Committee on Capital Markets Regulation

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The Committee on Capital Markets Regulation is an independent and nonpartisan 501(c)(3) research organization dedicated to improving the regulation of U.S. capital markets. Twenty seven leaders from the investor community, business, finance, law, accounting and academia comprise the Committee’s membership. The Committee co-Chairs are Glenn Hubbard, Dean of Columbia Business School, and John L. Thornton, Chairman of the Brookings Institution.

The Committee’s Director is Professor Hal S. Scott, Nomura Professor and Director of the Program on International Financial Systems at Harvard Law School. The Committee’s research regarding the regulation of U.S. capital markets provides policymakers with a nonpartisan, empirical foundation for public policy.

The Committee on Capital Markets Regulation (the Committee) issued a report on May 26 entitled “The Global Financial Crisis: A Plan for Regulatory Reform.”

This report discusses the think tank’s recommendations for U.S. financial regulatory reform that are broadly similar to those proposed by a number of national and international financial and economic committees, regulators, lawmakers, and organizations. Given the consistency of the recommendations here with similar proposals within the industry and lawmakers, it seems likely that this provides broad-brush insight as to the direction of regulatory reform that the industry is likely to experience, though I would be shocked if all of the recommendations were adopted.

The recommendations are based on two premises:

1. Regulate on Principle. [The Committee] believe[s] market outcomes should not be overridden unless there is a specific justification for government regulation. Such justifications may include:

∗ externalities (the most important being systemic risk);
∗ correction of information asymmetries;
∗ principal-agent problems;
∗ preservation of competition; and
∗ limitation of moral hazard arising from government support of the financial system.

2. Analyze the Costs and Benefits of Proposed Regulations. [The Committee] believe[s] a regulation should be promulgated only when its benefits outweigh its costs, and at the least possible cost.[1]

A. Reducing Systemic Risk

Credit Default Swaps Recommendations 1. Do Not Prohibit CDS Contracts. The Committee believes that CDSs are an important tool for addressing credit risk. 2. Mandate Centralized Clearing to address counterparty risk, liquidity, and transparency issues. 3. Increase Capital Requirements for Non-Centrally Cleared CDSs. The Committee recognizes that some CDSs cannot practically be subject to centralized clearing. 4. Improve Netting Capabilities to include centralized clearing of all derivatives, not just CDSs. 5. Establish 1 or 2 Global Clearing Facilities. 6. Adopt a CDS Reporting System to report volume and transaction data similar to the TRACE system for corporate bonds. 7. Require a Class of Exchange-Listed CDSs. The Committee recommends requiring the listing of certain standardized, high-volume CDSs on exchanges.

Regulation of Capital Recommendations

1. Adopt Standards for Institutional Coverage. “The Committee believes that institutions that have the ability to borrow from the Fed in its lender of last resort role should be subject to some form of capital regulation. Such rules should differ for different activities, e.g., insurance versus banking. Capital rules should be the quid pro quo for protection by the Fed safety net.[2] 2. Leave “Steady State” Risk-Based Capital Calibration Unchanged Pending Further Study. The Committee recommends leaving the “steady state” capital requirements unchanged absent compelling evidence that increased capital levels is warranted. 3. Adopt Counter-Cyclical Capital Ratios. “The Committee believes counter-cyclical capital ratios can be achieved in two ways. First, [the Committee] would encourage dynamic provisioning. This could be done without conflicting with existing securities regulation or accounting standards by providing that additional reserves over “known” losses did not run through the income statement but rather constituted a special appropriation of retained earnings. Secondly, one could require some form of contingent capital. Two promising proposals for contingent capital should be explored—one for catastrophic insurance based on a systemic trigger, and another for reverse convertible debentures based on a bank-specific market value trigger.”[3] 4. Hold Large Institutions to Higher Solvency Standards. 5. Focus Basel II changes on Strengthening Pillars II and III. 6. Maintain and Strengthen the Leverage Ratio. “[The Committee] recognize[s] that in the run-up to the crisis, the capital requirement that arguably performed the best was also the simplest metric—the leverage ratio. The Committee thus believes that a simple leverage ratio constraint should be retained in the United States, and, as proposed by the U.K.’s Financial Services Authority and the Financial Stability Forum (now the Financial Stability Board), adopted internationally. Consideration should also be given to whether the leverage ratio should be recalibrated in terms of common equity rather than total Tier I capital, as presently formulated.”[4]

Regulation of Non-Bank Financial Institutions Recommendations

Hedge Funds

1. Consider the Critical Role of Hedge Funds “…in providing liquidity, absorbing financial risks, and increasing the efficiency of the capital markets. Although [the Committee] support[s] hedge fund registration, [the Committee] reject[s] recent proposals seeking to force hedge funds publicly to disclose information that is otherwise proprietary. [The Committee] likewise reject[s] the imposition of bank-like capital requirements and other leverage requirements that would be ineffective and unsuitable for the diverse hedge fund industry.”[5] 2. Adopt Confidential Reporting of a fund’s liquidity needs, leverage, risk concentrations, and other relevant information. The regulator would bear the burden of demonstrating the need for required information and would have limited authority to take prompt action “where a fund poses a clear and direct threat to market stability.”[6] 3. Provide the Fed with Temporary Regulatory Authority until a permanent hedge fund regulator is established. 4. Facilitate Information Sharing Among National and Supranational Regulators. 5. Introduce Structural Reforms to the Industry.

Private Equity

1. Limit Regulation to Information Collection 2. Relax Acquisition Standards under BHCA and SLHCA. “Given the need for more capital and talented management in the banking and thrift sector, the Committee recommends approval of the acquisition of banks by one or more PE funds without the need for source of strength commitment extending beyond the banking silo of the PE fund complex. [The Committee] further recommend[s] amending the BHCA and SLHCA to permit a PE firm, whether or not it is managing or investing in commercial companies, to acquire a thrift or bank, provided there is adequate separation between the banking and commercial activities of the PE firm.”[7]

Money Market Mutual Funds

1. Introduce Mechanisms for Crisis and Risk Management. The Committee endorses proposals introduced by the Investment Company Institute. 2. Study How to Compensate for Potentially Ongoing Taxpayer Support.

Resolution Process for Failed Financial Institutions Recommendations

1. Establish a Single Insolvency Regime Applicable to All Financial Companies. 2. Provide Adequate Regulatory Flexibility. 3. Apply the Least Cost Test. 4. Authorize Enhanced Resolution Powers for Systemic Risk. “Enhanced resolution powers, including recapitalization, extending loans or guarantees, and “open institution assistance,” should be available to the designated regulator if the risk of insolvency of a particular financial company would pose a systemic risk.”[8] 5. Consider Financing Methods that Protect the Taxpayer. 6. Consolidate or Coordinate Cross-Border Insolvency Proceedings.

B. Reforming the Securitization Process

Incentives of Originators Recommendations

1. Prohibit or Restrict High-Risk Mortgage Products and Lending Practices from Entering the Securitization Market. 2. Strengthen Representations, Warranties, and Repurchase Obligations. 3. Explore Minimum Risk Retention to Improve Incentive Alignment “by requiring [originators] to retain a meaningful portion of the risk associated with the assets that they securitize.”[9] 4. Enhance Disclosure of Retained Economic Interests. “To enable investors to assess the degree of alignment they have with originators, regulators should require sponsors and originators to disclose the following information in public and private securitization offerings:

∗ the amount of economic interest they will maintain in the securitization;
∗ the location in the capital structure of all such retained economic interest;
∗ the duration for which the economic interest will be retained;
∗ the extent to which the sponsor or originator is able and intends to hedge such retained economic interest during the holding period; and
∗ the amount of fee or other income to be earned by the sponsor or originator over the expected and legal life of the securitization.”[10]

Disclosure Recommendations

1. Amend Regulation AB to Increase Loan-Level Disclosures. 2. Study Ways of Improving the Standardized Disclosure Package. 3. Revisit the Applicability of Section 15(d). “[The Committee] encourage[s] the SEC to consider whether the less-than-300-holder exemption from the periodic reporting requirements of Section 15(d) was meant to apply to the typical RMBS issuance otherwise covered by Regulation AB and, if so, to seek statutory changes that would exempt RMBS issuance from its provisions.”[11]

Credit Rating Agencies Recommendations

1. Develop Globally Consistent Standards. 2. Vest Enforcement of CRA Regulation at the Highest Government Level. 3. Avoid Governmental Interference in the Rating Determination Process. 4. Review References to Ratings in Regulatory Frameworks. Regulators should review the appropriateness of references to credit ratings to determine if relying on such ratings is appropriate as compared to other alternatives. 5. Increase Disclosure as to How Ratings are Determined.

C. Enhancing Accounting Standards


1. Study How FVA Can Be Improved. “The Committee believes “fair value” accounting is a problematic standard in inactive or distressed markets because it conflates the concepts of market value and credit model value and may confuse investors. [The Committee] do[es] not believe the problem has been solved by FASB’s latest guidance. [The Committee] recommend[s] continuing to study how “fair value” accounting can be improved. [The Committee] further recommend[s] that this be done on a joint basis by FASB and IASB, so the two major accounting standard setters are consistent in their approach.”[12] 2. Supplement FVA with Dual Presentation of Market and Credit Values with full disclosure of underlying valuation methodologies. 3. Allow the Fed to Use a Non-GAAP Methodology. 4. Implement FIN46R.

D. Regulation of Bank Activities


1. Refrain from Reimposing Glass-Steagall 2. Avoid Directed Lending

E. Reorganizing the U.S. Regulatory Structure


1. Retain Two or Three Regulatory Bodies. Retain the Fed and create the U.S. Financial Services Authority (USFSA), and possibly a new investor protection agency. 2. Increase the Role of the Fed to regulate matters relative to systemic risk and capital requirements of financial institutions. 3. Establish the USFSA. The USFSA would regulate all aspects of the financial system and would be comprised of all, or parts of the Comptroller of the Currency, the Office of Thrift Supervision, the FDIC, the Sec, and the Commodities Futures Trade Commission. 4. Enhance the Role of the Treasury Department to coordinate the work of the Fed and USFSA. 5. Study Supervisory Options. 6. Protect Consumers and Investors.

F. Facilitating International Regulatory Cooperation


1. Support Global Regulatory Reforms. 2. Enable the IMF to Play an Early Warning Role. 3. Strengthen Regulatory Dialogues.

  • [1] Committee on Capital Markets Regulation, “The Global Financial Crisis: A Plan for Regulatory Reform, Executive Summary” May, 2009, Page 4. [1]
  • [2] Ibid, Page 10.
  • [3] Ibid, Pages 10-11.
  • [4] Ibid, Page 11.
  • [5] Ibid, Page 12.
  • [6] Ibid, Page 13.
  • [7] Ibid, Page 15.
  • [8] Ibid, Page 18.
  • [9] Ibid, Page 22.
  • [10] Ibid, Page 22.
  • [11] Ibid, Page 24.
  • [12] Ibid, Page 29.


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