FASTEN YOUR
SEAT BELTS
From Washington
Kathleen W. Collins

Kathleen W. Collins is a partner in Morgan, Lewis & Bockius, and Washington Counsel of the Bank Insurance & Securities Association. She and Richard Starr write the "From Washington" column in alternate issues.

AS THE 111th Congress sets up shop in January, financial services regulatory reform will be near the top of its agenda. Some may call the re-regulation of the financial services industry "pay back," and some may see it as an enlightened response to a problematic regulatory environment.

But as sure as regulatory reform was pre-ordained in 1989 and 1991 when Congress armed bank regulators to the teeth with enforcement tools following the torrent of thrift and commercial bank failures in the 1980s, the financial services industry will be brought to task for the financial crisis and for putting a multitude of taxpayer dollars at risk.

President Obama has cast blame on regulators and Congress alike for being asleep at the switch as the subprime crisis developed and has vowed to aggressively pursue regulatory fixes. "We are going to have to greatly strengthen our regulatory apparatus," he vowed at a December 2008 news conference introducing part of his financial regulatory team. Meanwhile, the House Financial Services Committee scheduled a series of hearings on everything from identifying uses for remaining Troubled Asset Relief Program (TARP) funds to the Madoff investment scandal.

Perhaps surprisingly, 73 percent of bank executives queried by the American Banker in December 2008 agreed with the premise that the current regulatory structure of the financial services industry should be overhauled. With the exception of the need to consolidate regulators into fewer agencies, and to realign oversight by functions, large and small banks' views as to a new regulatory regimen differ widely.

With so many House and Senate committees with an axe to grind or a bull to gore, the best chance banks and securities firms have to temporarily avoid a regulatory smack-down is to hope that warring committees begin to fight over jurisdictional issues rather than how best to regulate.

As the 111th Congress sets up shop in January, financial services regulatory reform will be near the top of its agenda.

So where does Congress start?

Rush to judgment

The blame game has already focused on the Gramm-Leach-Bliley Act (GLBA) of 1999 as one of the many culprits that contributed to the 2008 financial crisis, the theory (I guess) being that Congress should not have rolled back the Depression-era Glass-Steagall Act restrictions on securities activities by banks, and banking activities by securities firms. Applying some type of cause and effect analysis, the system supposedly worked until the shackles and restraints of Glass-Steagall were removed, and then the financial world (again) fell apart. Of course the earlier, stricter view of the wall between commercial and investment banking supposedly erected by Glass-Steagall was pretty much in tatters as a result of litigation and regulatory interpretations by the time Congress finally acted in 1999. And banks were able to make and securitize mortgage loans long before GLBA was enacted.

But did GLBA, with its endorsement of functional regulation, create interstices so that certain products and risks went unregulated? Or was GLBA's failure one of lost opportunity—financial modernization legislation that failed to consider how to best regulate the financial entities and markets that had already evolved in the absence of such legislation? While touting functional regulation as a way going forward, GLBA did little to entice investment banks or insurance companies to join the legion of the more highly regulated. There was no push for non-bank holding companies to become financial holding companies, no consolidated regulator created to preside over complex organizations that were not financial holding companies, and no change in the cast of regulators charged with monitoring the situation.

Another supposed bête noire of the subprime mess is the Community Reinvestment Act (CRA) of 1977, a law that encourages depository institutions to meet the credit needs of all the communities in which they do business. But Congressional testimony and public statements of Federal Reserve officials thus far indicate that as little as 20 percent of subprime mortgages were made by banks and thrifts subject to CRA, and that most CRA loans were not higher-priced loans. There is also the inconvenient fact that CRA has been with us for some 30 years without sparking a crisis.

The rush to judgment also includes pointing fingers at the regulators who supposedly failed to detect what their changes were concocting. Those doing the "concocting" ran the gamut from lightly regulated independent mortgage originators to banks and thrifts already minded tightly by their financial regulators. Congress has made no secret that it wants banks out there lending-so how far does it go tightening up controls on securitizations or requiring determinations from lenders that borrowers are indeed credit worthy?

Perverse results?

Errant Congressional steps now could end the lending momentum that programs like TARP are supposed to be establishing in unfreezing the credit market.

Merging certain regulators while bank and thrift failure are on the rise is yet another scenario that may produce perverse results. Banks and thrifts in danger of failing require significant attention from their primary regulators. Regulators looking over their shoulders to see where they stand in an agency merger, while simultaneously monitoring compliance with several cease-and-desist orders and prompt corrective actions, are probably not going to be efficient regulators. Nor is it a good time for senior officials who worked through the last wave of failures in the late 1980s and early 1990s to be merged out of responsible positions and into early retirement, a natural adjunct of agency mergers.

And investors, particularly those entering unfamiliar terrain, want certainty-not regulatory intrigue and non-stop games of regulators playing musical chairs.

So while merger of certain regulators such as the Office of the Comptroller of the Currency and the Office of Thrift Supervision may be a consensus choice of bankers and Congress alike, putting it at the top of a regulatory "to do" list might not be the wisest choice until the list of troubled institutions is dwindling, not expanding as it is now.

The simple fact that many financial experts have been quick to misinterpret the causes of the financial crisis, coupled with the risks of taking a misstep, should give Congress room for pause. The appointment of a 9/11 type commission (National Commission on Terrorist Attacks Upon the United States) to study the root causes of the financial crisis and to come up with a plan to address not only what went wrong in the subprime debacle but also the legislative and regulatory changes needed to truly re-regulate financial services in the United States may not sound exciting-and it will certainly not satisfy those looking for quick scapegoats and headlines. As with the 9/11 Commission, the work must be done expeditiously and in a bipartisan manner. The 9/11 Commission was mandated by Congress in late 2002 and published its report and recommendations on July 22, 2004. Congress and the agencies affected must then move quickly to implement those recommendations.

The blame game has already focused on the Gramm-Leach-Bliley Act of 1999 as one of the many culprits that contributed to the 2008 financial crisis.

Chances are good that the next financial crisis won't emanate from poorly underwritten residential mortgage loans, but rather from some innovative product or service cooked up to avoid the new laws and regulations and increased regulatory burden that come with them. All the more reason to take these next steps carefully.