US regulatory reforms will target the big players

The Obama administration’s proposals on regulatory reform make it clear that, in future, size will matter to the regulation of US financial firms.

The proposals would assign the Federal Reserve responsibility for identifying and regulating large financial companies that pose a systemic risk – or Tier I financial holding companies (FHCs) – regardless of whether they are currently regulated as banks or not.

On June 17, President Obama said the move was partly a response to the fact the US had no system to prevent another AIG. “If you can pose a great risk, that means you have a great responsibility. We will require these firms to meet stronger capital and liquidity requirements so that they're more resilient and less likely to fail,” he said at a speech in Washington, DC.

It might also have helped avoid the problems of other large recipients of government assistance, such as Citigroup.

While the administration’s plans involve toughening regulation for financial market players generally, Tier I FHCs and their onshore and offshore subsidiaries would be particularly hard hit. These companies would be subject to more stringent regulatory requirements than other firms, including having to hold greater levels of regulatory capital in particular.

Capital requirements for financial firms would be strengthened generally, but capital requirements for Tier I FHCs “should reflect the large negative externalities associated with the financial distress, rapid deleveraging or disorderly failure of each firm,” the proposals said.

Tier I FHCs would be subject to monitoring of their liquidity risk management by the Fed and would be required to conduct regular liquidity stress tests, incorporating both on- and off-balance-sheet exposures. More generally, supervisory expectations surrounding the companies’ risk management practices would be in proportion to the risk, complexity and scope of their operations, the proposals said. Tier I FHCs would also be asked to give additional public disclosures and create an emergency plan in case they ever suffered severe financial distress.

Criteria proposed by the administration for identifying such firms includes their size, leverage, degree of reliance on short-term funding, and their role as a source of credit and liquidity for the financial system. It would also include the impact the company’s failure would have on the economy and financial system.

As part of the plan, the Fed will present recommendations on how to restructure itself to cope with its new role as a so-called “macro-prudential regulator” by October this year.

Elsewhere, the proposals seek to strengthen regulatory capital requirements for all banks, with a working group led by the US Treasury due to report back on changes to their design and structure by the end of 2009. The proposals also call for a review of bank accounting rules to promote transparency, as well as executive compensation standards that better align pay with long-term shareholder value.

Banks would receive oversight from a new National Bank Supervisor – the product of a merger of the Office of Thrift Supervision and the Office of the Comptroller of the Currency. It would regulate nationally chartered banks, agencies of foreign banks, federally chartered thrifts and thrift holding companies, eliminating the potential for regulatory arbitrage by regulated entities.

The idea of curbing firms that are “too big to fail” through enhanced regulation is winning support among regulators globally. The Obama administration’s plans follow remarks made by Bank of England governor Mervyn King during a speech in London on June 17. “If some banks are thought to be too big to fail, then, in the words of a distinguished American economist, they are too big,” he said.

See also: Obama reform plans show no progress on OTC derivatives clearing