The London Financial Regulation Seminar London School of Economics October 23, 2008

1. Regulatory Reform in the United States: Response to the Subprime Crisis and Recent Financial Market TurmoilProfessor Howell E. JacksonHarvard Law School The London Financial Regulation Seminar London School of Economics October 23, 2008

2. Outline • Reorganization of U.S. Financial Regulation • Systemic Risk and the Current Market Turmoil • A Word About U.S. Projected Costs and Capacity

3. President’s Working Group on Financial Markets (1988) Federal Financial Institution Examination Council (1979) CFTC (1921-22)/(1974) ERISA Agencies (1974) ---- Dept. of Labor I.R.S. PBGC Federal Reserve System (1913)/(1956) U.S. Treasury Securities and Exchange Com. (1934) SIPC. (1970) Comptroller of the Currency (1863) Office of Thrift Supervision (1933)/(1989) Federal Deposit Insurance Corp. (1933) National Credit Union Administration (1934)/(1979) NYSE & Exchanges NASD (1938) FINRA. (7/2007) National Association of Insurance Com. (NAIC) (1871) NCIGF) (1989) NASAA (1919) CSBS (1902) ACSSS (n.a.) NASCUS (1965) NOHLGA (1983) State Securities Com. (1911) State Banking Com. (1838) Other State Comms. State Securities Com. (1911) State Banking Com. (1838) State Insurance Com. (1850s) State Securities Com. (1911) State Banking Com. (1838) Other State Comms. State Insurance Com. (1850s) State Insurance Com. (1850s) State Banking Com. (1838) Other State Comms. Overview of U.S. Regulatory Structure o Industry Segmentation o Federalism & o Further Fragmentation

4. Structure of U.K. Financial Regulation Financial Services Authority + General Insurance Standards Council Office of Fair Trading (Consumer Credit) Occupational Pension Review Authority Dep’t for Trade and Industry (company law) Financial Report Council (audit/accounting)

5. My Six-Point Proposal Background on U.S. Regulatory Reform • Treasury Department Study Plan in Spring of 2007 • Treasury Blueprint Released in March 2008 • Emerging Political Consensus (?) in Fall of 2008 • EESA of 2008 (Bailout Bill) Sets Schedule: • Treasury Report by April 2009 • Congressional Report by Year End 2009

6. I.The authority of the Federal Reserve Board to oversee financial market stability should be expanded to cover all sources of systemic risk in the financial services industry, should be structured to coordinate effectively with other supervisory agencies, and should be designed to allow for consistent, appropriate forms of intervention in response to systemic risks. • Treasury Blueprint Approach • Immediate Actions (Fed Expansion; Mortgage Broker Licensing) • Intermediate Actions (Merger of SEC-CFTC; Rationalize Banking) • Long Term Optional Structure (Stability, Prudential, Market Conduct) • Events Since March of 2008 • Unilateral Action by Federal Reserve Board • Expansion of Treasury Oversight of GSEs in Housing Acct • Creation of Mortgage Licensing Board • Establishment of TARP Under EESA of 2008

7. II. Even after the authority of the Federal Reserve Board has been expanded, the consolidation of other federal financial regulatory functions should proceed; the experience of other leading jurisdictions indicates that consolidated supervision offer numerous benefits in terms of the quality and completeness of financial regulation and that the principal objections to consolidated supervision can be met through statutory safeguards and institutional design. • Affirmative Case • Consolidated Approach Matches Industry Structure • Centralization of Common Functions (consumer protection, etc.) • Better Resolution of Jurisdictional Gaps and Industry Innovation • Quality of Staff and Flexibility in Allocation of Resources • Simplicity of International Coordination • Persistent Points of Opposition • Fear of Bureaucratic Rigidity • Full Agency Capture/Lack of Responsiveness to Smaller Institutions • Status Quo Bias

8. III. Experience in other leading jurisdictions also demonstrates that many of the benefits of consolidated oversight can be achieved without the immediate merger of front-line supervisory units and the world’s premiere consolidated agency, the British FSA, was established first as an oversight body and only later assumed full supervisory functions. • Mapping Out Paths of Reform • Blueprint Approach: Supervisory Mergers Followed by Rationalization • HEJ Alternative: Create Administrative Body to Lead Consolidation

9. IV. Drawing on these experiences, U.S. regulatory consolidation should follow a four-stage process: 1) Immediate enhancement of the President’s Working Group on Financial Markets; 2) Prompt enactment of legislation creating an independent United States Financial Services Authority (“USFSA” or “Authority”) to provide industry-wide oversight, coordinate existing regulatory structures, and lay the groundwork for combination of existing supervisory agencies; 3) A second round of legislation authorizing the merger into the USFSA all other federal supervisory agencies; and 4) Ultimate resolution of the organizational structure of the Authority should be postponed until regulatory consolidation is complete.

10. V. This four-phase approach to regulatory consolidation improves the likelihood of successful transition by delaying controversial decisions, avoiding unnecessary steps, and providing an organizational structure that can lead reform while safeguarding continuity of supervision. • Attention to Pragmatic Problems of Transition • Lack of Parliamentary System in the United States • Need for Organizational Leadership • Location of Ultimate Regulatory Body Outside of Treasury • Administrative Concerns • Continuity of Personnel • Ongoing Supervisory Responsibilities • Avoiding Political Complexities of Supervisory Mergers • Converting Optimal Structure from Legislative to Regulatory Issue

11. VI. The creation of a United States Financial Services Authority is also consistent with expansion of the Federal Reserve Board’s role in overseeing market stability and would actually improve the capacity of the Board to perform that function effectively. • Long Term Role of the Federal Reserve Board • Focus on Market Stability and Monetary Policy • Elimination of Front-Line Banking Supervision • Elimination of Partial Responsibilities for Consumer Oversight • Coordination with Supervisory Units Remains to be Determined • Alternative Approaches • Enhanced Federal Reserve with Marginally Reduced Existing Agencies • Federal Reserve Board becomes de jure Consolidated Supervisor • Market Stability Functions and Procedures of Federal Reserve Board, FDIC, and Treasury • Standards for Intervention • Allocations of Costs

12. Outline • Reorganization of U.S. Financial Regulation • Systemic Risk and the Current Market Turmoil • A Word About U.S. Projected Costs and Capacity

13. Borrowers Public Claimant (depositors, etc.) Normal Justifications for Activities Restriction • Control Agency Costs • Prevent Moral Hazard • Deal with Collective Action • Problems of Public Claimants • Create Hypothetical Contract • Paternalism for Consumers Assets Capital

14. Pathways of Systemic Risk [Costs to Government for Covering Customer Losses] “Second Tier Privity” with Institutional Customers • Continental Illinois with Correspondent Banks in 1984 • Potential Losses from Fannie Mae & Freddie Mac Impact on Complex Network • Herstatt Bank in 1974 • Market Break of 1987 • Counterparties withBear Sterns/AIG/Lehman/CDS Market Precipitation of Financial Panics and other Self-Defeating Behavior • Unloading of Debt Securities with LTCM in 1998 • Junk Bond Liquidations of the Savings & Loan Crisis of 1989 • Runs on Northern Rock and Washington Mutual • Unwinding from Mark-to-Market in Current Environment • Pro-cyclical Effects of Capital and FDIC Funding Discontinuities of Financial Functions • Economic Downturn in the Early 1990’s Following Thrift Crisis • Mortgage Lending Response to Subprime Crisis • Credit Crunch Today

15. Ex Post Responses to Systemic Risks:Access to Liquidity or Solvency Support [or Coercive Unwinding] [Costs to Government for Covering Customer Losses] “Second Tier Privity” with Institutional Customers • Continental Illinois with Correspondent Banks in 1984 • Potential Losses from Fannie Mae & Freddie Mac Impact on Complex Network • Herstatt Bank in 1974 • Market Break of 1987 • Counterparties withBear Sterns/AIG/Lehman/CDS Market Precipitation of Financial Panics and other Self-Defeating Behavior • Unloading of Debt Securities with LTCM in 1998 • Junk Bond Liquidations of the Savings & Loan Crisis of 1989 • Runs on Northern Rock and Washington Mutual • Unwinding from Mark-to-Market in Current Environment • Pro-cyclical Effects of Capital and FDIC Funding Discontinuities of Financial Functions • Economic Downturn in the Early 1990’s Following Thrift Crisis • Mortgage Lending Response to Subprime Crisis • Credit Crunch Today

16. Portfolio Restrictions Consumer Protection Solvency Protection Jurisdictional Boundaries Clearing & Settlement Ex Ante Response to Systemic Risks [Costs to Government for Covering Customer Losses] “Second Tier Privity” with Institutional Customers • Continental Illinois with Correspondent Banks in 1984 • Potential Losses from Fannie Mae & Freddie Mac Impact on Complex Network • Herstatt Bank in 1974 • Market Break of 1987 • Counterparties withBear Sterns/AIG/Lehman/CDS Market Precipitation of Financial Panics and other Self-Defeating Behavior • Unloading of Debt Securities with LTCM in 1998 • Junk Bond Liquidations of the Savings & Loan Crisis of 1989 • Runs on Northern Rock and Washington Mutual • Unwinding from Mark-to-Market in Current Environment • Pro-cyclical Effects of Capital and FDIC Funding Discontinuities of Financial Functions • Economic Downturn in the Early 1990’s Following Thrift Crisis • Mortgage Lending Response to Subprime Crisis • Credit Crunch Today

17. Outline • Reorganization of U.S. Financial Regulation • Systemic Risk and the Current Market Turmoil • A Word About U.S. Projected Costs and Capacity

18. US Residential credit exposure (billions of USD) Non-agency Securitization (Subprime, Alt-A, Jumbo, 2nd-lien) AAA-rated $1640 Subordinates $480 Synthetic $160 2nd/HELOC $251 Total $2531 Depository Institutions Loans 1st lien $2020 2nd lien $869 Total $2889 GSEs Guarantees (Agency MBS) $4363 Retained whole loan portfolio $444 Total $4807 Losses ≈ $158 7.8% Losses ≈ $150 17.3% Losses ≈ $308 10.7% Losses ≈ $76 1.6% Losses ≈ $523 20.7%

19. US nonresidential credit exposure Securities CMBS $940 Consumer ABS $650 High-grade corporate $3000 High-yield corporate $600 CLOs $350 Total $5440 Whole Loans Commercial real estate $2400 Consumer $1400 Corporate $3700 Leveraged loans $170 Total $7670 Losses ≈ $195 2.5% Losses ≈ $475 8.7%

21. Estimated Costs of Recent Banking Crisis (FRB of Chi. Econ. Per. 2000) Country Period Estimated Cost as Percent of GDP United States 1980’s 2.5 % Japan 1990’s 20.0 % est. Norway 1987-89 4.0 % . . . . Korea 1997- 60.0 % p Indonesia 1997- 80.0 % p U.S.A. 2007-2010 $700 billion = 5.0 % $1600 billion = 11.4 % $3200 billion = 22.8 %

22. Regulatory Reform in the United States: Response to the Subprime Crisis and Recent Financial Market TurmoilProfessor Howell E. JacksonHarvard Law School The London Financial Regulation Seminar London School of Economics October 23, 2008