Financial Regulatory Forum

U.S. financial regulation: Three things to watch, and two not to, in 2011 – Complinet column

By Guest Contributor
January 3, 2011

MARKETS-STOCK/By Scott McCleskey, Complinet

The past year was a busy one for those interested in financial reform – you know, Dodd-Frank and all that. But the new year will be even more fateful in shaping the markets for decades to come. It is likely to be the most critical of the post-financial crisis period. The reason is that Dodd-Frank only gave the regulators their marching orders, and 2010 mostly saw just the preliminaries to the really tough regulation. It will be in 2011 that actual rules will be proposed, finalized and implemented – and all by mid-year, if deadlines are met. It will also be when the Republicans hit the beach in the House and attempt to moderate or reverse many of the reforms already underway.

There will be a tidal wave of Dodd-Frank work, and some areas of focus are already obvious. The launch and first steps of the Consumer Financial Protection Bureau will be one, and the rather iffy implementation of derivatives regulation will be another. These items have been and will continue to be covered by this organization and others. But there are other items largely outside the Dodd-Frank ecosystem which bear a close watch over the coming year – and there are also some receiving a lot of press lately which can be ignored.

WHAT TO WATCH:

Credit cards

The first big issue to watch will be the regulation of credit cards. The CARD Act passed in 2009 and has already taken hold on the industry (by which I mean they have already found ways around much of it). But its passage was, as Wellington would say, a damned close-run thing. It only passed in the Senate committee by a vote of 12 to 11 and by a similarly thin margin on the floor. But with the retirement of Chris Dodd, Tim Johnson of South Dakota is the heir apparent to chair the Senate Banking Committee from which the Act was spawned. As Senator Johnson would tell you, credit cards are big business in South Dakota, and it was no surprise that he voted against the CARD Act – the sole Democrat to do so. So an industry already seething at the limitations enshrined in the Act and holding the memory of a close vote for its passage may now see the opportunity to return to the offensive, with a friendly face on the key Senate committee and the Republicans now holding control in the House.

Remember also that the GOP and many in the industry are instinctively suspicious of the Consumer Financial Protection Bureau but largely powerless to reign it in. So if they can change the laws which the CFPB is meant to enforce, they can effectively blunt its onslaught. The CARD Act is the most likely place for them to do so.

High frequency trading

Rightly or wrongly, high frequency trading and its cousins were widely blamed for the May 2010 “flash crash”, though concerns over these practices were on the regulatory agenda even before the plunge. But the flash crash and the subsequent report into its causes gave a sense of urgency and legitimacy to reforms.

In general, this is sensible, since market rules and practices are largely based on the more leisurely pace of 20th century markets, and applying them to modern trading is a bit like applying the Dewey Decimal System to the Internet. The impact of changing these rules will be considerable: if high frequency traders dominate the equity markets as profoundly as the regulators would have us believe, there is no way to change their behavior without changing the structure of the market itself. For instance, stepping up oversight of high frequency traders and emplacing limits on their ability to enter and exit markets swiftly may well impel the departure of some firms, taking their liquidity with them. That’s not to say regulation is a bad thing – clearly a market executing hundreds of thousands of trades per second in each stock cannot regulate itself. But the direction and degree of detail in the regulatory proposals could have as deep an impact on market structure as did Regulation ATS, which ended the dominance of the big stock markets but resulted in a market structure which fragmented liquidity while transmitting risk. Anyone involved in the market, and not just high frequency traders, should watch this one.

Munis

It’s hardly a secret that municipal finances have one foot in the grave and the other on a banana peel. Yet it generally takes two hands to read predictions about the future of the muni sector. They shock the reader with tales of underfunded pension funds, shrunken tax bases and closed fire stations, but they invariably follow with “on the other hand, municipal bankruptcies historically have been rare.” That much is true, but so were five-notch downgrades on sovereign debt before the euro crisis, not to mention defaults on all those AAA-rated tranches of subprime mortgage debt.

If the situation continues to deteriorate, more and more financial managers may decide that it’s better to default on a bond than to close more schools. That would be bad enough, but if the ratings on existing (often decade-old) small municipality debt turn out to be stale and unreliable, the situation could turn systemic as the market begins to doubt the reliability of these widely-held instruments. With tens of thousands of issuers out there and hundreds of thousands of bonds, claims by any credit rating agency that its unblinking eye knows whose pension fund is underfunded and who is sitting on a pile of interest-rate swaps strain credibility. Right now, the market thinks the agencies play a ‘man-to-man’ defense, but they are in fact playing the ‘zone’ – and against a much larger team.

If defaults rise, particularly among small issuers holding investment grade ratings, these widely held instruments could threaten wide swaths of the financial system. And if that happens, expect to see the systemic risk regulators swing into action.

What not to watch:

Ron Paul vs the Fed

In case you hadn’t heard, Ron Paul doesn’t like the Fed. But in spite of such inspired nuggets as “I don’t think we need regulators” and a book called End the Fed, the chances are that the Fed will long outlast Rep. Paul. His ascension to head the Financial Services Subcommittee on Domestic Monetary Policy doesn’t spell doom for the Fed or its role in policing the markets, for several reasons.

First, it’s one thing to make bold soundbites but quite another to shepherd legislation through a committee that doesn’t have the same degree of venom for a century-old institution at the center of the economy. Secondly, the remit of Paul’s subcommittee’s over the Fed only covers its monetary operations, and not its existing or proposed regulatory activities. Lastly, putting the Fed to the sword in any meaningful way would require the cooperation of the Senate, not to mention the forbearance of the President’s veto pen. In the end, the Fed can expect audits of its decision-making process and scrutiny over its regulatory activities, but these things were already in motion without the hoopla.

Reform of the regulatory agencies

Improving the effectiveness of the regulatory agencies, and in particular the SEC, has been on the reform agenda since before the dust settled in the financial crisis. As well it should be: much of Dodd-Frank is based on the notion that if enough data is fed to the regulators, they will instinctively digest, comprehend, and act appropriately on that information. True, the SEC and other regulators quickly added new offices to their organization charts and recruited senior staff with honest-to-gosh industry experience. But without a way to keep those highly poachable experts or to train staff to understand their new duties, these steps will amount to the organizational equivalent of a sugar rush, leaving the organizations no more effective three years from now than they were three years ago. Moreover, it takes bags of money to hire people, train them, and equip them with the computers and software that will put them in the same league as those whom they regulate. That’s going to be a tough sell in the incoming Congress.

And so we start another year of financial reform. In perhaps an ominous sign, we also move in the Chinese calendar from the year of the tiger to the year of the bunny rabbit. Let’s hope the gods are just joking.

Scott McCleskey is managing editor, North America, at Complinet and is the author of “When Free Markets Fail: Saving the Market When It Can’t Save Itself” (John Wiley and Sons). The views he expresses in this column are his own and do not necessarily reflect those of Complinet or its parent, Thomson Reuters Inc.

Complinet, part of ThomsonReuters, is a leading provider of connected risk and compliance information and on-line solutions to the global financial services community. Established in 1997, Complinet serves over 100,000 industry professionals in 80+ countries. Its connected approach provides one single place to get all the relevant regulatory news, analysis, rules and developments from the region to support firms in highly regulated industries.

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