The Banking System Needs Wholesale Reform, Not Biden’s Proposal

Kramer Levin partner Yasho Lahiri reviews President Joe Biden’s recent proposal for addressing holes in the US banking system, contending that deeper systemic reform is needed across agencies to prevent collapses from happening in the future.

In the wake of several recent bank failures, President Joe Biden has unsurprisingly called for tightening of regulatory controls on the US financial system, a move that many observers believe is desperately needed and sorely overdue.

I wholeheartedly agree changes are necessary, but here’s a friendly reminder to the White House and others looking at regulatory reform: Attempting to regulate the US’ vast, highly complicated financial system with its existing regulatory infrastructure is akin to trying to fight a modern war using cannons and communicating via carrier pigeons.

The federal government’s most common response to financial crisis has been to form a new regulator, or grant new authority to an existing one, to address the root causes of the last crisis. This is precisely what we’re seeing from Biden in his new push for reforms.

These approaches work admirably to prevent future crises that are identical, or very similar, in nature to the most recent crisis. But no war, or financial crisis, is ever exactly the same as the last one—and we know that fighting the last war doesn’t prevent the next war. Moreover, each new regulator, and each new regulatory scheme, adds to administrative competition, further reducing the likelihood that the existing regulatory infrastructure will avert potential crises.

Let’s be blunt about where we are: The US has a crazy quilt of overlapping, and even competing, federal and state financial regulatory schemes.

Most of these schemes arose from historical cataclysms. The Great Depression and the resulting New Deal created the Securities and Exchange Commission and gave us the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940. The Federal Reserve and the Commodity Futures Trading Commission and its ancestors also arose from cataclysms.

Congress periodically seeks to modernize the securities laws after new crises. Thus, the takeover boom during the 1960s led to the Williams Act and, more recently, Sarbanes-Oxley, and then Dodd-Frank sought to apply lessons from corporate scandals and the global financial crisis.

Each of these regulatory schemes presumes a clearly defined and essentially separate area that it seeks to regulate. A glance at the reality of modern finance shows that that isn’t true. Pick a major financial institution at random and look at its website: Chances are it encompasses a mixture of banks, brokerages, insurance companies, and commodities firms. Similarly, the actual risk allocation mechanisms used in today’s financial system prove just how interconnected the system is.

Take, for instance, a company that wants to expand by building a transformative solar cell factory.

The company could sell shares to raise part of the capital for the project. It could also, or in addition, sell bonds, either by itself or as part of an arrangement with state and local governments to take advantage of tax efficiencies. The sale of shares or bonds is governed primarily, but perhaps not solely, by the federal securities laws.

The company could borrow part of the necessary capital from a bank, or a syndicate of banks, so banking regulation matters. The company could also, or in addition, borrow part of the capital from a private credit fund.

The private credit fund is typically regulated by a different portion of the securities laws. Some investors in the private credit fund may be US or foreign insurance companies, or US or foreign pension funds, implicating more regulatory schemes, now including some outside the US.

If there is a bank or a private credit fund as a lender, the loan will likely be sold into a securitization governed by the securities laws. The holders of the senior tranches of the securitization will likely be insurance companies, pension funds, college endowments, and other institutional investors.

Some of these investors’ appetites for the senior tranches of the securitization will depend on the net capital treatment afforded to the tranches by the regulatory schemes applicable to the investor.

Insurance companies, for instance, are subject to multiple sets of state net capital requirements. States generally look to the National Association of Insurance Commissioners to establish a uniform approach to net capital requirements. (One might ask why this unified approach could not be embodied in federal law, and subject to federal regulatory oversight.)

Global heating means that the solar plant both is a response to, and at the mercy of, climate risk. To guard against that risk, the company can buy insurance. Insurance companies and their reinsurers could lay off that risk by issuing catastrophe bonds or insurance-linked securities, again linking the insurance and securities markets. Alternatively, the company could, at least theoretically, lay off that risk to the futures market.

A successful response to crises, in our current system, depends on coordination between the many regulators with seats at the table, not one of which is charged with having a nuanced and broad-ranging view of the complexity of, and the connections in, the financial system. That the regulators often come up with something that works is a testament to their skill and effort, and it is a success despite, and not because of, our current regulatory mechanic.

We can, and must, do better. Perhaps a regulator with a broad mandate and jurisdictional clarity could even prevent crises, rather than inevitably responding to them.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Originally published by Bloomberg Industry Group, Inc. Reproduced with permission. Published Apr. 10, 2023. Copyright 2023 by Bloomberg Industry Group, Inc. (800-372-1033) http://www.bloombergindustry.com