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Senate Hearings Chart Way Forward on Financial Regulatory Reform

In the first of what promises to be a series of hearings on financial regulatory reform, the Senate Banking Committee heard from former Federal Reserve Board Chairman Paul Volcker, a top adviser to President Obama on financial regulation. Committee Chairman Christopher Dodd (D-CT) first outlined the essential elements that will drive the reform. The first order of business will be to erect a new financial regulatory regime in order to restore investor confidence in the securities markets. As part of this legislative effort, the committee will execute an ambitious schedule of meetings, briefings, and hearings to understand the strengths and weaknesses of the current regulatory system. The committee's inquiry and deliberations will be guided not by pre-conceived notions, but by core principles that must be reflected in any comprehensive reform effort, according to Dodd.

One core principle is that regulators must be strong cops on the beat, rather than turn a blind eye to reckless practices. As SEC Chairman Christopher Cox conceded earlier, voluntary regulation has failed and it is now clear that the financial markets alone cannot be entrusted to police themselves. The consequences for taxpayers are just too great to allow significant market actors to carry out their activities in an unregulated or under-regulated environment, Dodd said. He wants to consider replacing the current alphabet soup of regulators with a single prudential regulator.

Dodd said there will also be a need for a single agency to regulate systemic risk. If that agency is the Federal Reserve Board, he said the independence and integrity of the Fed's monetary policy function must be ensured. Some have expressed concern about overextending the Fed when it has not properly managed its existing authority. A systemic risk regulator is deemed crucial to restoring confidence in the markets because the current system of regulators acting in discrete silos does not equip any single regulator with the tools to identify or address enterprise or system-wide risks.

Volcker outlined a broad reform of financial regulation along the lines of the recent recommendations of a report he vetted for the G-30. The plan envisions a macro prudential regulator and more robust regulation of credit rating agencies. The plan states that fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets.

The plan recommends a framework for national-level consolidated prudential regulation over large internationally active brokerage firms, investment banks and financial institutions. In addition, money market mutual funds wishing to continue to offer bank-like services, such as transaction account services, withdrawals on demand at par and assurances of maintaining a stable net asset value ("NAV") at par should be required to reorganize as special-purpose banks with appropriate prudential regulation, government insurance and access to central bank lender-of-last-resort facilities.

Institutions that remain as money market mutual funds should only offer a conservative investment option with modest upside potential at relatively low risk. The vehicles should be clearly differentiated from federally insured instruments offered by banks, such as money market deposit funds, with no explicit or implicit assurances to investors that funds can be withdrawn on demand at a stable NAV. Money market mutual funds should not be permitted to use amortized cost pricing, with the implication that they carry a fluctuating NAV rather than one that is pegged at $1 per share.

Managers of private pools of capital that employ substantial borrowed funds should be required to register with the SEC or some other appropriate regulator, with provisions for some minimum size and venture capital exemptions from the registration requirement. The prudential regulator of these managers should have the authority to require periodic reports and public disclosures of appropriate information regarding the size, investment style, borrowing and performance of the funds under management. Since the introduction of even a modest system of registration and regulation can create a false impression of lower investment risk, disclosure and suitability standards will have to be reevaluated. For funds above a size judged to be potentially systemically significant, the prudential regulator should have authority to establish appropriate standards for capital, liquidity and risk management.

Regulatory standards for governance and risk management should be raised with particular emphasis on enhancing boards of directors with a greater engagement of independent members that have financial industry and risk management expertise. It is imperative to coordinate board oversight of compensation and risk management policies with the aim of balancing risk taking with prudence and the long-run interests of and returns to shareholders.

The reforms also must ensure that risk management and auditing functions are fully independent and adequately resourced areas of the firm. The risk management function should report directly to the chief executive officer rather than through the head of another functional area.