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A First Step on Financial Reform

Author: Roya Wolverson
July 15, 2010

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The U.S. Senate voted 60 to 39 in favor of financial reform legislation (NYT) on July 15, a major victory for President Barack Obama, who plans to sign the bill into law the week of July 19. But passing the legislation may prove (MSNBC) only a preliminary step in a longer process of enacting reform.

The bill's major provisions (WashPost) require banks to spin off a portion of their lucrative swap trading desks and limit banks' ability to invest in private equity and hedge funds. Federal regulators would be empowered to seize and dissolve large financial firms at risk of collapse, and a consumer protection agency would be created within the Federal Reserve. To tackle the problem of "systemic risk," the Fed would supervise the country's largest financial institutions and work with a Financial Stability Oversight Council of existing regulators.

But the legislation also allows financial regulators a lot of leeway in writing specific rules. According to the U.S. Chamber of Commerce, the bill directs regulators (WSJ) such as the Federal Reserve and the Securities and Exchange Commission to write 533 rules, compared to sixteen rule-making mandates in the 2002 Sarbanes-Oxley accounting law. That leaves many delicately-worded compromises (Reuters) within the bill vulnerable to continued debate and lobbying, including how exotic derivatives should be regulated, where to draw the line in limiting banks' so- called "proprietary trading," and how to limit banks' risk-taking. Senate Republicans and businesses, for instance, are especially dissatisfied with over-the-counter derivatives reforms, which they argue will limit access to credit for small and medium-sized businesses. Sen. Richard Shelby (R-AL) also† said the bill's delegation of power to the Fed on how to impose limits on the debit-card transaction fees banks charge would "substitute the judgment of a benevolent bureaucrat for that of the American consumer."

Other vagaries include how much authority the new consumer protection agency will have. "Such an institution might simply not have sufficient standing power against the Fed and other regulators, especially in its early years," says economics professor Thorsten Beck on the blog VOX. Beck also expects uncertain power shifts resulting from the Financial Stability Oversight Council's creation, to be headed by the treasury secretary, a political appointee. Putting the SEC in charge of assigning credit ratings to rating agencies, an option the legislation offers the agency, might also shift existing perverse incentives from business to government, rather than eliminating them. In this sense, says Beck, the reform bill will not prevent the next financial crisis but merely "provide the framework, within which the different actors and most importantly regulators, central bankers, and politicians will act."

There are ways Obama could strengthen the legislation even after its passage.† One measure is to choose a strong leader to head the new consumer protection agency that would quickly establish effective guidelines on "non-bank" businesses, such as payday and auto lenders and other consumer financial products, said Woodrow Wilson fellow Devin Fergus on a recent New America Foundation panel.

Ultimately, the legislation's effectiveness comes down to cultivating responsible regulators and bank heads, said former Treasury Secretary Henry Paulson in a recent New York Times interview. "I think it is asking a lot for regulators to be perfect--because they won't be. But what you have here is a mechanism that gives regulation a much greater chance to be successful." Even so, the bill's heavy reliance on further study means real reform action will not come for at least another two years, said the Consumer Federation of America's Travis Plunkett at the New America event.

Additional Analysis:

In the Financial Times, Viral V. Acharya says the Dodd-Frank bill falls short: It insufficiently discourages firms from putting the system at risk and fails to eliminate implicit government guarantees for systemically important firms, including Fannie Mae and Freddie Mac.

In the Washington Post, CFR's Sebastian Mallaby says Congress is creating obstacles for entrepreneurial boutique financiers - precisely the players who must absorb the risks that were appallingly mishandled by too-big-to-fail banks.

Background:

This Reuters Factbox outlines the winning† and losing government agencies in the financial bill.

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