The financial regulation reform bill (the Dodd-Frank bill) has tried to address seven major issues - regulation of the shadow banking system, limiting conflicts of interests, steps to limit the build-up of systemic-risk, consumer protection measures, internalizing the externalities imposed by systemic risks (costs of the inevitable bailouts), a resolution authority to dissolve failed large institutions, and regulator to monitor systemic macro-prudential risks. And needless to say, it is incomplete on all of them.
Shadow banking and limits on using derivatives
It expands federal banking and securities regulation from its focus on banks and public markets to a much wider range of financial companies, including those trading in credit derivatives. However, the legislation leaves regulators with broad leeway to shape its meaning and its impact.
The legislation establishes federal oversight of derivatives and requires most deals to be insured by a third-party clearinghouse and traded on public exchanges. In other words, henceforth standardized derivatives contracts will be traded on an open exchange, with prices and volumes reported publicly, and the contracts must also be cleared through a third party, an intermediary who guarantees that if one party defaults, the investor holding the other side of the trade will still be paid. The shift to clearinghouses will turn derivatives trading from a highly profitable niche to a more volume-based business, in which banks will have to compete on customer service and price.
But trading in credit-default swaps referencing lower-grade securities, like subprime mortgages, will have to be run out of bank subsidiaries that are separately capitalized. These subsidiaries may have to raise capital from the parent company, diluting the bank’s existing shareholders. Non-financial corporations would be allowed to set up their own financial affiliates to create and trade derivatives related to their businesses.
However, the bill permits banks to conduct trades for customers in interest rate swaps, foreign currency swaps, derivatives referencing gold and silver, and high-grade credit-default swaps. Banks will also be allowed to trade derivatives for themselves if hedging existing positions.
The legislation leaves to the discretion of regulators about which derivatives are to be traded on exchanges and how long traders can wait to disclose pricing information (so as to encourage competition). The important exclusions in the bill would only ensure that these trades would now shift to the hedge funds and special purpose vehicles outside the regulatory over-sight.
Systemic risk limiting measures
A large part of the debate on financial market regulation reforms have focused on the importance of having robust and self-acting mechanisms to address the build-up of systemic risk arising from concentration of risks within a few large firms - the too-big-to-fail (TBTF) problem.
A number of influential voices have argued that the only meaningful way to address this is to break-up the large financial institutions. They had argued that given the political power wielded by the large banks, the difficulty of regulators staying one-step ahead, and the moral hazard unleashed by the sub-prime bailouts, a repeat of the events that led to the sub-prime meltdown was inevitable.
However, it contains nothing on breaking up the big financial conglomerates nor limiting their size. Nor is there any action on stronger capital requirements. Further, it does not cover the large foreign banks, which in the absence of comparable restrictions will face a competitive advantage and resultant skewed incentives to continue these undesirable practices. In conclusion, the bill fails completely on the issue of limiting systemic risks arising from TBTF firms and their inter-connectedness.
The legislation restricts banks from making speculative investments with their own money, a provision known as the Volcker Rule, but allows banks to take small stakes in investment funds including hedge funds and private equity funds. This in turn dilutes the rigor of Volcker Rule type restrictions. It also authorizes regulators to impose restrictions on large, troubled financial companies.
It creates a Consumer Financial Protection Bureau within the Federal Reserve Board (with separate financing and an independent director), to be appointed by the president, to write and enforce rules protecting consumers of financial products like checking accounts, mortgages and payday loans and also increases the authority of state regulators to enforce protections. Lenders would now be required to provide plain-English disclosures, price comparisons with alternative products and clear tripwires before fees are assessed. Banks may cut back on free checking as they spread costs more evenly across the customer base, rather than relying on a minority of customers to make bad choices.
However, it exempts loans provided by auto dealers from the Bureau’s oversight. If the super-regulator feels that if a consumer protection measure threatens the soundness or stability of the financial system (read "threatens bank profitability"), they can override the consumer protection bureau’s rules.
The legislation establishes a Financial Stability Oversight Council, as an überregulator, to be led by the Treasury secretary and made up of top financial regulators, to coordinate the detection of risks to the financial system. With the objective of giving the Congress more oversight of the Fed, the legislation also provides for audits of the Fed's Fed Special Lending Facilities, Open Market Operations, Discount Window Loans.
It creates a process for the government to liquidate failing companies at no cost to taxpayers, which is similar to the FDIC process for liquidating failed banks. Regulators believe they now have the authority to force troubled banks into a resolution process, something they didn't have before, and that they can do so in a way that won't disrupt the banking sector and create even bigger problems. However, as Mark Thoma has written, "regulators won't know if this will actually work until they try it, and that's the problem".
See assessments of the bill by Gretchen Morgenson, Simon Johnson, and Tobin Harshaw. See also this and this on the evolution of the Bill across the House of Representatives and the Senate. See this excellent description of the variouys components of the Bill by Mark Thoma.
Robert Reich has this assessment,
"(T)he legislation does nothing to diminish the economic and political power of these giants. It does not cap their size. It does not resurrect the Glass-Steagall Act that once separated commercial (normal) banking from investment (casino) banking. It does not even link the pay of their traders and top executives to long-term performance. In other words, it does nothing to change their basic structure. And for this reason, it gives them an implicit federal insurance policy against failure unavailable to smaller banks — thereby adding to their economic and political power in the future...
Customized derivates can remain underground. The consumer protection agency has been lodged in the Fed, whose own consumer division failed miserably to protect consumers last time around. On every important issue the legislation merely passes on to regulators decisions about how to oversee the big banks and treat them if they’re behaving badly."
James Henry and Laurence Kotlikoff describes this law as like being "invited to dinner and served pictures of food". More debate on the Dodd-Frank bill here.