The Devil is in the Exemptions

We’ve been discussing financial regulatory reform for well over a year now, and unfortunately, the discussion is still taking place at a very high level of abstraction. Of course, the real battles in financial regulation aren’t fought at the theoretical level, nor are they fought at the statutory level. The real battles are fought in comment letters on proposed and interim regulations, in SEC no-action letters, and in various (carefully selected) requests for exemptions. It’s not enough to say, “We should limit Wall Street’s risk-taking if they’re going to have access to the federal safety net.” At some point, people have to start getting specific about the wording of regulations they’d like to see, or about how specific existing regulations need to be changed.

Here, I’ll kick it off. Here are two specific regulatory changes I’d like to see. They both involve Reg W, so you just know they’re exciting. I don’t have a lot of time to explain the background (which some of you don’t need anyway), but this should give enterprising young financial reformers and legislative aides more than enough information to get them started. So without further ado:

1. Jesus H. Christ, can we please get someone to revise the derivatives exemption in Reg W so that derivatives are subject to the Section 23A limits? (And by “someone,” I mean “the Fed.”) The Section 23B limits — which generally require transactions between banks and their non-bank affiliates to be conducted on market terms — are clearly not enough. We need to swing the big bats when it comes to derivatives transactions between FDIC-insured banks and their non-bank affiliates, and that means the hard quantitative caps of Section 23A. If memory serves, the reason the Fed gave for exempting derivatives (other than credit derivatives, which weren’t exempted) from Section 23A was that there wasn’t enough evidence yet on the risks posed by derivatives transactions between banks and their non-bank affiliates. Still waiting for that evidence, are we?

2. Get rid of Reg W’s “ready market exemption,” and go back to the old “Wall Street Journal test.” Yes, I know some people thought the Fed didn’t go far enough with the ready market exemption, but they were wrong then and they’re wrong now. Pretty much every security has an electronic service that provides real-time data on price anymore, and the SEC is way too liberal with its definition of a “ready market.” The ready market exemption basically allowed some banks (I won’t name any names) to use their insured deposits to, shall we say, “support” some pretty crappy paper, like ABS and ABCP. And it wouldn’t take much for comparable securities to get back into that exemption. Let’s just go back to the old “Wall Street Journal test.” It was conservative and reasonably clear, which is exactly what we’re looking for in regulations governing large, complex financial institutions.

This isn’t the stuff op-eds are made of, but this is where all the action is. You can talk about moral hazard until you’re blue in the face — and then Wall Street will take your lunch money anyway, and they’ll do it in a comment letter on some proposed interim rules you weren’t even aware of.