Super-Regulator – You can’t get there from here


New York – While the financial community is feeling a little more relaxed at present, there are still some major imponderables to overcome in the near future. Investment banks are primarily wondering about potential new financial regulations that are being mulled in Washington, but also about the impact of the TARP and Treasury money that has radically increased the leverage of the government over the investment banks involved in the programs.

There are really just two main drivers of opportunities in the market. Major market moves tend to be driven by regulation and/or technological changes.  This year there is no doubt that the greatest threat to the nascent market recovery is the brooding of congress as it considers a legislative response to the financial market melt-down.  The trial balloons are not encouraging for those that prefer the status quo.  After all, it is quite common that legislators, driven by constitute zeal, tend to produce regulatory frameworks that in retrospect are overkill (e.g. swatting a fly with a baseball bat).

Perhaps the most feared dialogue on Capitol Hill involves the construction of a super-regulator that would have jurisdiction over the entire financial services industry.  In Britain, the FSA was created in 2000 by the conglomeration of 7 separate regulatory bodies.  One thought is to have the Federal Reserve take on this role.  The super-regulator would embody all of the current functionality of the Fed, the SEC, the OCC, The office of Thrift Supervision, and the CFTC, to name the most prominent.


The Financial Services Modernization Act of 1999 is best known as the end of Glass Steagal. As part of this, the legislation paved the way for the creation of Financial Holding Companies (HFCs).  The HFCs can now participate in a number of markets and services, which cross are regulated by various regulatory bodies.  While the Act streamlined the corporate structure of HFCs, it failed to improve the coordination of oversight.

 In 2004, then chairman of the SEC Donaldson agreed with the HFCs to allow those institutions to count the full institution’s capital when assessing its capital required for the brokerage businesses.  In exchange for this concession, the SEC got the right to inspect the books of the full HFC-something which it had never seen before. All in all this seemed to be a good trade.  The HFCs could radically expand their leverage to goose returns in the then dull markets and the SEC could take a look at the entire financial position of the HFC. The problem was that leverage increased dramatically at the same time as the Cox SEC simply did not exercise its right to review the HFCs’ books.

Structure of Oversight

While there are a number of players in the field, the important ones are the Fed and the SEC. The Federal Reserve‘s basic mantra is the management of the payments system, the control of inflation and the lender of last resort to the commercial banking system. It is clear that Volker and many economists believe that the best contribution the Fed can provide is an orderly payments system and the control of inflation. The fact that the Fed is the lender of last resort conflicts with its goal of controlling inflation at certain times (such as right now).  This is a delicate balancing act and it is likely that this is what the Fed ought to focus on.

The SEC is responsible for investor protection, fairness, efficiency of the securities markets and the encouragement of capital formation.  Complaints that the SEC has not done its job are valid, but that does not mean that the rules, or the structure of the oversight needs fixing-it means that the SEC should apply the regulations that it is empowered to apply.

One element that needs to be brought under the auspices of federal control is the insurance industry.  This industry is currently monitored by the Office of Thrift Supervision and state regulators. Apparently, not even the witty and gregarious actuarial crowd is capable of sniffing out systemic risk.

Product Oversight

One area that really does need fixing is the regulatory structure around derivatives.  The CTFC was created in 1974 and has basic oversight of the commodities and financial futures and options markets.  The CFTC has jurisdiction over the exchange traded markets, while the SEC has adopted the OTC derivatives market. Clearly this is a non-optimal allocation of regulatory authority.

Weighing the Outcome

While we are admittedly not political hacks, it would seem that change will occur along the most logical trajectory and via the course of least resistance. This implies that the Fed and SEC will remain independent regulatory bodies, but that there will be some melding of roles among the SEC, the CFTC and the Office of Thrift Supervision in the oversight of derivatives trading and risk management. We doubt that congress will force the OTC market to move to the exchanges. This would likely leave the SEC in control of much of the data that would be required for the task of overall systemic risk analysis. However, the Fed is already managing the Treasury lending and the TARP programs and was responsible for the “stress testing” of the banks’ capital positions last month.  And let’s not forget that Treasury Secretary Geithner and Obama consultant Volker will lean toward additional powers for the Fed.

We expect that the Fed will gain additional oversight in the area of systemic risk, while the SEC will gain ultimate oversight of the exchange and OTC derivatives markets as well as a greater role in monitoring the insurance industry and some quasi-oversight of the hedge fund industry.

What does it mean to the Alternative Research Industry?

This year will see even more disruption in the alternative research industry. Given that commission spending will be down significantly and that the Global Research Settlement is ending, the outlook of research revenue is poor. We have heard that that the ARPs involved in the global settlement may lose as much as 2/3rds of their revenue after the settlement winds down in July (Thomas Wiesel and Deutsche will continue into next year). Sell-side research will continue to be under pressure as the banks rationalize cost center expenses, while buy-side shops will seek to build research capabilities internally and through greater use of alternative research products.  We expect that the alternative research industry will grow in numbers in 2009, as displaced fundamental analysts opt to set up shop as alternative research providers, but shrink in revenue.


About Author

Leave A Reply