Wall Street faces curbs on risk taking and the prospect of lower profits under sweeping U.S. proposals to prevent a repeat of the credit crisis.
The Obama administration's plan to rewrite financial rules, announced on Thursday, would create a single regulator to monitor any firm whose failure could threaten the financial system, while also tightening rules for big hedge funds and private equity firms.
U.S. Treasury Secretary Timothy Geithner told Congress comprehensive reform was needed to prevent a repeat of the current credit crisis, the most virulent since the 1930s. Not modest repairs at the margin, but new rules of the game.
The proposals Geithner presented also require large, interconnected institutions to hold more capital, provide for derivatives to be traded on an exchange, and give the government authority to shut down troubled financial firms.
Leaders from the Group of 20 rich and emerging nations gather for a meeting next Thursday in London at which regulatory reform will be high on the agenda. President Barack Obama will make the case that Washington is moving forward boldly and others must step up to do the same.
Our hope is that we can work with the Europeans on a global framework ... which has appropriate global oversight, so that we don't have a balkanized system at the global level like we had at the national level, Geithner said.
Under the plan he laid out for the House of Representatives Financial Services Committee, one entity would be responsible for ensuring systemic stability over both major institutions and critical payments and settlement systems. Many lawmakers have considered giving the Federal Reserve that role.
Currently, a variety of regulators control different parts of the banking system, and some participants in insurance and other sectors largely fall between the regulatory cracks.
We have a moment of opportunity now. We don't want to waste this opportunity, Geithner said. We need to act.
HEDGE FUNDS, PRIVATE EQUITY FIRMS FACE SCRUTINY
Securities and Exchange Commission Chairman Mary Schapiro, whose agency came under harsh criticism for not seeing the current crisis coming, said the agency should not be sacrificed in order to set up an overarching regulator.
Even as attention focuses on reconsidering the management of systemic risk, investor protection and capital formation ... cannot be compromised, she told lawmakers.
In one key move, Geithner said hedge fund advisers and others who control big pools of capital like private-equity funds and venture capital firms should be forced to register with the SEC.
Some European officials, notably in Germany, have long sought registration of hedge funds and criticized free-wheeling hedge fund operators in the United States for helping create an environment that permitted excessive risk-taking.
Geithner used the example of American International Group to make the point that companies like insurers were taking huge risks on exotic products like credit default swaps that were barely understood by some market participants.
Let me be clear: the days when a major insurance company could bet the house on credit default swaps with no one watching and no credible backing to protect the company or taxpayers from losses must end, Geithner said.
He promised unparalleled transparency for the market for derivatives related to stocks, bonds, currencies or other financial instruments or risks. Dealers would have to clear derivatives contracts through central counterparties so they could be monitored.
Analysts said the proposals potentially were as significant as the Depression-era Glass-Steagall provisions that set up barriers between commercial banks and investment banks. That law was swept aside in 1999, permitting companies to mix banking with other financial activities.
Geithner wants a regime that would subject systemically important firms to more scrutiny than smaller ones.
If you're a systemically important company, you are ultimately backed by taxpayers, not just shareholders, so it makes sense to look at regulation this way, said Karen Shaw Petrou, managing partner at Federal Financial Analytics in Washington.
These large firms would be required to hold more capital than other financial companies, and would face tougher liquidity, counterparty and risk-management rules.
The systemic risk regulator would get powers to order prompt corrective action if capital levels decline, similar to the power the Federal Deposit Insurance Corp has for banks.
Despite the strong prescriptions to increase scrutiny, the administration signaled some flexibility on accounting. For example, so-called fair value accounting rules will be reviewed to try to identify changes that could reduce wild swings in profit and capital levels as markets move up and down.
Similarly, accounting for loan loss reserves might be revised to ensure firms are setting aside enough money to get through rough economic spots without collapsing.
(additional reporting by David Lawder, Rachellen Younglai, Karey Wutkowski, Corbett B. Daley and Patrick Rucker in Washington, and Dan Wilchins in New York)