With the Dodd-Frank Act, Congress has agreed to reduce a decade-old barrier standing between the Federal Reserve and the separately regulated subsidiaries of the holding companies it supervises.
No longer will the Fed be required to defer to so-called functional regulators when it wants to examine a bank affiliate, a broker-dealer, a futures business or an insurance arm of a company it oversees on a consolidated basis.
Of course, the Fed will be expected to rely on the reports of fellow regulators to the extent that it can, and it must avoid a duplication of duties whenever possible. But if it wants to request information from a subsidiary or conduct an exam of its own, it merely must consult first with the subsidiary's primary regulator.
How this new authority in the bill — scheduled to be signed Wednesday by President Obama — will be exercised by the Fed can hardly be known. But in any case it embodies a significant change in the thinking about, and approach to, functional oversight since previous legislation on the topic.
The Gramm-Leach-Bliley Act of 1999 instructed the Fed to steer clear of subsidiaries regulated elsewhere and to defer to fellow regulators when questions arose about the subsidiaries. Conventional wisdom at the time held that risks in diversified companies were best evaluated by regulators with expertise in specific lines of business. Moreover, Congress accepted the notion that unregulated financial entities could be more easily nudged toward supervision if they were promised that the Fed would maintain a light touch.
The latter notion looks naïve in hindsight. But the former still holds sway in Congress, which did little in the new legislation to consolidate the splintered regulatory system and, in some cases, entrusted new powers to agencies with functional regulatory responsibilities. This time, though, important checks and balances were attached. For example, the Fed is to be permitted to go inside a functionally regulated subsidiary without first having to prove, as it did under Gramm-Leach-Bliley, that the subsidiary posed a risk to a depository institution within the holding company.
"Unless you get into a subsidiary and examine it, it's really tough to leap to conclusions that whatever is going on [in the subsidiary] is jeopardizing the insured-deposit affiliate," said Kathleen Collins, a partner in the business and finance practice at Morgan, Lewis & Bockius LLP and Washington counsel to the Bank Insurance and Securities Association trade group. With the new approach prescribed by Dodd-Frank, she said, "you're rearming the Fed with supervisory authority over functionally regulated entities."
Under Dodd-Frank, if the Fed suspects trouble at a functionally regulated affiliate of a bank holding company, it must "provide reasonable notice to and consult with" the appropriate regulator — typically a bank agency, the Securities and Exchange Commission, the Commodity Futures Trading Commission or a state insurance department — but ultimately has authority to do its own exam.
For nonbank financial companies that come under Fed oversight, the central bank can recommend in writing that the functional regulator of a subsidiary initiate a supervisory action or enforcement proceeding. And if a response acceptable to the Fed is not produced within 60 days, it "may take the recommended supervisory or enforcement action, as if the subsidiary were a bank holding company subject to supervision by the Board of Governors," the bill says.
Moreover, the Fed is given authority to examine any subsidiary of a systemically important, nonbank financial company for information about its operations or risks to the safety and soundness of the subsidiary, the company or the financial system as a whole.
Fed officials declined to speak on the record about the new approach's implications, but they pushed to get the broadest possible view of the companies they would be charged with monitoring.
"Large organizations increasingly operate and manage their businesses on an integrated basis with little regard for the corporate boundaries that typically define the jurisdictions of individual functional supervisors," Jon D. Greenlee, the Fed's associate director of banking supervision and regulation, testified in March before the House subcommittee on capital markets, insurance and government-sponsored enterprises.
Scoping out risks to a holding company, its subsidiaries and the system itself "requires a comprehensive and integrated assessment of activities throughout the holding company," he added.
It is unclear that the Fed would have acted any differently in the years leading up to the financial crisis had it been able to examine functionally regulated units of the biggest bank holding companies. But presumably its supervisors at least would have had the chance to get a richer, unfiltered picture of the companies' entire operations.
"If the SEC allowed securities firms to leverage again the way they did before, the Fed might" step in and act, said Melanie Fein, a banking and securities lawyer who practices in Washington and leads an American Bar Association task force on the causes of the financial crisis. "But I would imagine in the near term it's not likely that the Fed would be examining" securities affiliates.
Certainly doing so would risk the delicate balance that regulators have achieved in the years since Gramm-Leach-Bliley's enactment.
Cynthia A. Glassman, a former SEC commissioner, saw plenty of agency tension in the early years of the law's implementation.
"At least part of the issue had to do with sharing information," said Glassman, now a senior research scholar at the Institute for Corporate Responsibility at the George Washington University School of Business and a director of Discover Financial Services. "The banking agencies' main focus was safety and soundness, and they didn't want to make public things that could be fixed in private because they didn't want to disclose things to the market that could cause runs on banks. The SEC's mission is very different. At the SEC, if there is an enforcement action, they want to make it public so it will deter others."
Whether the Dodd-Frank legislation will change the rapport that the Fed and functional regulators have developed in the 11 years since Gramm-Leach-Bliley will depend largely on how aggressive the Fed becomes in exercising its new authority if it senses trouble within functionally regulated businesses. But on a day-to-day basis, the division of labor will probably be unchanged, with functional regulators carrying out their usual duties.
"When you talk about the differentiation between functional regulators and more supreme oversight regulators, we still are tasked with chopping the wood, so to speak," said Connecticut Insurance Commissioner Thomas R. Sullivan.
And that means banks themselves might not notice an effect until the Fed decides to test the new regulatory structure established by Dodd-Frank.
"I think this is one of those areas where we're not going to know how it works until it either works or doesn't work," said Collins, the Washington lawyer. "I think it's going to take some time, probably even for the Fed itself, to figure out how it wants to utilize this newfound authority. But at the end of the day, if there's a [regulatory] shortfall, it can be laid at their feet now, so I'm sure they will be vigilant."
This story has been reprinted with permission from American Banker.
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