Regulatory Reform in the United States: Response to the

Subprime Crisis and Recent Financial Market Turmoil

Professor Howell E. Jackson

Harvard Law School

The London Financial Regulation Seminar

London School of EconomicsOctober 23, 2008

Outline

• Reorganization of U.S. Financial Regulation

• Systemic Risk and the Current Market Turmoil

• A Word About U.S. Projected Costs and Capacity

Overview of U.S. Regulatory Structure

StateBanking Com.

(1838)State

Banking Com.(1838)

StateBanking Com.

(1838)

Comptroller ofthe Currency

(1863)

Federal ReserveSystem

(1913)/(1956)

Federal DepositInsurance Corp.

(1933)

Office of ThriftSupervision

(1933)/(1989)

U.S. Treasury

StateSecurities Com.

(1911)State

Securities Com.(1911)

StateSecurities Com.

(1911)

Securities andExchange Com.

(1934)

NYSE &Exchanges

NASD(1938)

FINRA.(7/2007)

CFTC(1921-22)/(1974)

State InsuranceCom.

(1850s)State Insurance

Com.(1850s)

State InsuranceCom.

(1850s)

National Association of

InsuranceCom. (NAIC)

(1871)

NCIGF)(1989)

NOHLGA(1983)

SIPC.(1970)

ERISA Agencies(1974)

----Dept. of Labor

I.R.S.PBGC

National Credit Union

Administration(1934)/(1979)

Federal Financial Institution Examination Council (1979)

CSBS(1902)

StateBanking Com.

(1838)

ACSSS(n.a.)

NASCUS(1965)

NASAA(1919)

President’s Working Group on Financial Markets (1988)

Other StateComms.Other State

Comms.

Other StateComms.

o Industry Segmentationo Federalism &o Further Fragmentation

Structure of U.K. Financial Regulation

FinancialServices

Authority

+ General Insurance Standards Council Office of Fair Trading (Consumer Credit) Occupational Pension Review Authority Dep’t for Trade and Industry (company law) Financial Report Council (audit/accounting)

Background on U.S. Regulatory Reform

• Treasury Department Study Plan in Spring of 2007

• Treasury Blueprint Released in March 2008

• Emerging Political Consensus (?) in Fall of 2008

• EESA of 2008 (Bailout Bill) Sets Schedule:

– Treasury Report by April 2009

– Congressional Report by Year End 2009

My Six-PointProposal

I. The authority of the Federal Reserve Board to oversee financial market stability should be expanded to cover all sources of systemic risk in the financial services industry, should be structured to coordinate effectively with other supervisory agencies, and should be designed to allow for consistent, appropriate forms of intervention in response to systemic risks.

• Treasury Blueprint Approach– Immediate Actions (Fed Expansion; Mortgage Broker Licensing)

– Intermediate Actions (Merger of SEC-CFTC; Rationalize Banking)

– Long Term Optional Structure (Stability, Prudential, Market Conduct)

• Events Since March of 2008– Unilateral Action by Federal Reserve Board

– Expansion of Treasury Oversight of GSEs in Housing Acct

– Creation of Mortgage Licensing Board

– Establishment of TARP Under EESA of 2008

II. Even after the authority of the Federal Reserve Board has been

expanded, the consolidation of other federal financial regulatory functions should

proceed; the experience of other leading jurisdictions indicates that consolidated

supervision offer numerous benefits in terms of the quality and completeness of

financial regulation and that the principal objections to consolidated supervision

can be met through statutory safeguards and institutional design.

• Affirmative Case– Consolidated Approach Matches Industry Structure– Centralization of Common Functions (consumer protection, etc.)– Better Resolution of Jurisdictional Gaps and Industry Innovation– Quality of Staff and Flexibility in Allocation of Resources– Simplicity of International Coordination

• Persistent Points of Opposition– Fear of Bureaucratic Rigidity– Full Agency Capture/Lack of Responsiveness to Smaller Institutions– Status Quo Bias

III. Experience in other leading jurisdictions also demonstrates that many of the benefits of consolidated oversight can be achieved without the immediate merger of front-line supervisory units and the world’s premiere consolidated agency, the British FSA, was established first as an oversight body and only later assumed full supervisory functions.

• Mapping Out Paths of Reform– Blueprint Approach: Supervisory Mergers Followed by Rationalization

– HEJ Alternative: Create Administrative Body to Lead Consolidation

IV. Drawing on these experiences, U.S. regulatory consolidation should follow a four-stage process:

1) Immediate enhancement of the President’s Working Group on Financial Markets;

2) Prompt enactment of legislation creating an independent United States Financial

Services Authority (“USFSA” or “Authority”) to provide industry-wide oversight,

coordinate existing regulatory structures, and lay the groundwork for combination of

existing supervisory agencies;

3) A second round of legislation authorizing the merger into the USFSA all other

federal supervisory agencies; and

4) Ultimate resolution of the organizational structure of the Authority should be

postponed until regulatory consolidation is complete.

V. This four-phase approach to regulatory consolidation improves the likelihood of successful transition by delaying controversial decisions, avoiding unnecessary steps, and providing an organizational structure that can lead reform while safeguarding continuity of supervision.

• Attention to Pragmatic Problems of Transition– Lack of Parliamentary System in the United States

– Need for Organizational Leadership

– Location of Ultimate Regulatory Body Outside of Treasury

• Administrative Concerns– Continuity of Personnel

– Ongoing Supervisory Responsibilities

– Avoiding Political Complexities of Supervisory Mergers

– Converting Optimal Structure from Legislative to Regulatory Issue

VI. The creation of a United States Financial Services Authority is also consistent with expansion of the Federal Reserve Board’s role in overseeing market stability and would actually improve the capacity of the Board to perform that function effectively.

• Long Term Role of the Federal Reserve Board– Focus on Market Stability and Monetary Policy– Elimination of Front-Line Banking Supervision– Elimination of Partial Responsibilities for Consumer Oversight– Coordination with Supervisory Units Remains to be Determined

• Alternative Approaches– Enhanced Federal Reserve with Marginally Reduced Existing Agencies– Federal Reserve Board becomes de jure Consolidated Supervisor

• Market Stability Functions and Procedures of Federal Reserve Board, FDIC, and Treasury– Standards for Intervention– Allocations of Costs

Outline

• Reorganization of U.S. Financial Regulation

• Systemic Risk and the Current Market Turmoil

• A Word About U.S. Projected Costs and Capacity

Normal Justifications for Activities Restriction

Assets

Capital

Public Claimant(depositors, etc.)

Borrowers

•Control Agency Costs•Prevent Moral Hazard•Deal with Collective Action Problems of Public Claimants•Create Hypothetical Contract•Paternalism for Consumers

Pathways of Systemic Risk

[Costs to Government for Covering Customer Losses]“Second Tier Privity” with Institutional Customers

– Continental Illinois with Correspondent Banks in 1984– Potential Losses from Fannie Mae & Freddie Mac

Impact on Complex Network– Herstatt Bank in 1974– Market Break of 1987– Counterparties with Bear Sterns/AIG/Lehman/CDS Market

Precipitation of Financial Panics and other Self-Defeating Behavior– Unloading of Debt Securities with LTCM in 1998– Junk Bond Liquidations of the Savings & Loan Crisis of 1989– Runs on Northern Rock and Washington Mutual– Unwinding from Mark-to-Market in Current Environment– Pro-cyclical Effects of Capital and FDIC Funding

Discontinuities of Financial Functions– Economic Downturn in the Early 1990’s Following Thrift Crisis– Mortgage Lending Response to Subprime Crisis– Credit Crunch Today

Ex Post Responses to Systemic Risks:Access to Liquidity or Solvency Support [or Coercive Unwinding]

[Costs to Government for Covering Customer Losses]“Second Tier Privity” with Institutional Customers

– Continental Illinois with Correspondent Banks in 1984– Potential Losses from Fannie Mae & Freddie Mac

Impact on Complex Network– Herstatt Bank in 1974– Market Break of 1987– Counterparties with Bear Sterns/AIG/Lehman/CDS Market

Precipitation of Financial Panics and other Self-Defeating Behavior– Unloading of Debt Securities with LTCM in 1998– Junk Bond Liquidations of the Savings & Loan Crisis of 1989– Runs on Northern Rock and Washington Mutual– Unwinding from Mark-to-Market in Current Environment– Pro-cyclical Effects of Capital and FDIC Funding

Discontinuities of Financial Functions– Economic Downturn in the Early 1990’s Following Thrift Crisis– Mortgage Lending Response to Subprime Crisis– Credit Crunch Today

Ex Ante Response to Systemic Risks

[Costs to Government for Covering Customer Losses]“Second Tier Privity” with Institutional Customers

– Continental Illinois with Correspondent Banks in 1984– Potential Losses from Fannie Mae & Freddie Mac

Impact on Complex Network– Herstatt Bank in 1974– Market Break of 1987– Counterparties with Bear Sterns/AIG/Lehman/CDS Market

Precipitation of Financial Panics and other Self-Defeating Behavior– Unloading of Debt Securities with LTCM in 1998– Junk Bond Liquidations of the Savings & Loan Crisis of 1989– Runs on Northern Rock and Washington Mutual– Unwinding from Mark-to-Market in Current Environment– Pro-cyclical Effects of Capital and FDIC Funding

Discontinuities of Financial Functions– Economic Downturn in the Early 1990’s Following Thrift Crisis– Mortgage Lending Response to Subprime Crisis– Credit Crunch Today

PortfolioRestrictions

ConsumerProtection

SolvencyProtection

JurisdictionalBoundaries

Clearing& Settlement

Outline

• Reorganization of U.S. Financial Regulation

• Systemic Risk and the Current Market Turmoil

• A Word About U.S. Projected Costs and Capacity

US Residential credit exposure (billions of USD)

Depository Institutions Loans

1st lien $2020

2nd lien $869

Total $2889

Non-agency Securitization

(Subprime, Alt-A, Jumbo, 2nd-

lien)

AAA-rated $1640

Subordinates $480

Synthetic $160

2nd/HELOC $251

Total $2531

GSEs

Guarantees (Agency MBS)

$4363

Retained whole loan portfolio

$444

Total $4807

Losses ≈ $1587.8%

Losses ≈ $15017.3%

Losses ≈ $30810.7%

Losses ≈ $52320.7%

Losses ≈ $761.6%

US nonresidential credit exposure

Whole Loans

Commercial real estate $2400

Consumer $1400

Corporate $3700

Leveraged loans $170

Total $7670

Securities

CMBS $940

Consumer ABS $650

High-grade corporate $3000

High-yield corporate $600

CLOs $350

Total $5440

Losses ≈ $1952.5%

Losses ≈ $4758.7%

Amount Outstanding Estimated Losses

Residential Credit:Depository Institution Loans $2,889 $308Non-Agency Securities $2,531 $523GSE Exposures $4,807 $76 Subtotal $10,227 $907

Non Residential Credit:Loans $7,670 $195Non-Agency Securities $5,440 $475 Subtotal $13,110 $670

Total $23,337 $1,577

Overview of Credit Exposures and Estimated Losses(September 2008; billions of US dollars)

Estimated Costs of Recent Banking Crisis (FRB of Chi. Econ. Per. 2000)

Country Period Estimated Cost as

Percent of GDP

United States 1980’s 2.5 %

Japan 1990’s 20.0 % est.

Norway 1987-89 4.0 %

. . . .

Korea 1997- 60.0 % p

Indonesia 1997- 80.0 % p

U.S.A. 2007-2010 $700 billion = 5.0 % $1600 billion = 11.4 %

$3200 billion = 22.8 %

Regulatory Reform in the United States: Response to the

Subprime Crisis and Recent Financial Market Turmoil

Professor Howell E. Jackson

Harvard Law School

The London Financial Regulation Seminar

London School of EconomicsOctober 23, 2008