FUNDAMENTAL FAILURE
AND FUNDAMENTAL REFORM
From Washington
Richard D. Starr

Richard D. Starr is BISA Director of Government Affairs and Chairman of BISA's Legislative, Regulatory, and Compliance Committee. He is also President of Financial Institutions Group, Inc., a full-service financial services consulting firm focusing on bank insurance and securities issues. He can be contacted via email at rstarr@bisanet.org. He and Kathleen Collins write the "From Washington" column in alternative issues.

SOME THINGS just don't change, and in this instance it is the fact that there is far more uncertainty than certainty regarding financial services regulation. In every BISA meeting we tell regulators that our members, uniformly, are burdened by layer upon layer of regulation that chokes the businesses and reduces profits without providing any benefit. And in every meeting the regulators reply that to expect less regulation—ever—is folly and denies the reality of regulation.

Okay, they don't say it exactly that way, but government's solution is always to fix something that was not foreseen by prior regulation. It is always looking in the rearview mirror. That's what they mean by "reform."

The process is usually the same: assign blame to the opposing political party, and, if the reason for angst and proposed action is still remembered, get your name in the headline as the person more offended, disgusted and outraged than any other individual in government—even if you were the author and cause of the problem.

Root causes?

But a couple of interesting things are emerging from the morass in this instance.

Two extensive arguments are being woven for the purpose of proving what did not cause the current economic crisis. It seems important to a lot of people to make sure there is a strong case that neither the Community Reinvestment Act (CRA) nor the Gramm-Leach-Bliley Act (GLBA) is the root cause of anything. While erstwhile legal writers weave complicated and confusing strands of real and rewritten historic fabric together to make the case, they carefully sidestep the likelihood that misadministration of those acts might be a root cause.

Today there is far more uncertainty than certainty regarding financial services regulation.

While CRA is not usually the province of the BISA, GLBA is close to its beating heart. Passed in 1999 to replace the Depression-era Glass-Steagall Act and to bring the financial services industry into the 21st century, GLBA's loose structure of functional regulation could be the target of "new and improved" regulations. The deregulation achieved in the 1980s and 1990s will give way to re-regulation; the pendulum swings.

All the talk of a new, comprehensive regulator that would oversee all things financial begs the question of whether the United States has sufficient regulations on the books that were just never really implemented. Some redefinition of "securities" could bring many derivative and commodity products under the watchful eye of the SEC. Forcing hedge funds and private equity entities to register with the SEC and be bound by disclosure rules is just not that complicated.

The plan on the Treasury table is the creation of a new, comprehensive "systemic risk regulator" that would oversee the financial and non-financial companies that fit the definition. Who will decide and how they will decide what companies are systemic risks is yet undecided, but it is fair to bet the weightier vote will be held by the liberal elements inside the Beltway. The largest bank broker-dealers and bank insurance agencies are owned by the largest banks that will certainly be considered "systemic risks." And, these broker-dealers and insurance agencies distribute financial products that would be subject to new and expanded regulation.

'System failed in fundamental ways'

To quote Treasury Secretary Timothy Geithner, "Our system failed in fundamental ways. To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game." Further, he envisions and supports "better, smarter, tougher regulation." Protective gear will be necessary in the upcoming contests between good and evil. It appears that regulators are concentrating on deleveraging non-government entities while at the same time super-leveraging the nation's balance sheet. The move to have government own and operate the means of production is the most pronounced since the FDR administrations.

The plan for a federal insurance regulator has been revived as the result of the near-collapse of AIG. The optional federal charter proponents have gained renewed optimism that the 50-state regulation of the insurance industry will finally be fully addressed. However, it is quite likely the "optional" element will be swept aside if regulation of any of the insurance industry moves to Washington. It does not make sense to regulate part of insurance carriers' business at the federal level while other parts are relegated to the states. Barney Frank (D-MA), Chairman of the House Financial Services Committee, has in the past supported the federal insurance charter.

The whole systemic risk discussion is further muddied with the unresolved alternative of creating a new systemic risk regulator or placing that oversight in the hands of an existing regulator. Reorganization and/or redirection of the existing financial regulators, namely OCC, OTS and SEC seem certain if a whole new bureaucracy is to be avoided.

Should FINRA regulate investment advisors?

Into this reformulation will be the consideration of supervision and examination of investment advisers. Many bank broker-dealers are, or are affiliated with, investment advisors. Is FINRA the natural regulator for the investment advisors? Consider for a minute what this could mean for FINRA.

A return to simplicity in investing is under way, and with it is the shedding of a lot of add-on features, such as variable annuity riders that are difficult to understand and are of questionable value.

To the existing 5,000 FINRA member firms that collectively own 173,000 branch offices would be added nearly 12,000 registered investment advisor entities comprising some 300,000 individuals. Today, FINRA examines approximately 1,500 firms every year on a scheduled cycle basis. It is feasible to combine examination of the bank broker-dealer with its investment advisory business, but that is a minor number compared to the non-bank investment advisors that would come under FINRA's authority. And all this would take place in the shadow of the question as to whether failed self-regulation is at the bottom of the existing regulatory morass and some notable securities frauds.

Added to the systemic risk issues are several major concerns that have arisen from the headline fraud cases of the likes of Bernie Madoff. How could this happen under the watchful eye of the SEC, FINRA and independent auditors? The SEC says its role is enforcement, not examination. FINRA's role is presently limited to member broker-dealers that do not include unregulated hedge funds and private equity firms. The requirement for annual, independent audit does not define the required size and proven capabilities of the auditor.

Is this authority gap the reason Madoff's schemes succeeded for so long? If there were no other telltale signs of problems, one might leave it at that. But at least one well-publicized writer seems to have led the regulators to the Madoff trough several times; he just could not get them to drink. During congressional testimony he made the case that the SEC was lazy and disinterested at best, and more likely blind and incompetent.This whole fiasco has already caused several senior regulatory executives to find gainful employment elsewhere, and its effect will probably result in some meaningful examination reform led by SEC Chairwoman Mary Shapiro, who is a seasoned, respected, former FINRA executive.

Madoff fallout

The fallout from the Madoff mess has already caused a lot of pain and suffering at some financial institutions in the form of quiet settlements marked by major reimbursement of customers' investment losses. In order to get in on the much-publicized success of some of the Madoff-like funds, some large banks arranged for their high net worth investment customers' funds to be managed by hedge funds. Some banks were among the "feeder funds" that took fees for managing assets and then placed the funds with the unregulated hedge funds that then charged huge additional fees. When the Ponzi schemes collapsed, the management arrangements were exposed.

This raises serious compliance concerns even for some of the lower profile third-party asset management programs many bank and non-bank broker-dealers utilize. A thorough product due-diligence process must be undertaken for any and all outside management arrangements. It is not sufficient to have the managers' brochures and account documents on file. Performance measurements for many third-party managers that are not registered as '40 Act funds are not extensively tested and confirmed.

Most of the third-party managers are active traders. Many of the risk factors and expenses are not conveyed to the customers in understandable terms. Does the manager have the appropriate credentialed staff to do the research? Are the portfolio managers experienced and credentialed? Do the performance numbers represent an adequate cross-section of the manager's customer base? Do you and your compliance staff have the credentials and experience to do the due diligence?

The use of third-party commodity funds has become widespread in an effort to have all asset classes represented in a broadly diversified portfolio, and this has introduced an element of volatility that many stock and bond investors have not previously encountered and for which many registered representatives are not trained. These are the types of investments that are easily challenged by regulators and by investors, so the extraordinary due diligence, documentation, and supervision is warranted.

Return to simplicity

Just as with deleveraging, a return to simplicity in investing is under way, and with it the shedding of a lot of add-on features, such as variable annuity riders, because they are difficult to understand and are of questionable value. Many bank broker-dealers are weeding out the approved but seldom-used riders. They are also reducing the number of approved products. They are doing deeper due diligence to ensure the products they offer are beneficial to the clients, not just the providers. If the tested formula Value = Benefit/Price as applied to any investment product sold to your customer cannot be documented to be greater than one, get rid of the product; it is a liability. Your program cannot afford to get the reputation for being a solution looking for a problem.

More regulation

More and different regulation is on the horizon because of the economic meltdown and because of massive fraud. The portfolio losses have been staggering, and we are only beginning to see the impact of all the legislative and regulatory factors on our future business. Keeping abreast of the rapid changes is challenging, and we are working diligently at the BISA to help institutions sort it all out. By June 1, when we convene the Legislative, Regulatory & Compliance Symposium in Washington, DC, we should have a clearer picture of the regulatory schema of the future. Please be sure to check the BISA website at www.bisanet.org for the program and agenda updates.