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By announcing proposals for a significant package of reform to improve the framework and policies of US financial services regulation, the Obama administration hopes that a new risk regulator and a series of detailed changes to existing regulation will do a much better job of predicting, detecting, and minimising the effects of another financial crisis.

The defining feature of the current system of financial services regulation in the US is the number of separate agencies participating in the regulatory process. Unlike the reforms made in the UK in 2001 to create the FSA, the US still has an alphabet soup of different agencies responsible for different products and sectors within financial services. The reform plan is ambitious in that it proposes to create new regulators and to disband some others.

The proposals do not go so far as to create a single overarching regulator for the financial sector. Some commentators have suggested that is a missed opportunity. However, given that the single regulator model of the FSA was no more successful than the US regulators at detecting and avoiding the financial crisis in the UK, the emphasis of the reform plan on rule changes as well as structure may prove to be wise.

Whatever the eventual success of the plan, large financial services companies across the world are likely to see an increase in reporting requirements to US regulators. Similarly, the new US regulators are likely to liaise more than ever with the FSA and other major European regulators in an effort to ensure a global approach to regulation and enforcement.

Recommendations

The 85-page reform plan is organised into five key objectives under which are set out a series of detailed recommendations which the Obama administration hopes will become law by the end of the year. The detail of these recommendations is impressive. Some of the highlights of the proposals are summarised below.

Promote robust supervision and regulation of financial firms: The plan proposes the creation of a systemic risk regulator in the form of the Financial Services Oversight Council. The Council will comprise the Secretary of the Treasury and the leaders of the other main financial services regulators. A National Bank Supervisor will also be introduced.

Certain large financial institutions which could pose a threat to financial stability will be identified as Tier 1 Financial Holding Companies. Legislation will propose stricter prudential standards for these firms, including stricter capital adequacy requirements. Supervision of Tier 1 FHCs will extend to parent companies and all subsidiaries, both US and foreign.

Significantly, the reform plan proposes that hedge funds will be subject to registration requirements and regulated by the SEC. In the EU there has been calls for the regulation of hedge funds but as yet little progress.

Establish comprehensive regulation of financial markets: Credit default swaps and similar derivatives will be more closely regulated. Excessive securitisation of debt will be limited so that the originator must retain an economic interest in a material portion of the credit risk.

Protect consumers and investors from financial abuse: Enhanced consumer protection is possibly the most ambitious and controversial aspect of the proposals. The plan provides for the creation of a new Consumer Financial Protection Agency to regulate financial services products sold to consumers, taking that role away from banking regulators. The CFPA will operate at a federal level and will coordinate enforcement with state bodies.

Provide the government with the tools it needs to manage financial crises: The US government plans to create a resolution regime to steer large financial institutions through an orderly process of dissolution if they fail. The reforms change the Fed’s powers of emergency lending so that the written approval of the Secretary of the Treasury will be required for any extensions of credit.

International regulatory standards and cooperation: The plan lists efforts that should be undertaken by the international Basel Committee on Banking Supervision, and commitments made by other countries at the last G20 summit.

The most significant of these efforts include urging overseas authorities to tighten the regulation of credit rating agencies, requiring the regulation of hedge funds, and promoting compensation structures that do not reward excessive risk-taking. The reform plan also supports increasing harmonisation of accounting standards and a strengthening of the arrangements for international cooperation in the global supervision of financial services firms.

Reactions

The reforms have been billed by some as profound and sweeping, but other commentators have observed that with the exception of new regulation of hedge funds and OTC derivatives the proposals do not give brand new powers to the Fed, SEC or other regulators.

However, the reforms signal a change in emphasis, requiring regulators to focus on, and act more quickly in response to, systemic risk. The proposals emphasise “macroprudential” standards. Changes are also proposed to enable the Fed to seek information more widely and to consider risk to the financial system as a whole.

Some observers have expressed concern that a new agency tasked with consumer protection would overly restrict access to loans and constrain the development of new consumer products. While these concerns may have some merit, this balance may be the price paid for reducing the risk of large scale loan defaults contributing to another economic collapse.

In perfect time to coincide with the US government’s announcement, Alistair Darling delivered his annual Mansion House speech. The speech acknowledged that no model of regulation adopted by any country had been successful in limiting the risks and problems that caused the financial crisis, but made clear that the UK government does not intend to make major changes to the FSA.

The chancellor set out a number of substantive proposals to change the operation of the FSA without the additional systemic changes proposed in the US. That said, many of the UK government’s proposed operational changes echo the proposals of the US reform plan.Better mechanisms for managing failed institutions, enhanced focus on systemic risk and the need to work closely with the G20 to improve international regulation.

Impact

US and UK regulatory agencies already liaise and cooperate routinely in matters of financial services regulation. That communication is likely to continue, although it is difficult to know whether it will become more effective or just more voluminous with the creation of four new US regulators.

The recommendation that Tier 1 FHC regulation by the Fed should extend to the parent company and all subsidiaries, including foreign subsidiaries, on the basis that threats to financial stability can emerge from any business line or subsidiary, will likely increase the regulatory and reporting burden on some UK companies.

The plan gives little indication of how the Fed will conduct regulation of foreign subsidiaries. Extra-territorial regulation may pose particular difficulties where those subsidiaries are already subject to another regulatory regime such as that of the FSA. The plan states breezily that information will be “gathered from reports required or exams conducted by other supervisors” where possible. In practice, large financial services institutions may expect an extra layer of reporting to impact their businesses across the world, with the attendant costs and time associated with reporting similar information in a different way to a new regulator.

The regulatory framework that the reform plan proposes, brings the US regulatory structure closer to that of the UK’s FSA, without implementing wholesale structural reform. It also contains detailed recommendations for change which will affect the substance as well as the form of US regulation.

The introduction of the new systemic risk regulator, the Financial Services Oversight Council, seeks to bring together regulators at a high level to coordinate and focus on systemic risk. However, detailed and sound work will need to be done behind the scenes of the council’s meetings to ensure that this new body is effective and not merely a talking shop.

Unsurprisingly, proponents of “small government” are concerned by the increasing number of regulators created by the reform plan. Whether more regulators means better regulation remains to be seen.

It seems clear, however, that the proposals will lead to more reporting requirements for financial services firms within and outside the US, and to greater international cooperation.

Alex Rene is a partner and Sarah Thomas an associate of Fulbright & Jaworski International LLP