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A bold step forward

On the 15th July the United States Senate gave final legislative approval to an overhaul of the rules that govern America’s financial system. This constituted the most significant reform of US financial regulations since the Great Depression of the 1930s. The passage of the Wall Street Reform and Consumer Protection Act represents a key legislative victory for Barack Obama and his Democratic Party. A few weeks earlier, the House of Representatives obliged the administration by passing the Act by 237 votes to 192. The finance reform bill created a divide between America’s political factions with Democrats in favour and Republicans bluntly against. However, unlike the healthcare reforms, undertaken a few months previously, which divided America right down the middle, this time Mr Obama has wider support amongst most sections of American society. Many Americans believe Wall Street bankers were to blame for the crisis and must be better controlled.

To assume that the new law will end all future bank bail-outs may be presumptuous, as it contains some obvious omissions. For instance, the Act completely ducks the future status of Freddie Mac and Fannie Mae, the two housing mortgage companies that were partly instrumental in creating the financial crisis. Moreover its success is consequent largely on how it is implemented – the manner in which agencies draft rules and guidelines – as Congress has left a lot of the detailed dreary stuff for later.

But the reforms are from any measure, far reaching and bold in three critical areas – regulatory oversight; derivatives and troubled banks. The Act creates a ten member council of regulators led by the Treasury Secretary which would monitor emerging threats to the financial system and determine which companies were so big or interconnected that their failure could jeopardise the financial system. These companies would then be subject to greater regulation and if they teetered, the government would liquidate them. The costs of taking such a company down would be borne by other industry peers. The Act consolidates oversight of consumer financial products from mortgages, short term loans to credit cards into a single consumer protection agency which would be housed within the Federal Reserve. Currently, in America, consumer protection is spread amongst various bank regulators. The Fed’s relationship with banks would face careful scrutiny from the Government Accountability Office; specifically, low cost loans made to lenders would come under special audit.

Although not the primary cause of the financial crisis, derivatives are considered a contender for causing the next one as they add both opacity and leverage to the financial system. Derivatives were until now traded out of sight of regulators – dealer to dealer. They will, in accordance with the new Act, be traded on public exchanges in a more transparent manner. This would lessen the risk that one dealer’s failure brings down others. Banks would be prohibited from trading in riskier (and hence more profitable) derivatives with the objective of protecting tax-payers, since bank deposits are guaranteed. They may however continue to trade in interest rate and forex swaps. Some analysts insist this move would impact the return on equity amongst banks within this business segment by a substantial amount. Fee reductions, compliance costs and tying up of more capital in trading could effect further reductions in margins forcing some less profitable lenders to merge with others.

Shareholders would get to vote on executive pay, although the votes would not be binding. The Fed would oversee executive compensation to ensure that it does not encourage excessive risk taking – if a payout appeared to promote risky business, the Fed could block it. Credit rating agencies that give bad advice could be legally liable for losses to investors. Regulators would study the issue of conflicts of interest which is at the heart of the rating system – credit rating agencies are paid by the very banks that issue the securities they rate. This is the main reason they gave strong ratings to mortgage investments that were basically worthless.

Mr Obama had proposed during the recent meeting of the G20, a tax on the liabilities of banks (amounting to USD 90 billion over a ten year period) which is designed to discourage size. The intention is to claw back the subsidy such institutions enjoy in their borrowing and encourage them to shrink and indeed pay for their clean up costs when they fail. The G20 failed to agree on such a tax last week but America is likely to press ahead on its own. If this goes through, it would in the least encourage others to give it another serious look.

The Consumer Protection Act is a fine beginning towards reforms in the financial sector. Ultimately, however, the devil is in the detail. The extent of control exercised by regulatory agencies on the functioning of banks and other financial institutions will be consequent upon how effectively the rules and guidelines are articulated. In a desire to have the legislation through quickly without frustrating political opposition Chris Dodd and Barney Frank, the Act’s main architects, left a number of ends open. They did so in the fear that extensive debate on finer points would hamper the very basics of what they sought to achieve. Consequently, they left a lot for regulatory agencies to settle. Bankers believe they have the ability to persuade regulators more effectively than they can influence politicians. Hence, the final outcome of the Act may not be as catastrophic from their perspective then first indications suggest. The litmus test however remains the Act’s ability to prevent another crisis for that is really what matters most to the American people.

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