It is a testament to the importance of getting financial regulation right that almost 10 years since the emergence of a crisis in sub-prime mortgages in the US, those countries most affected by the unfolding credit crunch are still struggling to put it behind them. The new Financial Stability Board of regulators of the largest economies believes that asking banks to fund an increasing amount of loans with what it calls total loss-absorbing capacity (TLAC) will reduce the prospect of costly bank bailouts in the future. However, these new regulatory structures are built on fundamentally flaky foundations. A couple weeks ago in Mumbai, I gave the feature address to an assembly of Asia’s deputy central bank governors responsible for financial regulation. I explained what is wrong with financial regulation, why it matters and how we can reinvent it.

Too many financial supervisors consider regulation to be an exercise in “de-risking”. Risk is curbed, they believe, by requiring a financial firm to put up biting amounts of capital against risks. However, risk shares much with the first law of thermodynamics—energy can neither be created nor destroyed, only transformed. When we effectively tax-risk in one place, it shifts to another, like mutual funds. When we find it there and tax it again, it merely shifts once more, perhaps to shop-based credit cards and so on. The logical conclusion of this process is that risk will continually shift until it settles where we can no longer see it. That is a bad place for risks to be. The regulatory exercise should be about incentivizing risk to flow out of dark corners and to settle where it can be best absorbed.

Another fundamental flaw with the modern approach to risk management is the notion of risk-sensitivity on which the new TLAC requirements are built. Banks don’t topple over from doing things they always knew were risky. They topple from doing things they were convinced were safe before they turned risky. Against loans they deem risky, banks demand extra guarantees, collateral, interest, and repayment reserves. Against their reported risk-weighted assets, they were never as well capitalized as just before the crisis. Under the risk-sensitive approach, they had (and will have) the least capital against those assets that they thought were safe, just before they turned bad. It’s not the things you know are dangerous that kill you.

Worse, in the regulatory-approved practice of risk sensitivity, banks, corralled into using the same risk models and data sets, end up buying the same assets that the models estimate had the best yield-to-safety ratio in the past. These risk models then force them to sell these assets at the same time when there is some disturbance in market volatilities and correlations. This has been generously called the Persaud Paradox of market-sensitive risk management—the observation of safety creates risks.

Another fundamental error is the adding up of different risks and slapping a capital requirement to cover them all. Different types of risk require different hedges. While capital is appropriate for credit risk, it is not the best hedge for all other risks. For instance, the way to hedge liquidity risk—that is, the risk that, were you forced to sell an asset tomorrow, would fetch a far lower price than if you could wait to find an interested buyer—is by having long-term funding to tide you over. If markets became illiquid and you were short-term funded, no tolerable amount of capital would save you. Credit risks, on the other hand—the risk that someone defaults on payments to you—rise the more time you have. Matching credit risk to long-term funding would not hedge credit risks. The way to hedge credit risks is to diversify across uncorrelated assets.

Financial regulation needs reinventing along different principles. The first is that financial institutions of all shades should be required to put up capital or reserves against the mismatch between each type of risk they hold and their natural capacity to hold that type of risk. Risk capacity is not risk appetite. It is the ability to naturally hedge a risk when your estimate of that risk proves wrong and it blows up. Risk capacity takes a structural approach to risk management rather than a statistical approach. For instance, part of the extra return from equity market investments, over that available on cash, is compensation for daily price volatility. Institutions with long-term funding or liabilities, like life insurers and pension funds, have a natural capacity to earn this risk premium because unlike a bank or casualty insurer, their liabilities do not require constant liquidity and stability before they become due.

If capital was set against mismatches between risk capacity and risk taking, banks would be incentivized to sell good-quality credit but low-liquidity assets, like infrastructure bonds, to life insurers who are better placed to hold them. Banks would buy less than stellar credit risks, like corporate bonds as they are better placed to spread and hedge these risks than insurers. The direction of these risk transfers would strengthen the financial system. They are in the opposite direction to the transfers witnessed in the run up to the financial crisis when risks ended up where there was greatest ignorance of them and least capacity to absorb them. Resilience would come from repositioning risks to where there is a natural absorptive capacity and therefore where, if these risks blew up, they would not bring down the entire financial system.

Instead, life insurers and pension funds are being forced to shun long-term investments because these instruments are not liquid or stable enough in the short-term, even though life insurers and pension funds do not need short-term stability and liquidity. If long-term investors were able to fund more long-term investment, we may be better able to tackle structural stagnation in the developed world and the investment needs of the developing world. This reinvention of financial regulation could treat savers better, make the financial system more resilient, and raise economic growth.

Avinash Persaud is emeritus professor, Gresham College, and non-executive chair of Elara Capital Plc,

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