‘Failed’ Wall Street Means Biggest Rules Rewrite Since 1930s

By Alison Fitzgerald and Alison Vekshin

Feb. 4 (Bloomberg) -- Camden Fine’s nightmare is a Bank of America or Citibank branch on every corner.

“Do we really want to create more cycloptic monsters stomping around the country ruining people’s lives?” asks Fine, president of the Independent Community Bankers of America. He says he fears new U.S. financial regulation might include a merger of agencies favoring big banks over his 5,000 members.

Robert Greifeld, on the other hand, sees his Nasdaq OMX Group benefiting if a restructuring of Wall Street’s rules steers more business to the exchange’s clearinghouse for interest-rate swaps. That would also reduce profits for private derivative traders, said Greifeld, the group’s chief executive officer.

In coming months, President Barack Obama and Congress will pick winners and losers in tackling the biggest overhaul in financial regulation since Franklin D. Roosevelt and Congress created the Federal Deposit Insurance Corp. and the Securities and Exchange Commission in the 1930s. It’s part of the price the industry must pay after a $700 billion bank bailout.

“The present system has been broken; it’s failed the test of the marketplace,” former Federal Reserve Chairman PaulVolcker said Jan. 15 in New York in calling for strengthening regulation. Volcker, an Obama adviser, is scheduled to testify today at a Senate hearing on the subject.

Obama will discuss re-regulation at the White House later this week with congressional leaders, according to spokesman Robert Gibbs. Lobbyists, CEOs, traders and hedge fund operators already are jockeying to influence proposed legislation that includes controls on unregulated hedge funds; new rules for executive pay; and restricting credit-default swaps to those who own the underlying debt.

‘Major Moment’

Former Treasury Secretary Henry Paulson is among those who suggest merging the SEC with the Commodities Futures Trading Commission. Other proposals include combining five current U.S. bank regulators, creating a new federal overseer for the insurance industry, and setting up an umbrella regulator for all financial transactions.

“This is a major moment,” said Robert Engle, a professor at New York University’s Stern School of Business and the winner of the 2003 Nobel Prize in economics. “We’re looking at a situation like we’ve never seen. Only at this point can you get the attention of people to give up something that they think is their special right.”

The proposed changes would reverse three decades of deregulation. They are driven by the meltdown that has cost global financial companies more than $1 trillion and outraged taxpayers who lost retirement funds.

‘Shameful’ Pay

“Shameful” was Obama’s description of $18.4 billion in bonuses Wall Street paid itself last year. He promised to restrict executive pay for companies accepting bailout funds.

Obama told Senate Democrats last month that financial re- regulation is the “third leg of the stool” in rebuilding the economy, along with shoring up banks and an $819 billion stimulus plan to produce millions of jobs.

In the last year the U.S. has rescued, taken over or helped to sell Bear Stearns Cos., Merrill Lynch & Co., American International Group Inc., IndyMac Bancorp Inc., Fannie Mae, Freddie Mac and Citigroup Inc.

The collapse of Lehman Brothers Holdings Inc. in September triggered a panic in U.S. credit markets that forced Fed Chairman Ben S. Bernanke and Paulson to ask Congress for $700 billion to stabilize the system.

The turmoil rocked an industry that in 2007 accounted for 33 percent of U.S. corporate profits and 8.25 million jobs. Earnings fell to 26 percent of the total last year while more than 227,000 financial professionals have lost their jobs since the February 2007 peak.

Investor Confidence

“Regulatory reform is essential in getting the economy back to health,” said House Financial Services Committee Chairman Barney Frank, 68, a Massachusetts Democrat who will draft the main legislation, in an interview. “Investors are afraid to invest. One of the elements we have to have is a sense of confidence on the part of investors that it’s OK to go back in the water and that means reform.”

At the same time, more aggressive oversight may be all that’s really needed, William Seidman, a former FDIC chairman, said in an interview.

“I’m not convinced this has to be done,” Seidman said. “The regulators just didn’t do their jobs. The laws are all on the books.”

Resigned to Change

Financial executives say they are resigned to change.

“Hopefully we end up with good regulation instead of very bad regulation that’s done out of haste and anger,” said JPMorgan Chase & Co. CEO Jamie Dimon, on a conference call with reporters and analysts on Jan. 15.

The regulatory structure Roosevelt put in place in the 1930s in response to the Great Depression remains largely intact. Until now, it has mostly succeeded in shielding investors from abuses and protecting bank customers’ deposits.

The FDIC, which insures deposits in the U.S., was created in 1933 following thousands of bank failures that cost consumers their savings. It was set up to restore public confidence and prevent bank runs. Since then, the FDIC says, no customer has lost any money up to the deposit insurance limit, which was temporarily raised from $100,000 to $250,000 per account last year.

The SEC was established in 1934, requiring publicly owned companies to register and to report annually on their financial condition. The agency failed to detect Bernard Madoff’s alleged $50 billion Ponzi scheme and didn’t notice faulty risk modeling and excessive leverage that last year led to the collapse of Bear Stearns Cos.

Decision Makers

With the entire regulatory system under attack, trade groups representing banks, mortgage brokers, and dealers in credit default swaps are maneuvering to get proposals in front of Frank, Volcker, Treasury Secretary Timothy Geithner and Lawrence Summers, Obama’s top White House economic aide.

The Managed Funds Association in Washington, which represents hedge funds, last week hired two new in-house lobbyists from Merrill Lynch and Credit Suisse Group AG, according to its Web site.

The Financial Services Roundtable in Washington, a group of 100 financial firms including General Electric Co., Visa Inc., and Wells Fargo & Co., on Jan. 30 announced its “Six Principles” for change, including merging bank regulators.

Bank of New York Mellon Chairman Robert Kelly is leading a Financial Services Forum task force to come up with recommendations that the group of 17 financial services CEO’s can agree upon, said forum president Robert Nichols.

While the Obama economic team hasn’t laid out its re- regulation proposals yet, Bernanke, Frank and Volcker have made some of the core elements clear. “Financial firms of any type whose failure would pose a systemic risk must accept especially close regulatory scrutiny of their risk-taking,” Bernanke said Jan. 13.

Systemic Risk

Frank said his “No. 1 priority” is to create a systemic- risk regulator, perhaps the Fed, to supervise the activities of any financial firm, be it a bank, hedge fund or insurance company, that poses a danger to the system.

Such firms “will be subject to a particularly strong oversight,” Volcker said last month as he released an 18-part regulatory overhaul plan sponsored by the Group of Thirty, an organization of former central bankers and finance ministers.

Volcker recommended limits on the trading that firms such as Goldman Sachs Group Inc. can do with their own capital and urged oversight of and capital requirements for hedge funds and private-equity companies deemed “too big to fail.” Volcker said he’ll present the plan to Obama, calling it “a reasonable indication of the direction in which we might go.”

Compensation Review

Increased scrutiny would ensure that executive-compensation plans don’t promote excess risk-taking, according to Volcker and Bernanke. That means a Fed bank examiner who earns at most $198,000 a year could object to compensation packages such as the one that awarded Lehman Brothers Chairman Richard Fuld $34.4 million for 2007, nine months before his firm collapsed.

One focus of change is bringing government oversight to unregulated areas such as the $1.5 trillion hedge-fund industry. Senators Carl Levin, a Michigan Democrat, and Charles Grassley, an Iowa Republican, introduced legislation Jan. 29 to require that hedge funds file an annual disclosure form with the SEC, comply with the agency’s record-keeping standards and cooperate with its investigations.

Geithner and Mary Schapiro, Obama’s new SEC chairman, during their confirmation hearings endorsed requiring hedge funds to register with regulators. Volcker recommended that funds large enough to be “systemically significant” should have to meet capital, liquidity and risk management standards.

Regulating Derivatives

Lawmakers also are proposing oversight of unregulated over- the-counter derivatives, or financial instruments that are derived from stocks, bonds, loans, currencies or commodities. Bad bets on privately traded credit-default swaps, which are based on bonds and loans and are used to speculate on an issuer’s ability to repay debt, led to the failure and government takeover of insurer AIG in September.

Representative Collin Peterson, a Minnesota Democrat who is chairman of the House Agriculture Committee, is already circulating a bill that would temporarily ban credit-default swap trading unless investors own the underlying bonds, which they do in about 20 percent of existing trades, according to Eric Dinallo, superintendent of the New York Department of Insurance. The measure would also force trades to be processed by a clearinghouse.

Credit-Default Swaps

Peterson’s bill “would effectively eliminate” the credit- default swaps business in the U.S., said Robert Pickel, chief executive officer of the International Swaps and Derivatives Association, a trade group for the industry. “Mandating clearing of all OTC derivatives is unwarranted.”

The proposed legislation would benefit new clearinghouses competing for credit-default swap trades. It would also cut into the profits of traders such as Goldman Sachs and Morgan Stanley, which as much as 40 percent of their profits from OTC derivatives trading, according to CreditSights Inc., a New York research company.

“You put these instruments on the exchange, spreads collapse quite dramatically,” Greifeld said after a speech at the National Press Club in Washington last month.

Other proposals include creating a new U.S. overseer for the insurance industry, now under state regulation, or bringing all financial oversight under a single regulator, such as the United Kingdom’s Financial Services Authority.

‘Fight Like Hell’

Financial services companies don’t agree on what would be the best outcome.

Fine says community bankers in his organization are concerned a single regulator would pay too much attention to the largest lenders and adopt policies that encourage consolidation, making it harder for small competitors to survive.

“We’ll fight like hell against that,” Fine said.

Obama has said he’ll have his regulatory plan out by April 2, when the Group of 20 industrialized and emerging market countries meets in London.

Charles Dallara, president of the Institute of International Finance in Washington, which represents almost 400 global firms, including Barclays Plc and Societe Generale SA, said his group is urging regulators worldwide to coordinate their efforts, so that banks don’t find conflicting rules -- and added costs -- in each country.

Dallara’s group, led by Deutsche Bank AG CEO Josef Ackermann, is proposing the creation of a Global Financial Regulatory Coordinating Council, which would supervise the largest international financial institutions.

Lawmakers should wait until the crisis is over before rewriting standards, according to Wayne Abernathy, executive vice president of the American Bankers Association in Washington.

“When you start changing the rules, investors go to the sidelines,” he said. Lawmakers should wait, Abernathy said, because “it’s hard to work on a plan to reorganize a fire department when you’ve got lots of fires going on.”

To contact the reporters on this story: Alison Fitzgerald in Washington at afitzgerald2@bloomberg.net; Alison Vekshin in Washington at avekshin@bloomberg.net