regulation of u. s. financial systemintl.jxufe.cn/u/jianxiregulationoffinindfinalshort...delegated...

Regulation of U. S. Financial System

10/30/2012 1Copyright Dr. M. Myra S. White, J.D.

10/30/2012 Copyright Dr. M. Myra S. White, J.D. 2

To understand China "it is necessary to get to know her yesterday, her today, and her tomorrow.” Premier Wen Jiabao, Harvard Business School, 2003


Goal of Training

To understand the U.S. system you must understand the reasoning behind the system. This will help you anticipate what the U.S. will do next. This program will:

• Provide an Overview of Sources of Regulatory Power in U.S.

• Explain the U.S. Regulatory Philosophy

• Provide a Historical Summary of Major Regulatory Statutes

• Discuss the Effectiveness of the U.S. System

• Discuss Future Directions


Caveat Emptor!Let the Buyer Beware.


• Belief that democracy and capitalism are linked. Free markets are essential to democracy.

• Regulation only follows a crisis.

• Deregulation comes with economic booms.

• A lot of regulation lies with nongovernment entities. For example, the SEC delegates regulatory authority to the NYSE and other exchanges.

Ambivalence About Regulation


• Belief that the economy drives financial markets.

• Belief in the efficient-market hypothesis (EMH)

• Financial markets are "informationally efficient“

• Prices of traded assets (e.g., stocks, bonds, or property) already reflect all available information about the economy, and instantly change to reflect new information.

Ambivalence About Regulation


The U.S. Regulatory Maze

Longleat House Maze


Where Does Regulatory Power Lie?

Federal Government

Legislative BranchMakes laws regulating the financial industry.



Federal Government

Executive BranchPresidentDept. of Justice

Civil Cases--Claim of fraud on the government.• Sued Ken Lay, CEO of Enron, claiming the assets he

accumulated were the result of criminal activity.

Criminal Cases--Prosecutes criminal security violations.• Prosecuted Jeffrey Schilling, Kenneth Lay and others

for securities fraud: concealing company losses from investors and SEC; selling stock using inside information not available to other investors.

• Failed to convict two Bear Stearns hedge fund managers on charges of misleading investors about the health of the funds.



Federal Government

Executive BranchTreasury Department• Office of the Comptroller of the Currency

Charters, regulates and supervises national banks.

• Office of Thrift SupervisionRegulates savings institutions.

• Office of Financial StabilityRuns Troubled Asset Relief Program (TARP): purchases assets and equity from financial institutions that are difficult to liquidate and value.



Federal Government

Judicial Branch• District Courts

Hear cases brought by Dept. of Justice and individuals suing under federal law and constitutional challenges.

• Appellate CourtsHear challenges to District Court decisions. These challenges can be based on failure to follow procedure or

constitutional challenges.



Federal Government

Judicial Branch• Supreme CourtConstitutional challenges. Must file a writ of certiorari.Only about 1.5% of writ of certiorari accepted.Types of cases it hears:

• Constitutionality of a provision of Sarbanes Oxley which limited accounting conflicts of interest was challenged.

• Currently hearing a case that centers on when the five year statute of limitations for bringing a claim for fraud on the market begins to run in SEC and other government enforcement actions at the time of discovery or when it occurred. Gabelli v. SEC.



The Fourth Branch

The Federal Reserve

The Federal Reserve is the US government’s banker.

It sets US monetary policy

It regulates and supervises the banking system.

• Monitors, inspects and examines member banks to make sure they are in compliance with relevant laws and regulations.

• Has authority to take action to correct problems it finds.



The Fourth Branch

Federal Reserve

Many question whether the Federal Reserve acts in the interests of the US government or the financial industry.

The Federal Reserve Bank has many features of a private corporation and some features of a federal government agency.

• Created by the Federal Reserve Act of 1913. Great controversy over whether it should be private or run by the government.

• Result is a hybrid organization that acts like a private corporation but the President and Congress exercise some limited control over it.



The Fourth Branch

Federal Reserve

• Pays all profits to US government.

• All national banks must be members of the Federal Reserve. As part of their membership they must buy shares in the bank. They receive a dividend on their shares that can’t exceed 6% in the value of their shares.

• It is run by the Federal Reserve Board which has seven members who are appointed by the President and confirmed by the Senate. The Chairman is selected by the President.



The Fourth Branch

Federal Reserve

• The only way that a member of the board can be removed is by impeachment which is a long and difficult process that must be initiated by the Senate.

• Congress has the capacity to change the statute that created the Federal Reserve Bank to limit its power but typically their only oversight involves inviting the Chairman to come to Washington to provide a report.

• Many powerful figures from the financial industry are often members of the various governing bodies in the various federal reserve district banks thus leading people to suggest that it acts in the interests of the financial industry rather than the United States. i.e. Jamie Dimon is one of the board of directors for the New York district bank.



The Fourth Branch

Federal Reserve

The Enormous power of Federal Reserve.“It is either our curse or blessing that we live in the Republic of the Central Banker.” Brad DeLong, Berkeley Economic Historian after the Federal Reserve rescued Wall Street.

The Federal Reserve can create money and transfer it to bank accounts when it wants with a few computer key strokes. Normally it only lends to member banks but it does have the power to lend to any institution if it declares the circumstances “unusual and exigent” and the borrower has sufficient collateral. However, until the credit crisis of 2008 the Federal Reserve only lent to member banks.



The Fourth Branch

Federal Reserve

The Enormous power of Federal Reserve.On a Sunday in March 2008 the Bernanke, Chairman of the Federal Reserve & Geirthner, head of the New York Federal Reserve broke with 70 years of policy. They lent $30 billion to JPMorgan Chase to buy Bear Stearns. This was a change of 70 years of policy.


Where Does the Power Lie?

The Fourth Branch

Federal Reserve

September 14, 2008 Bernanke, Geithner and Paulson let Lehman Brother’s fail because they did not believe that it had the assets to cover a loan. In the next week they:

• Lent AIG $85 billion.

• Got Bank of America to buy Merrill Lynch


Where Does the Power Lie?

The Fourth Branch

Federal Reserve

In the next week they:

• Converted Goldman Sachs and Morgan Stanley into bank holding companies so they could access the Fed’s discount window. (Need to have the Federal Reserve’s approval to do this.) Federal Reserve gave them temporary permission to continue to operate as a high risk investment banks. Namely, they exempted them from the Fed’s Market Risk Rule which determines how capital requirements are calculated.


Where Does the Power Lie?The Fifth Branch

Independent Regulatory Agencies

• Created by Congressional statutes which give them rule-making power. Essentially they are an arm of Congress.

• Run by boards and commissioners appointed by the President and approved by Congress.

• They are not part of the executive branch so the President does not directly control them.

• Congress can amend the laws that created them if they disagree with their regulations and actions.

• Examples: Securities and Exchange Commission, Commodities Futures Trading Commission (Regulates commodity futures and option markets).



Independent Regulatory AgenciesAgencies, like Congress, have the power to make laws.• Congressional statutes are broadly worded and just state basic

the basic roles and objectives of the an agency.

• Agencies interpret the statutes and promulgate rules based on their interpretation.

• Proposed rules are put out for public comment. The final rule is usually voted on by the commissioners or board members. Once a rule is published it becomes law.

Example: Security and Exchange Commission: http://www.sec.gov/rules/proposed.shtml ( Rule regarding issuer repurchase of securities they have issued.)

http://www.sec.gov/rules/proposed.shtml




The regulations agencies create are subject to judicial review.

They can be challenged in court on 4 grounds:• Statute giving authority to the agency is constitutionally vague

and as a result gives the agency too much authority.

• Statute or the regulation violates the U.S. Constitution.

• The regulation exceeds the authority granted by the statute.

• In issuing the regulation the agency failed to follow the procedures set forth in the Administrative Procedures Act.




Agencies have enforcement functions. • Bring actions that are held before

independent administrative judges. These are frequently actions to impose sanctions and penalties.

• Work with the Dept. of Justice, and state attorney generals to bring criminal charges.


Where Does the Power Lie?The Sixth Branch

Self Regulatory Organizations Private companies or organizations that have been delegated authority to regulate an industry or profession.

• An Example: SEC has delegated authority to the NYSE to enforce certain industry standards and requirements related to securities trading and brokerage. The NYSE:

• Creates rules and regulations.

• Has its own enforcement division which enforces its rules and also SEC rules.


Where Does the Power Lie?The Sixth Branch

Self Regulatory Organizations

• An example: SEC has delegated authority to FINRA: Financial Industry Regulatory Authority, a private company, to: • Oversee brokerage firms and registered securities

representatives.

• Write rules, enforce these rules and also federal security rules.

• Perform market regulation under contracts with NASDAQ, American Stock Exchange, the International Securities Exchange and the Chicago Climate Exchange.


Where Does the Power Lie?The Seventh Branch

50 State governments and two territories.


Where Does the Power Lie?The Seventh Branch

50 State governments and two territories.• Most states have a securities act that is similar to the

federal act. For example, securities sold in the state must be registered and there are strong anti-fraud sections with criminal and civil penalties.

• Massachusetts has a strong Securities Division which actively pursues actions against violators of provisions of its securities laws.


Overlap of Regulatory Structures

Legislative

Judicial

Independent Agencies

State Governments

Self Regulating

Organizations

Federal Reserve

Executive


Overlap of Regulatory Agencies Commercial Banks are regulated by the following:• Federal Reserve: Regulates all member banks.

• FDIC: Regulates all banks that carry deposit insurance.

• State Regulators: Regulate all state chartered banks. Some of these may also be members of the Federal Reserve and have federal deposit insurance.

• The Office of the Comptroller of the Currency: The Office of the Comptroller of the Currency (OCC) charters, regulates, and supervises all national banks


Overlap of Regulatory Agencies Commercial Banks

Regulation of banks traditional operations has been highly effective. However, in the new financial era many institutions were created that played a key role in capital markets that were not banks and fell outside of banking regulations.

Federal Reserve

Office of the Comptroller of the Currency

Federal Deposit Insurance

Corporation

Federal Reserve

State Regulatory Agency

Federal Deposit Insurance

Corporation

Federal Banks State Banks


Overlap of Regulatory Agencies

55 different agencies regulate securities including the securities commissions in the 50 states and 14 territories.


Reasons Regulation Fails

Despite the enormous amount of regulation financial institutions have found ways to evade regulation as the credit financial crisis of 2008 has illustrated.

• Regulatory structure designed for a different era. Major securities laws were written 75 years ago.

• Use of technology and computers have increased the speed and complexity of transactions.

• Internationalization of financial industry.


Focus of Regulation

• Disclosure—Making all relevant information available to institutions and the public. Key focus of regulation of securities.

• Liquidity—Reserves and collateral—amount of deposits/assets held to cover defaults. Key focus of regulation in banks and exchanges.

• Conflict of Interest—Are the parties or person making a decision serving more than one master—a personal vs. an institutional interest?


Disclosure• Roots lie in the key role that fraud plays in the legal

system. Fraud is hiding information from people, giving them false information or misleading them.

Smoke and Mirrors


Disclosure• Belief is that disclosure will protect against fraud.

Brandeis wrote in 1914: “Sunlight is said to be the best

of disinfectants; electric light the most efficient policeman.”

Supreme Court Justice, 1916-1939

Investors don’t need to be protected from risk: Caveat Emptor.


Disclosure• Purpose of disclosure laws is to set the grounds for criminal

and civil cases against financial institutions and individuals who commit fraud by failing to disclose information or by providing deceptive or inaccurate information.

• Fraud is both a criminal offense and a civil offense under US law.

• Criminal offense: Go to jail and be fined.

• Civil offense: You can be sued for the monetary damage that you caused.


DisclosureKey criminal charges against Bernie Madoff were fraud.

Federal Prosecutors brought 11 charges.

6 of these charges were based on fraud.

• Securities Fraud

• Investment Advisor Fraud

• Mail Fraud

• Wire Fraud

• False Statements

• Making a False Filing with Securities and Exchange Commission


Disclosure

Securities and Exchange Commission brought civil charges based on fraud.

“We are alleging a massive fraud — both in terms of scope and

duration," said Linda Chatman Thomsen, Director of the SEC's Division of Enforcement. "We are moving quickly and decisively to stop the fraud and protect remaining assets for investors, and we are working closely with the criminal authorities to hold Mr. Madoff accountable."


Liquidity

Reserves are a key area of bank regulation. • Regulatory bodies are given the power by law to set

reserve requirements--the amount of capital a bank must hold as a percentage of assets.

• U.S. has implemented the Basil II Accord with some modifications which calculates capital reserve requirements based on the degree of risk to which a bank is exposed. This involves an assessment of potential loss of value of assets based on market movement.

Copyright Dr. M. Myra S. White, J.D. 41

Liquidity

Reserves are a key area of bank regulation. • U.S. banks use the VAR (Value at Risk) model to calculate

asset risk. This proved inadequate during the credit crisis because historically mortgage defaults had been low.

• Models relied on historical data which did not take into account housing market bubbles and market speculation.

• Models failed to take into consideration that the risk of default of bundled mortgages (MBS) and loans (CDO) might be correlated.

10/30/2012


Liquidity Collateral Requirements

• Banks have collateral requirements though they are often minimal.

• To obtain mortgages the property to be mortgaged must be valued at greater than the value of the loan.

• Exchanges and brokerage houses have margin requirements.


Conflict of Interest• Important legal concept in western law.

• Goal is prevent agents acting in their own interests rather than their clients’ interest.

• Securities laws have restrictions on the ability of issuers of shares to purchase shares they issue because it creates a conflict of interest. As active players in the market they could manipulate the price by buying shares.

• Requirements that brokers and institutions disclose who is paying their commission.


Effectiveness of RegulationPatch-Work System

• Most regulations been created in response to a crisis.

• Lack of a comprehensive approach to regulation which encompasses the entire system.

• Numerous regulatory bodies.


Effectiveness of RegulationSerious Gaps in Regulation

• Examples

• Mutual Funds and hedge funds are not as heavily regulated as other securities

• Commercial paper, a short-term debt instrument usually issued by well-known credit-worthy firms, is usually unsecured with collateral. As long as its maturity is less than 270 days it doesn’t need to be registered with SEC.

• Loop-hole used to raise money by JPMorgan derivative traders to avoid regulation and reserve requirements.


Effectiveness of RegulationSerious Gaps in Regulation

• Privately placed bonds don’t need to be registered with SEC. Often placed with institutional investors like insurance companies, pension funds etc.

SEC also doesn’t regulate the trading of them among large institutions.

• Futures contracts are regulated by SEC but over the counter derivatives and swaps are not.

Issue being addressed by Congress but the financial institutions in this area are very powerful as illustrated by the passage of the Commodities Futures Modernization Act.


Effectiveness of Regulation• Gaps in regulation

• Over the counter markets—penny stocks are often not regulated.

• Creative Legal Structures

Shell companies, like special purpose entities, allow companies to hide their debt.

Began with Enron.


Effectiveness of RegulationAntiquated system.

• Major securities laws passed 75 years ago.

• World where there were no computers.

• Credit derivatives, Swaps, MBS and CDO’s didn’t exist. • Regulatory groups lack mechanisms for keeping up with

an innovative and sophisticated market


Effectiveness of RegulationCreative Accounting

• Many ways to distort expenses

Examples:

Investors ignore one-time write-offs against expenses which occur when a project ends. However, some firms shift normal operating expenses into these write-offs which misleads investors to believe that on-going expenses are lower than they really are.Enron created special purpose entities in which to download losses. If investor capital in one of these entities is 3 percent of partnership capital, the entity doesn’t need to be treated as a subsidiary and it isn’t legally required to be included in the company’s financial statements.


Effectiveness of RegulationRevolving door between regulators and financial industry.

• Federal ReserveRegional banks are owned by member banks in their district. Each member is required to buy stock in the regional federal reserve bank.Members of the local banking community sit on committees and boards. In NY many are from the large NY financial institutions like Goldman Sach’s & JPMorganChase.


Effectiveness of RegulationManipulation of restrictions on reserves.

• Greece misrepresented the amount of its debt in order to evade European Union deficit requirements. Through a series of cross-country currency swaps Goldman Sachs provided money up front in exchange for the right to future income streams from lotteries and airport fees.

• AIG avoided reserve requirements by exploiting a regulatory gap. It was listed as an insurance company which allowed it to evade the reserve requirements of banks must meet.


Effectiveness of RegulationThe Power of Lobbyists & Influence

• International Swaps and Derivatives Association was a powerful force in seeing that swaps and over the counter derivatives were not regulated.

• Large financial institutions have easy access to the Federal Reserve because people in the financial industry in New York all know each other. There is a revolving door between the Fed and large financial institutions.

• Even the Federal Reserve has a Washington lobbyist.

• Large financial firms lobby the rating agencies to get favorable ratings for their securities. This happened with mortgage backed securities.


Effectiveness of RegulationLack of Accountability

• Difficult to design regulations that hold people accountable and reduce risk.

• Fannie Mae and Freddie Mac took enormous risks but there were no consequences for their actions. The US government owned them and would always bail them out.

• Moral Hazard Problem: If institutions think that they are insulated from risk, then they will take bigger risks, i.e. credit default swaps.


Effectiveness of RegulationProblem of using the legal system

• Extremely Costly

• Criminal System is not that effective

• Problems of Proof

• Enron prosecutors never proved their case. They instead relied on public outrage.

• Failure to get a conviction in Bear Stearns case.

• Only partial disgorgement ever occurs.


Future RegulationWhere is regulation going now?

New regulations at SEC

Congressional bills

New policies at Federal Reserve.

•Citigroup and JPMorgan became bank holding companies so that they can now have access to the discount window. This makes them subject to Federal Reserve reserve requirements.


Regulations Never Fully Protect Investors

Who can you trust?• Impossible to have full disclosure

Is it too good to be true?• Madoff

Where is the collateral?

• How many degrees of separation from security to assets?

• Use your own auditors.

Know with whom you are dealing!

regulation of u. s. financial systemintl.jxufe.cn/u/jianxiregulationoffinindfinalshort...delegated...

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