Tuesday, November 13, 2012

Financial Reform Bill Does Little to Address Systemic Risk

As written, the new financial regulatory framework will do relatively little to reduce systemic risk or cut industry profits, Oxford Analytica argues in this guest post.

The agency rule-making procedures that must now be undertaken will provide ample opportunity for banks to press for further weakening of the statutory framework.

Congress passed the final version of financial reform legislation on July 15, and President Barack Obama will sign the bill within days. The effect of the legislation on the industry will be relatively modest — and could be further weakened depending on whom the president chooses to lead a new regulatory body, and how existing regulators implement and promulgate new rules over the next few years.

The Restoring American Financial Stability (RAFS) Act provides an unfinished blueprint outlining the scope of financial reform. The text of the legislation leaves undefined significant, substantive details of the new regulatory regime. By some estimates, at least 75% of the substance of the legislation remains unsettled.

Consumer Financial Protection Bureau. The new Consumer Financial Protection Bureau (CFPB) is a significantly scaled-down version of President Barack Obama’s initial proposal. The design of this new entity has been tightly drafted, so that it will be difficult for the new agency to tip the regulatory balance in a more consumer-friendly direction; the CFPB is housed within the Fed, rather than structured as a stand-alone entity, and will be headed by an independent director appointed by the president.

Although this streamlined structure should, in theory, make it easier to for the CFPB to design and implement consumer-friendly provisions, various offsetting structural provisions will inhibit its effectiveness. Other regulatory bodies have the power to appeal CFPB decisions they believe would endanger the soundness or stability of the financial system.

Administration stance is key. The CFPB’s structure makes its effectiveness dependent on the general approach to consumer issues taken by the administration. Obama’s choice of a CFPB director will be crucial to realising the entity’s potential:

  • Warren. In addition to her work on consumer protection, Harvard Law School Professor Elizabeth Warren heads the Congressional Oversight Panel that has overseen various aspects of the banking bailout (including the Troubled Asset Relief Program).
  • Other candidates. Other front-runners may include Michael Barr, who currently serves as assistant Treasury secretary for financial institutions and was formerly a law professor at the University of Michigan, and Gene Kimmelman, currently chief counsel for competition policy and intergovernmental relations in the antitrust division of the Department of Justice and a former officer of the Consumers Union, an advocacy group.

Warren is the highest profile candidate. If Obama were to choose someone else, it would signal a desire to pursue a more low-key approach to consumer protection issues.

Rule-making procedures. New rules will be promulgated and implemented over the next few years, involving all major agencies tasked with financial regulation. Rule-making procedures will shape the scope and impact of two key aspects of the reform legislation:

  • Volcker rule. The final legislation incorporates a weak version of the ‘Volcker Rule’, which would have prevented banks that accepted federally guaranteed deposits from engaging in proprietary trading. As adopted, the legislation limits the proprietary trading activities of banks, subject to significant exceptions, and restricts bank holdings of ‘alternative investments’ — private equity funds, and hedge fund — to 3% of their Tier 1 capital. The full impact of this provision will be difficult to gauge until rule-making procedures are completed, as banks seek to exclude certain types of trades from the requirements.
  • Derivatives regulation. A provision requiring banks to spin off their derivatives trading activities into a separately capitalised subsidiary was retained, but with significant exclusions. Banks will continue to trade in various types of derivatives instruments, including foreign exchange derivatives, interest-rate swaps, and investment grade credit default swaps (CDS). Equity derivatives, commodity swaps, and non-investment grade derivatives must be traded via a separate subsidiary.
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