The Blame Game Part III: Control Confusion

by Jay Hammond on January 14, 2009

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The American system for regulating banks, stock markets, public companies, taxes and other financial institutions is a patch-work quilt of decentralized federal agencies, state agencies and other regulatory bodies may have played a significant role in the current financial crisis. If it isn’t fixed, some experts contend this cobbled together system will make such meltdown increasingly likely in the future.

It becomes plausible that failures in regulatory oversight, including by the SEC, may have played a greater cause in the economic debacle than has been generally emphasized, by softening requirements for disclosure and due diligence standards,? said Hillary Sale, a securities law expert in the University of Iowa College of Law and co-author of the paper ?Redesigning the SEC: Does the Treasury Have a Better Idea??. The paper will be published in a forthcoming issue of the Virginia Law Review from the University of Virginia College of Law.

According to Sale and co-author, Columbia University law professor John Coffee, one of the reasons for the current economic meltdown was the lack of cohesive regulatory approach that allowed financial institutions to inflate the real estate and mortgage bubble. For example: four agencies, The Federal Reserve, the Office of the Comptroller of the Currency, (OCC) the Federal Deposit Insurance Corporation (FDIC) and the Office of Thrift Supervision (OTS) oversee various aspects of financial institutions such as banks, savings and loans and credit unions. Two agencies, the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) regulate securities including stocks, bonds, mutual funds and other investment vehicles. No federal agency is responsible for regulating insurance although many state agencies are. Making the situation even more challenging is that all these agencies have different resources and missions which may conflict. They also frequently engage in political turf wars ranging from internal struggles leading to management dysfunction to federal struggles leaving large enforcement gaps and loopholes to international struggles which force international organizations to keep multiple set of books. Add in the attitude that less regulation is better which has prevailed in Washington and on Wall Street for the last several years and you have a recipe for disaster where agencies like the SEC are just not robust enough to prevent corporate scandals let alone contend with economic bubbles.

It isn’t as though the agencies have just been sitting idly by during this crisis. The SEC, for instance, points out that the agency is ?aggressively combating fraud and market manipulation through enforcement actions, taking swift action to stabilize financial markets and enhancing transparency in financial disclosure.? The FDIC has temporarily increased coverage of depository funds to at least $250,000. Federal Reserve Chairman Ben Bernanke has frequently to the public, the media, legislators and anyone that will listen how the Federal Reserve has been responding to the current economic situation.

The Federal Reserve has responded aggressively to the crisis since its emergence in the summer of 2007,? Bernanke said during his Stamp Lecture at the London School of Economics in London, England. ?In historical comparison, this policy response stands out as exceptionally rapid and proactive. In taking these actions, we aimed both to cushion the direct effects of the financial turbulence on the economy and to reduce the virulence of the so-called adverse feedback loop, in which economic weakness and financial stress become mutually reinforcing.?

None of these actions, however, address the issue of dispersed regulatory control and, some would say, are doomed to failure, or at least limited success because they do not address the fundamental problems at the heart of the the crisis. In the wake of the economic collapse, Sale and others say, the government needs to create a new regulation framework.

The Department of the Treasury recognized this and released a paper suggesting a number of changes in the regulatory framework in 2006.

Over the course of our nation’s history, we have added multiple regulators to respond to the issues of the day. Our regulatory system has adapted to the changing market by expanding, but perhaps not always by focusing on the broader objective of regulatory efficiency,? Treasury Secretary Paulson said in November 2006. ?There is a growing awareness in the financial community of the desirability of streamlining the regulatory system.?

Sale and coffee support aspects of the Treasury recommendations, including giving some agencies the mission to ensure the soundness of a institution’s or company’s financial soundness while charging other agencies with protecting consumers. They suggest a division of labor in which the SEC takes over consumer protection functions while a merged Federal Reserve and OCC monitor the business soundness of institutions and organizations. In addition, Sale and Coffee argue that the government must restore a robust regulatory emphasis to make sure lenders and businesses do not take undue risks in order to gain a competitive advantage as well as rebuild investor and consumer confidence rather than allowing more self-regulation or forcing state regulators to defer to federal agencies in fraud investigations as Treasury suggested.

Once the market becomes hot, the threat to civil liability-either to the SEC or to private plaintiffs in securities class actions ? seems only weakly to constrain this momentum,? Sale states, pointing to numerous examples in recent years of banks making billions of dollars of questionable loans that ultimately will not be repaid. ?Explosive growth and a decline in professional standards often go hand in hand.?

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    hope they handle this because seems to be No end in sight with respect to the economy and the same old revolving doors keep a turning
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    Does your new regulatory scheme have any role for the states? We tried for years to rein in the liar loan style of lending, only to be told by the Supreme Court that any entity hiding behind a Federal charter was beyond our remit. Guess what happened then? Everyone not already a bank "agreed" to be bought by a Federally-chartered bank.

    Overturn the Wachovia case and force Federal entities to comply with each and every state's consumer protection laws.
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    Great to see Captain Ned back in the comments :)

    This post just goes to show what a complete and utter failure there was in oversight in this mess. The Fed who oversees the national banks was known for having the least oversight in mortgage lending, and big banks used their weak regulatory stance to overrun state laws and regulations under federal protection.

    Trying to manage the state licensing requirements for lenders is a joke, with each state having their own peculiar set of regulations and definitions that make it maddening to deal with (trust me, I had to deal with it).

    The government does need to overhaul the licensing and regulation of the industry to an agreed upon standard that is adopted by the states. There should also be an NASD-type licensing structure so that one national database of lending employees is kept and managed.

    Only when we level the licensing and regulatory playing fields will the consumer begin to see some modicum of consistent protection. It's going to take a lot of work.
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    Glad to be back; wasn't aware I was missed. ;-)

    Well, the Nationwide Mortgage Licensing System is up and running, and my state is using it. It's based directly on the NASD system; in fact the states contracted with NASD to run the thing based on their prior experience. I understand the issues companies working in multiple states have with licensing issues; the NMLS should fix that.

    My worry is that in the ever-present zeal to bayonet the wounded Congress will do even more to cut the states out of the regulatory pie, or will reduce us to nothing more than subcontractors enforcing Federal law. After all, we've been the ones on the front lines; the ones taking the complaint calls from aggrieved borrowers; the ones conducting the interviews with elderly couples who have been screwed out of thousands of dollars and, ultimately, their home. Hell, I've even been the lead witness at a Federal trial that put 2 corrupt mortgage brokers in the Federal Pen.

    I and my colleagues know what's needed in our state, and what will work here may not even be close to what's needed in far more populous states. I hope that when all the dust settles us state-level regulators will retain the ability to set consumer protection law that best fits the consumers in our several states.

    I also want to make very clear that what I and the rest of the states expect in return for making the licensing system a single point of contact (the NMLS) is the ability to require Federally-regulated entities to conform to State consumer-protection law, in other words an explicit overturn/rejection of the Wachovia case. Any time I hear someone advocate for nationwide regulatory consistency what I really hear is "how far down can we push standards and get away with it". After all, consistency is only ever found at the lowest common denominator.

    Let each and every state write the laws that best protect their own citizens, and require every player in the industry to obey those laws. Will that add cost? Undoubtedly, but we've seen what happens when low cost becomes the sole guiding principle. It'll also force entities to decide if they're willing to spend the dosh for a nationwide presence or instead to specialize in a smaller area. I, for one, believe that the nationwide entities were the larger problem in our recent past.
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    Of course you were missed! You were our regulatory voice and perspective. Invaluable here.

    I do believe that states are best suited to protect their citizens when it comes to consumer protection. As long as their is a national registry that keeps unscrupulous firms and individuals from jumping from state to state to wreak havoc financially then I can get behind individual state licensing.

    I agree that consensus floats to the bottom as well and leads to looser standards than otherwise. We've seen that "too big to fail" is clearly a myth, so maybe it's not a bad idea making the barrier to 50-state footprints higher with higher regulatory fees. If you think about it, take a million or two off the CEO bonus and you'd be able to fund a decent amount of your licensing needs right there :)
 

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    April 21, 2009 at 11:11 am

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