Panel Begins to Set Rules to Govern Financial System

WASHINGTON — The new regulatory board charged with overseeing the stability of the financial system took its first big steps on Tuesday to set out tentative guidelines to limit trading by banks for their own accounts and to restrict the growth of the biggest financial companies.
The Financial Stability Oversight Council, the grand council of financial regulators created by the Dodd-Frank Act, also proposed rules as to which large financial companies that were not banks would be regulated by the Federal Reserve because they constituted a potential threat to the nation’s financial system’s stability based on their size.

It is likely to take several days for Wall Street to wade through and decipher many of the implications of the recommendations, which were embedded in reams of studies, reports and regulatory filings released simultaneously Tuesday afternoon. Among the four documents was a 79-page report on the Volcker rule, the ban on trading by banks for their own accounts that is named for Paul A. Volcker, the former Fed chairman who championed the idea, and 46 pages of proposed rules on regulating nonbank financial companies.

The recommendations made public on Tuesday are subject to revision based on public comments and the recommendations of various other state and federal regulatory agencies. But the proposals are among the most concrete steps yet aimed at preventing financial institutions from becoming “too big to fail” and at keeping tabs on insurance companies and other companies whose activities could endanger the American economy.

Treasury Secretary Timothy F. Geithner, who serves as chairman of the oversight council, said the proposed rules and policy recommendations were necessary “so that consumers and investors can have more confidence that they won’t be taken advantage of and so that businesses and working families will not be vulnerable again to the type of crisis we’re just coming out of.”

Among its actions, the council laid out a set of 10 steps to adopt the Volcker rule.

Jaret Seiberg, a research analyst at MF Global’s Washington Research Group, said in a report that some of the council’s Volcker rule recommendations were “even more positive than the industry was expecting,” including provisions that would allow banks to hedge trading positions used in market-making activities that serve clients.

Under the rules, banks would have to sell or wind down their proprietary trading desks, set up a supervisory system to distinguish prohibited trading from legitimate market-making and capital-raising activities on behalf of customers, and refrain from investing in or sponsoring hedge funds or private equity funds.

While several banks have shut or announced plans to sell the proprietary trading operations that were sources of losses during the financial crisis, the council said in a report that some proprietary trading might still be occurring in disguise, “within permitted activities that are not organized solely” for that purpose.

Regulators now have eight months to draw up specific regulations on proprietary trading, which are likely to include new quantitative measures to differentiate between permissible and banned activities. The law calls for the Volcker rule to be set by mid-September.

Separately, the council released recommendations to adopt a Dodd-Frank provision aimed at preventing already large financial companies from becoming “too big to fail.” Specifically, the proposed rules would prohibit mergers or acquisitions that would result in any company’s liabilities — customer’s deposits and money the bank has borrowed — exceeding 10 percent of the financial industry’s total liabilities.

The 10 percent limit is potentially stronger than an earlier law restricting any company from exceeding 10 percent of the nation’s financial deposits, the council said. By including nondeposit liabilities and off-balance sheet exposures, like special types of borrowings, the rule would limit the ability of banks to hide their risks in more volatile and exotic securities.

One of the biggest debates after the financial crisis stemmed from a lack of oversight by the Fed of financial companies that were not banks but which, because of their dealings in derivatives and other products, posed a significant threat to the banking system.

In the recommendation offered by the council, a framework for assessing a company’s systemic importance would be based on six factors: its size, the lack of substitutes for the products it provides, its interconnectedness with other financial firms, its leverage, liquidity risk and existing regulatory scrutiny.

The oversight council also has begun considering an overhaul of government involvement in the mortgage market. The Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, said Tuesday that it had directed the companies to develop a system for collecting payments from borrowers, a process known as mortgage servicing.

Mortgage servicers are paid a pittance by mortgage investors like Fannie and Freddie, enough to cover their routine responsibilities but not the additional work of dealing with delinquent borrowers. And servicers have little or no incentive to help borrowers avoid foreclosure.

Alternatives could include paying a larger fee, or requiring servicers to transfer delinquent loans to companies that specialize in working with troubled borrowers.