Tuesday 16 September 2008

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Scope of Regulatory Revamp
Is Likely to Widen

Derivatives Market
Could Get Oversight
As Fed Expands Role

By KARA SCANNELL
September 16, 2008

The dizzying events of the weekend make it increasingly likely that regulatory oversight lines will be redrawn by the next administration and Congress.

A big regulatory overhaul already was under discussion in Washington. Now that likely will go beyond the question of agency regulation of investment banks. The result could also end in oversight of derivatives and tighter provisions to prevent firms taking on too much debt.

Since the sale of Bear Stearns Cos., the Securities and Exchange Commission has shared oversight of big, independent brokerage firms with the Federal Reserve. Over the summer, it solidified that arrangement in a memorandum of understanding.

Lehman Brothers Holdings Inc.'s bankruptcy filing and Merrill Lynch & Co.'s sale to Bank of America Corp. add heft to the argument that the Federal Reserve should oversee investment banks to ensure market stability. The weekend's shake-up left the SEC with oversight of just two large brokerage firms, Goldman Sachs Group Inc. and Morgan Stanley.

"The role of the Fed as the systemic risk regulator was well on its way to being adopted, and this will make it more likely," says Robert Glauber, a former Undersecretary at the Treasury Department for domestic finance.

Treasury Secretary Henry Paulson issued a blueprint for a regulatory revamp in March that called for a bigger role for the Fed in guarding the overall health of the financial system. Mr. Paulson said Monday that "major changes" need to be made, including establishing a process to unwind investment banks akin to the orderly process in place for unwinding commercial banks.

Future oversight is "going to have to be streamlined and more effective regulation," he said.

In 1999, Congress created a system of "functional regulation" that put the SEC in charge of brokerage firms and the Fed in charge of commercial banks. Congress didn't address brokerage-firm parent companies.

The Fed has oversight of commercial banks in part because they have access to the Fed's special lending facilities and because the government insures customer deposits.

Brokerage firms, by contrast, have been subject to different regulation because their business model has been based more on helping companies raise capital and on risk-taking. The current credit crunch, which has brought the Fed into a much tighter relationship with Wall Street, has changed that dynamic.

SEC Chairman Christopher Cox in July told a congressional committee that the SEC should be given statutory oversight of investment-bank parent companies, given its staff's deep knowledge of financial markets. On Monday, through a spokesman, Mr. Cox said, "Even in the aftermath of Merrill and Lehman, the concept of functional regulation still makes sense."

He said that it would still make sense even if investment banks merged into commercial banks, but he added, without elaboration, that the Fed and SEC's approach would have to "be adapted."

Richard Breeden, a former chairman of the SEC, said switching regulators alone, without taking a deeper look into what went wrong, would be a mistake.

"The issue that is most important to me is making sure that regulators are able to have a realistic picture of overall leverage and do a better job of controlling it than we have done historically," he said.

Other regulatory changes also are likely to gain momentum, former government officials said. Federal regulators have called for changes to the over-the-counter derivatives market -- the trading of complicated financial products -- where there are fewer standard rules and procedures compared with regular stock markets. That has become an issue for regulators as they try to determine the impact of one firm's trades on the entire market.

Additional regulation could range from requiring more details about who is trading what, and with whom, to requiring such contracts be traded on an exchange. Wall Street firms have resisted such moves for years because they would eat away at profit margins. But the credit crunch has exposed how intertwined those contracts are.

Monday, lawmakers said Congress needed to conduct examinations to find out what led up to the current credit crunch. In addition, Rep. Paul E. Kanjorski (D-Pa.) called for the House to pass a law that would create an office within the Treasury Department to oversee insurance.