January 2007

Can We Improve Policymaking in Financial Services Regulation?

Recently, the movement of financial activity out of the United States has received considerable attention, with study groups and commentators focusing on excessive and costly regulation as a likely cause. London’s success in attracting financial transactions and securities offerings has been attributed to less punitive and costly regulatory policies, but organizational elements may also be a factor. Over the past decade, the United Kingdom has combined its financial services regulation under a coordinating body called the Financial Services Authority (FSA). Not only does the FSA see the development of consistent and reasonable regulatory policies as an important part of its charter, but it is also able to coordinate the regulatory policies applicable to banks, securities firms, and insurance companies—three constituents of the financial services industry that are increasingly in competition with one another.

In a world in which regulatory policies can have an important impact on a nation’s competitiveness, does the United States need a coordinating body for financial services regulatory policy? Does the increasing competition among banks, securities firms, and insurance companies signal the need for a new regulatory structure? If changes in regulatory structure should be considered, what form should they take? On January 24, at the first in a series of AEI conferences on how we regulate banks, securities firms, and insurance companies, panelists presented papers on the convergence of financial products and a new regulatory strategy intended to facilitate this phenomenon.

Peter J. Wallison
AEI

In recent months, there has been a sudden recognition of the damaging consequences for U.S. competitiveness in the financial markets that have flowed from excessive regulation and frivolous litigation in the United States. One example is the recent report commissioned by Senator Charles Schumer (D-N.Y.) and New York City mayor Michael Bloomberg, which noted that without reform, the United States would lose its leadership in finance within ten years.

That a prominent member of the Democratic Party and other policymakers, as well as members of the public, have become concerned about this issue means that the time may be right for a serious look at how to modernize a financial regulatory system that seems increasingly dysfunctional. One specific area that merits examination is the competition that various financial services industries--banks, insurance companies, and securities firms--all share with each other. These companies, with competing products, are regulated under different agencies and regulatory regimes, which inevitably distorts inter-industry competition. This peculiar arrangement is the result of historical industry differences that are now fast eroding, ad hoc solutions to financial crises of the past, and Congressional inattention. The good news about the erosion of U.S. predominance in global financial services is that it may finally have caught the notice of people in government who can actually do something about it.

Melanie L. Fein
Goodwin Proctor, LLP

The past two decades of convergence in U.S. financial products could possibly provide a basis for changes in the regulatory structure governing the financial services industry. This convergence has been driven mainly by the quest for synergies, economies of scale, and the intense competition among various financial institutions.

In 1999, Congress responded to this phenomenon by passing the Gramm-Leach-Bliley Act (GLBA), which created a framework for convergence by allowing affiliations among banks, securities firms, and insurance companies through supercharged bank holding companies called financial holding companies. GLBA also established “functional regulation” as the basis for the new regulatory framework under which financial institutions are regulated according to the products they offer. Banking regulators regulate entities offering banking products, securities regulators regulate entities offering securities products, and insurance regulators regulate entities offering insurance products. Because firms now offer many different types of products across traditional industry lines, they are subject to regulation by multiple agencies, which has resulted in a morass of overlapping rules and supervisory requirements.

The current regulatory structure is inadequate to deal with the convergence that has taken place, and it is possible that a single regulator could be more efficient. Yet in devising appropriate regulatory reform, several issues must be taken into account. One issue is the fact that the there is no precise definition of "financial product," and it often is impossible to consider financial products separate from the services that accompany them and the type of institution that offers them. In addition, such a proposal would have to factor in the implications for state regulators, as well as ensure that the new regulator does not become myopic or overly heavy-handed, since the current multi-regulator system has afforded degrees of flexibility to which certain institutions have become accustomed.

Gregory Wilson
Gregory Wilson Consulting

Over the past few years, strong competition from financial centers such as London and others in Europe and Asia has started to erode U.S. dominance in the global market for financial services. Outside of factors over which the United States has no control--such as the fact that London is in a more preferable time zone and is geographically closer to continental Europe, Asia, and the Middle East--one of the major reasons for the declining competitiveness of the United States is its complex, excessive, and burdensome legal and regulatory regimes.  The United States must take an active response to regain its competitiveness.

The United States must have a clear, comprehensive, and agreed upon vision for its financial services sector. Once this vision is in place, policymakers can develop a strategy to attain that vision for the competitiveness of U.S. financial markets. This strategy should entail three specific initiatives: first, a set of common regulatory principles to guide the interactions between the various regulators; second, a new single, market-oriented financial services license for all financial intermediaries, including commercial banks, investment banks, insurance companies, and non-banks; and third, an immediate review and cost-benefit analysis of all major financial regulations. Finally, to complement the vision and strategy, there should be a single regulator to oversee the institutions that fall under the universal charter, an agency similar to the FSA in the United Kingdom.

Robert R. Glauber
Harvard Law School

The current U.S. regulatory regime is redundant and chaotic, and while GLBA did enable product convergence, it did not deal with the problem of institutional convergence. One of the major drawbacks of the balkanized system is that it can produce gaps in regulatory coverage. For example, many derivative contracts fall between the authority of two government agencies, the Securities and Exchange Commission and the Commodity Futures Trading Commission.

The cumbersome regulatory structure currently in place has contributed strongly to the decline of U.S. competitiveness in global financial markets. As financial centers in other countries have improved and investment opportunities have expanded around the world, the United States has to make an active effort to maintain its dominance in the global financial sector. The concept of a single charter overseen by a single regulator that firms can opt into voluntarily would certainly face opposition, but it would be far easier to implement than attempting to forcefully integrate the current regulatory agencies.

Michael J. Ryan Jr.
U.S. Chamber of Commerce

When examining the financial-services legal and regulatory framework in the United States, it is important to understand how and why U.S. financial products have developed the way they have. If product development has stemmed primarily from complex demand and market forces, then that reflects positively on the country’s financial sector.

However, it does not bode well if firms have developed new products principally to circumvent a regulatory structure that has not kept pace with the changing world. If the regulatory regime is creating an artificial competitive advantage for certain firms or is having a negative impact on the international competitiveness of the United States, policymakers must evaluate whether regulatory reform is needed. Consideration should be given to the proposal for a universal financial services charter.

This would present a great opportunity to establish a new regulatory approach from a clean-slate. The transition, however, to a new system would be difficult, and one critical issue that will inevitably arise is how to deal with similarly situated firms that are regulated under the current different regimes.

AEI research assistant Daniel Geary prepared this summary.