While the Treasury Department’s proposals for overhauling regulatory oversight of the financial industry have been in preparation almost since the day Secretary Paulson assumed office, their release at this time almost certainly is a reflection of the realities and massive concerns which have arisen resulting from the near-collapse of Bear Stearns.

As its guiding principle in preparation of the proposals, Treasury states that it “has developed each and every recommendation in this report in the spirit of promoting market stability and consumer protection.”

The short-term recommendations contained within the proposals seem likely to receive immediate consideration by Congress. The intermediate-term and longer-term proposals will probably incite another round of “turf wars” and massive lobbying on the part of the many governmental and business groups which will be directly affected.

The Treasury has taken particular note of the subprime mortgage crisis, which may have been caused in substantial part by the origination of risky mortgages by operators whose credentials and business ethics may leave something to be desired. In addressing that issue, the Treasury recommends creation of a “Mortgage Origination Commission” as the vehicle for Federal oversight of this part of the industry. The Mortgage Origination Commission would be charged with the responsibility of developing or promulgating uniform minimum licensing qualification standards which the States would be required to follow, including personal conduct and disciplinary history, minimum educational standards, testing criteria and procedures, and license revocation standards. The Federal Reserve would retain the sole authority to write regulations implementing the Federal Truth In Lending Act.

In light of the broad national trend toward qualification and licensing of professionals, the Treasury seems to have spotlighted a weak link in the system whereby unscrupulous and unregulated mortgage originators preyed upon vulnerable borrowers; after which such unworthy loans were packaged, re-invented, and sold off to financial institutions which were panting at the gate for product which had been magically transformed by the rating agencies into prime goods, to the eventual pain of all. Having in mind the current trend toward licensing, it would seem that a proposal to impose upon the States a Federal requirement that mortgage originators be properly qualified and licensed ought to enjoy a favorable and quick reception in Congress.

The Treasury’s second major short-term proposal would confer upon the Federal Reserve the power to provide non-depository institutions the right of access to the “discount window,” which right is currently limited by law to depository institutions (i.e., banks). Clearly, the Treasury has in mind the contorted device to which it resorted in the Bear Stearns matter, whereby access to funds or guarantees from the Federal Reserve to Bear Stearns was provided indirectly through the use of JPMorgan Chase (clearly a “depositary institution”) as an intermediary.

Common sense would seem to say that the proposal to streamline the “discount window” process in order to reflect reality ought to be favorably received by Congress.

The membership in The President’s Working Group on Financial Markets, which was established by Executive Order some twenty years ago following the crash of 1987, would be expanded, and its scope of authority would be broadened so as to include the entire financial system, not only financial markets. Its role is as the (”the,” not “a”) coordinator for financial regulatory policy.

Intermediate-term, the Office of Thrift Supervision would be closed and its duties assumed by the Office of the Comptroller of the Currency.

The Treasury’s report points out that, historically, the insurance industry in the United States has been regulated by the States, not by the Federal Government. This, of course, has led to a costly nightmare involving the necessity for an insurance company to conform to the particular requirements of each State in which it would like to do business. In addressing that issue, the Treasury proposes the creation of an “optional federal charter for insurers within the current structure.” (“optional” is the operative word). The optional Federal charter system would provide for Federal chartering, licensing, regulation, and supervision of insurers, reinsurers, insurance agents, and insurance brokers. Those insurers not electing to “opt-in” would continue to be regulated at the State level. For those opting-in, the Federal rules would pre-empt State rules, with exceptions. “No optional federal charter would authorize an insurer to hold a license as both a life insurer and casualty insurer.” The writer foresees some substantial problems with that statement; and unless modified in actual practice, might effectively preclude some insurers who enjoy a multi-state business presence from opting-into the Federal system.

The entire operation of the “optional national charter” system would be administered by a new office – the “Office of National Insurance,” to be headed by the “Commissioner of National Insurance.”

The Commodity Futures Trading Commission would be merged into the SEC, with an implicit finger-wag directed at the SEC to be open to listen hard to some of the CFTC’s less-restrictive operating practices. Treasury wants “to preserve the market benefits achieved in the futures area,” and desires “that the SEC undertake a number of specific actions….to modernize (its) regulatory approach to accomplish a more seamless merger of the agencies….Core principles should be modeled after the core principles adopted for futures exchanges and clearing organizations…..By imbuing the SEC with a regulatory regime more conducive to the modern marketplace, a merger between the agencies will proceed more smoothly….Concurrent with the merger, the new agency should adopt overarching regulatory principles focusing on investor protection, market integrity, and overall financial system risk reduction. This will help meld the regulatory philosophies of the agencies. Legislation calling for a merger should task the (President’s Working Group) with drafting these principles.”

The authority and responsibility of the Federal Reserve would expand. Whereas the Fed is now seen as the supervisor of certain banks and of all bank holding companies, its role would be recast as the regulator of systemic risk. It would be responsible for overall issues of financial market stability. It would be in charge of three new charters or offices: the Federal Insured Depository Institution charter; a Federal insurance institution; and a Federal financial services provider. Other offices would be formed to supervise them directly.

Bank holding companies would be required to incorporate their banking subsidiaries’ statements onto the balance sheet of the holding companies. The Federal Reserve would have broader information-gathering tools, and would be empowered to participate in and initiate examinations of Federally-chartered entities. The Fed would have the power to compel public disclosure “about financial exposures that are important to overall market stability” so as to “highlight areas of risk exposure that market participants should be monitoring.” The Fed would “have authority to require corrective actions to address current risks or to constrain future risk-taking”….the Federal Reserve “would have residual authority to enforce compliance with its requirements under this authority.”

The Treasury’s proposal calls for the establishment of a “business conduct regulator,” which would “monitor business conduct regulation across all types of financial firms…”. Treasury is interested in “key aspects of consumer protection such as disclosures, business practices, and chartering and licensing of certain types of financial firms.” This regulator would focus on “providing appropriate standards for firms to be able to enter the financial services industry and sell their products and services to customers.”

The Federal Deposit Insurance Corporation would be reconstituted as the Federal Insurance Guarantee Corporation, whereby its responsibilities would expand beyond deposit insurance.

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The underlying premise of Treasury’s report is to ensure that the United States “maintains its preeminence in the global capital markets” and to improve the regulatory structure to that end. Its desire is to move from the current functional regulatory approach to an objectives-based regulatory atmosphere.

The Secretary’s fingerprints are all over the Treasury’s report. One should bear in mind from whence he came – namely, he served as Chairman of the Board of Goldman Sachs. Considering that background, it is perhaps a little surprising that so much additional regulation and creation of alphabet soup agencies has been recommended. And yet, it seems quite remarkable and far-reaching in the apparent desire to improve operations across the board in the longer term, in the interest of strengthening the competitiveness of our financial system worldwide, as well as its intention that the mortgage meltdown and near-death of Bear Stearns must never happen again.

William Kurtz March 30, 2008 http://www.candlewave.com