NEW YORK - Regulatory officials are pondering significant changes to the way the U.S. oversees financial markets in the wake of last year's credit crisis and the failure to prevent Bernard Madoff's massive Ponzi scheme, but lawmakers will have to make some hard choices before any real changes can happen.

Financial industry experts blame these failures on the way regulatory agencies operate in silos and fail to share vital information.

This is about to change. As soon as Congress finishes its prolonged debate over healthcare, lawmakers will turn their sights to financial regulatory reform. A hot item on the agenda is the creation of a systemic risk council that would have the authority and ostensibly the political impunity to "take away the punch bowl before the party gets out of hand."

"During the crisis last year, the President's Working Group on Financial Markets turned into a systemic risk regulator," said Walt Lukken, senior vice president of legal and global market structure at NYSE Euronext, at the Investment Company Institute's annual Capital Markets Conference here. "Now we are seeing a need for a standing risk council that can look around the corners to see what may be coming down the pike."

Appointing the Federal Reserve to this job seemed like a great idea for a few days, but public sentiment quickly shifted to the idea of a systemic risk council, along the lines of the Working Group. Indeed, on Thursday, Fed Chairman Ben Bernanke told Congress that a broad-based oversight council of financial regulators, not just the Fed, should handle systemic risk oversight.

Possible members of the risk council could include the secretary of the Treasury, chairman of the board of directors of the Federal Reserve, chairman of the Securities and Exchange Commission, chairman of the Commodity Futures Trading Commission and chairman of the Federal Deposit Insurance Corp.

"The consensus is that there needs to be somebody thinking about these issues on a standing basis," Lukken said.

"It has become increasingly obvious, particularly during the recent financial crisis, that the current bifurcated approach to securities and futures regulation is outdated and in need of overhaul," said SEC Commissioner Elisse Walter during the SEC-CFTC joint meetings on regulation harmonization held last month. "Splitting the regulation of securities markets and the futures markets between two agencies makes it very difficult for either agency to have comprehensive oversight of our financial markets. Regulatory cooperation is absolutely essential if we are to come as close as possible to consolidated real-time information over markets that have become highly interrelated in recent years. That knowledge is necessary if our respective agencies are going to be able to prevent market manipulation, fraud and other abuses effectively.

"To put it simply, you cannot regulate what you cannot see," she said.

Another logical and much-discussed idea is the merger of the SEC and the CFTC, but political insiders laugh at the notion that the Congressional oversight committees of these agencies would be willing to give up or share their power.

The House Financial Services Committee, chaired by Rep. Barney Frank (D-Mass.), oversees the SEC, while the House Agriculture Committee, chaired by Rep. Collin Peterson (D-Minn.), oversees the CFTC.

"Eight months ago, this was considered the low-hanging fruit in Congress. Now it's not even in the bill," said Jeffrey Brown, senior vice president of the office of legislative and regulatory affairs at Charles Schwab & Co.

There are 46 members of Congress on the agriculture committee and 71 on the financial services committee, and many of them have fought long and hard to be there. The prestige of being on such an authoritative committee is often a major factor in receiving campaign contributions, Brown said.

"When people say merger, they really mean takeover," Lukken said. "There are significant differences between the two agencies that must be reconciled. A simple merger is not enough. Even if you put them under one roof, the tensions would still exist."

In an ideal world, lawmakers would be able to put these political squabbles behind them and focus on real regulatory reform, Lukken said.

"I think we should burn both to the ground and really think about what a regulator should be," he said.

In lieu of merging the two agencies, Congress has dampened down the discussion to focus on the harmonization of the two agencies. The SEC and CFTC have agreed to a memorandum of understanding and have held joint meetings to reach a common ground and clear up some of their many differences.

"The underlying statutes of the two agencies are very different," said Erik Sirri, a professor of finance at Babson College and the former director of the SEC's division of market regulation. "The SEC is retail and investor oriented, while the CFTC is about prices, futures and shifting risk."

As separate agencies, the SEC and CFTC divide regulatory jurisdiction as follows: The SEC regulates financial markets-including stocks, bonds, mutual funds, hedge funds, securities-based swaps, securities indexes, U.S. government debt and interest rates-while the CFTC regulates physical commodities like wheat, natural gas, copper and commodities-based derivatives.

This all seemed pretty straightforward until market innovators, doing what they do best, started creating derivative instruments that mixed a variety of swaps and danced across jurisdictional lines. Regulators weren't sure who was responsible for what, and because they weren't communicating with each other, these products fell into a magical regulatory no man's land.

"As financial products become increasingly indistinguishable in economic function and purpose, it is very difficult to determine their correct regulatory treatment," Walter said. "Agency disputes over products that straddle regulatory boundaries serve neither the interests of investors nor the efficiency and competitiveness of our financial markets. The time has definitely come for our two agencies to not only work together, but to successfully harmonize our regulatory regimes where differences are not justified."

Political capital is a finite resource, and if the Democrats in Congress are able to succeed in reforming healthcare, many financial leaders say the merger plans for the SEC and CFTC could surface again.


(c) 2009 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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