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Strengthen Our Financial System With Effective Regulations

by

William M. McGee

February, 2012

When discussing regulations affecting financial services organizations, or for that matter, regulations affecting any type of industry, people tend to be in one of two major groups - those who believe that having fewer regulations is always better, and those who believe that more regulations are needed to protect the public. In my view, both groups are wrong. Let's discuss why.

The Need for Regulation

The economic downturn that began in 2008 has created severe hardships for millions of Americans who have lost jobs and not been able to find new ones. Many of these same Americans have lost their houses due to foreclosure, or have watched as the value of their primary assets, their houses, plummeted well below the total of the mortgages that they still owe on them. In addition, the US Government was forced to bailout many large financial services organizations due to the concern that their failure would send shock waves through the worldwide financial system and cause global markets to collapse. These bailouts added at least a trillion more dollars to our burgeoning national debt that is already too large to be handled reasonably. This downturn, which has been so devastating to so many, was caused by a lack of effective regulation over our financial system.

There is a reason why financial services organizations have traditionally been regulated more closely than companies in other industries. The impact of a financial services organization failing, or following unsound operating practices, is far-reaching. Much more far-reaching than normal product or service companies. Not only do financial services organizations carry huge levels of risk, in comparison to their capital levels, that risk is also intertwined with risk in other financial services organizations. The collapse of even one financial services organization can potentially cause the collapse of others, which in turn can potentially bring down global economies.

Our Current Regulatory Environment

The regulatory environment within which financial services organizations operate has been gradually weakened over a long period of time, at least 40 or 50 years. At this point, most of the major tenets of the regulations that were enacted shortly after the Great Depression have been swept away. In their place, we have enacted newer regulations that focus more on "how" business is conducted, rather than "what" business is conducted. These newer regulations require detailed documentation of operating policies and procedures, along with required testing to ensure compliance with the policies and procedures. In addition, examinations from various regulatory entities have gotten more frequent and more detailed oriented. During our recent economic downturn, it goes without saying that most, if not all, financial services organizations that were bailed out by the taxpayers had detailed documented policies and procedures in place, and were in solid compliance with recent examinations, when they collapsed.

The regulations that are currently in place are onerous and costly to implement and maintain, but more importantly, they just are not effective.

The Regulations That Are Needed

Once that major regulatory constraints have been released, it is extremely difficult to put them back into place, and enacting new regulatory constraints would be equally as difficult. However, if new regulations were going to be created, they should require the following:

  • Separation of commercial and investment banking. This requirement was originally a part of the Glass-Stegall act, which is no longer in effect. However, we were supposed to learn this valuable lesson in the 1930's.

  • Capital requirements on derivatives. There should be adequate capital maintained against the total amount of risk in derivative portfolios, without allowing netting of counter-party risk.

  • Risk diversification guidelines at the total institution level. Each institution should be required to have stated guidelines that diversify its total risk by product and product type, collateral type, geography, and major customers, including joint ventures and interlocking directorships.

New regulations are needed to strengthen our financial system. Our current regulations are not effective, and new ones will be difficult to enact. However, new potential regulations should focus on "what" business is allowed, and not "how" business is conducted. That should lead to a regulatory environment that is more effective and efficient.

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