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Fundamental Changes Ahead

Paul S. Pilecki

On Dec. 11, 2009, the U.S. House of Representatives approved, by a vote of 223 202, regulatory reform legislation, The Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173). The legislation contains fundamental changes to the structure and approach of financial regulation and supervision in order to address what are perceived to be the principal causes of the financial crisis that grew out of abuses in real estate finance, asset securitization, and unregulated participants in the financial services industry.

The product of the House deliberations reflects the intense advocacy efforts from many sources and resulted in numerous compromises by leadership of the House Financial Services Committee. Nevertheless, the legislation includes many provisions that are not acceptable to the financial services industry. Significant differences exist between H.R. 4173 and the proposal of Sen. Christ Dodd (D-CT), which is expected to be the subject of Senate Banking Committee debate in early 2010.

I. Improving Financial Stability and Enhancing Prudential Regulation

Systemic Supervision and Regulation. This legislation creates a Financial Services Oversight Council to monitor and take actions to address systemic risk. The Council will monitor the marketplace to identify potential threats to the stability of the financial system by strengthening the regulation and supervision of large, interconnected financial firms with the objective of reducing the likelihood of future crises.

The Council would subject those financial companies and activities that it believes pose a threat to financial stability to stricter standards and regulation, including, with respect to companies, higher capital requirements, leverage limits, a debt-equity ratio of not more than 15:1, periodic stress tests, and limits on concentrations of risk. A financial company subject to the stricter standards would be required to develop a plan for its orderly dissolution in the event of severe financial distress.

The Federal Reserve Board (“FRB”) will serve as the agent of the Council in regulating systemically risky firms on a consolidated basis and systemically risky activities wherever they occur, ensuring broad accountability for such regulation.

The Council is authorized to subject financial activities or practices to stricter standards upon making certain determinations regarding the impact such activities or practices could have on the stability of the financial system or economy. Any determination under this authority could affect all financial institutions whether or not an institution is systemically significant.

All financial companies with more than $10 billion of total assets would be required to conduct semi-annual stress tests and report the results to both the appropriate primary federal regulator and the FRB. In addition, the FRB could conduct stress tests of a financial company that is not systemically significant without regard to its asset size. A company that the FRB determined to be significantly or critically undercapitalized would be required to submit a rapid resolution plan.

The systemic provisions could apply to a company organized under the laws of another country that has significant operations in the United States (“foreign financial parent”) through a branch or agency of a foreign bank or a U.S. operating entity that engaged in financial activities. In considering whether to apply stricter standards to a foreign financial parent, a financial regulatory agency must consider the extent to which the company is subject to prudential standards on a consolidated basis that are administered and enforced by a comparable foreign supervisory authority.

In addition, a federal financial regulatory agency, in applying standards to a foreign financial parent or its U.S. operations, would be required to take into account principles of national treatment and equality of competitive opportunity.

A financial company that does not control a bank but that is determined to present systemic risk would be required to form an intermediate holding company under a new section 6 of the BHC Act or to terminate any of its nonfinancial activities. The holding company would be subject to the activities restrictions of the Bank Holding Company Act of 1956, as amended (“BHC Act”), specific regulatory requirements, and supervision by the FRB.

Any financial holding company (“FHC”) would be required to meet the well-capitalized and well-managed standards that currently only apply to depository institution subsidiaries of bank holding companies and to foreign banks. The agencies would be required to consider the potential effect on financial stability of any proposed merger, acquisition or consolidation in considering whether to grant approval under the BHC Act or the Bank Merger Act. A financial holding company transaction involving the acquisition of more than $25 billion of assets would be subject to prior FRB approval.

Improved Consolidated Supervision. H.R. 4173 would remove the problematic constraints under the Gramm-Leach-Bliley Act on the consolidated supervision of large financial companies by the FRB, and provides specific authority to the FRB and other federal financial agencies to regulate for financial stability purposes and quickly address potential problems. The FDIC would receive broader authority to conduct examinations related to its resolution responsibilities.

Enhanced Regulation for Non-Banks. H.R. 4173 would place additional safeguards on industrial loan corporations (“ILCs”) and other non-bank depository institutions, bringing them under a consolidated supervisory framework. Existing non-bank banks, ILCs, and similar companies that engage in commercial activities but are not currently subject to bank holding company regulation will not be forced to divest, but their financial activities will be brought under a regulated holding company structure and will face limits on transactions with their commercial affiliates.

The bill also would close prospectively the ILC exemption from the definition of “bank,” so that no additional commercial companies would be allowed to own banks or ILCs without conforming their nonbanking activities and investments to the restrictions of the BHC Act.

The exemption from the definition of “bank” would continue for credit card banks. Indeed, the scope of the exemption would expand by (i) permitting commercial loans to small businesses and (ii) applying to an institution that issues virtual or intangible devices that function as credit cards.

Consolidation of the OTS into the OCC. The House Financial Services Committee holds the view that the existing system resulted in a bias toward “lighter touch” regulation and arbitrage among federal bank and thrift regulators. To address this concern, the bill would consolidate the Office of Thrift Supervision (“OTS”) with the Office of the Comptroller of the Currency (“OCC”).

The bill would not eliminate the thrift charter for organizations dedicated to mortgage lending, but would subject thrift holding companies to supervision by the FRB. The Chairman of the FRB or his designee would become a member of the FDIC Board of Directors to replace the Director of OTS.

Restrictions on Assistance in Times of Crisis. Under H.R. 4173, the FDIC could extend Emergency Financial Stabilization loan guarantees to solvent banks and predominantly financial companies only in a liquidity crisis. This facility, which will only result in a government payout if a guaranteed loan defaults, will be funded by fees paid by financial companies that request guarantees. A similar facility managed by the FDIC generated positive net revenues for the government in the recent liquidity crisis. This authority sunsets on December 31, 2013, unless extended by Congress.

The Federal Reserve’s use of lending authority under section 13(3) of the Federal Reserve Act (“FR Act”) would be subject to significant new restrictions. Use of this authority would require approval by two-thirds of the members of the Council and the consent of the Treasury Secretary after certification by the President that an emergency exists. This authority could not be used to provide assistance to individual companies, and Congress would be able to disapprove further use of the authority.

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