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Financial Reform End Game

Time for Congressional Leaders to Protect Consumers

SOURCE: Center for American Progress

Both the Senate and the House of Representatives have passed financial regulatory reform bills, with the Senate approving legislation sponsored by Senate Banking Committee Chairman Chris Dodd (D-CT) last month on a 59-39 vote.

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The end game of financial reform begins this week in Congress, with the stakes as high for American families as they are for Wall Street’s financial titans. More than a year and a half ago, the financial crisis that spawned the Great Recession began in earnest. The failure of the investment bank Lehman Brothers Co. and the near collapse of the insurance giant American International Group Inc. required the Federal Reserve to engineer multiple rescue packages, but now Wall Street is back to reaping billions of dollars in profits while most Americans are still struggling to recover from the Great Recession.

In fact, three of Wall Street’s biggest traders—Goldman Sachs Group Inc., Bank of America Corp., and JP Morgan Chase & Co.—did not suffer trading losses on a single day in the first quarter of this year. Yet Wall Street has roared back to profitability without Congress enacting new rules of the financial road, leaving markets as opaque and wild as ever.

That will change this month. Both the Senate and the House of Representatives have passed financial regulatory reform bills, with the Senate approving legislation sponsored by Senate Banking Committee Chairman Chris Dodd (D-CT) last month on a 59-39 vote. The House passed its own version, driven by House Financial Services Chairman Barney Frank (D-MA), last December. Now, all that stands between President Obama’s signature and financial reform is a conference committee to reconcile the two bills and a final vote in each body.

Rep. Frank, who will be chairing the conference, said that he expects the effort to be completed by the Fourth of July. "I’ve cleared my calendar for the month of June to get this done," he said. But will get done? While the two bills are largely similar, there are some key differences between them. Here are the most important:

Consumer protection

Sen. Dodd’s bill creates a Bureau of Consumer Financial Protection housed within the Federal Reserve. The bureau would have a presidentially appointed director, an independent budget (which will equal no more than 10 percent of the Fed’s operating budget), and the ability to take enforcement action against banks with more than $10 billion in assets. The bureau has rule-writing authority, but its rules could be vetoed by a two-thirds vote of the proposed Financial Stability Oversight Council, which will be composed of the heads of the bank regulatory agencies, the secretary of the Treasury, and the chairman of the Federal Reserve.

The House bill creates a fully independent Consumer Financial Protection Agency, with a presidentially appointed director and an independent budget. It has full rule-writing authority (with some exemptions, see below) and the ability to enforce its rules for banks with more than $10 billion in assets.

While full and complete independence for the new consumer protection regulator is preferable, both bills match the four criteria that Elizabeth Warren, chairperson of the congressional oversight panel reviewing the government’s rescue of financial firms, has said are critical to the regulator’s success:

  • An independent director
  • Independent source of funding
  • Rule-making authority
  • Enforcement powers

The conferees should fight any attempt to add carve-outs or exemptions for special interest groups or niche financial products (like payday loans).

Derivatives

The Senate’s legislation on derivatives—the complex financial instruments that played a large role in the collapse of many large financial firms, most notably AIG—was authored by Agriculture Committee Chairwoman Blanche Lincoln (D-AR). It mandates that all standardized derivatives be traded on public exchanges (just like stocks are traded currently), and that all customized derivatives go through clearinghouses, which ensure that both parties in a trade have adequate collateral backing it up. There is an exemption from the requirements for nonfinancial companies, but it is not extensive. The controversial Section 716 of the Senate bill would require federally insured commercial banks to spin off their derivatives trading desks, placing them under an independently capitalized subsidiary.

The House’s bill mandates exchange trading for standardized derivatives and clearing of customized derivatives, but with larger exemptions for end users. It does not force banks to spin off their swaps desks.

The more derivatives activity that is put on exchanges, the better, and those trades that can’t be placed onto exchanges should be centrally cleared. This will make the derivatives market transparent both for investors and for regulators looking for wrongdoing. End-user exemptions, if they exist at all, should be narrow, to ensure that financial companies can’t exploit them.

Ban on proprietary trading

The Senate’s version of the “Volcker rule,” named after former Federal Reserve Board chairman and current Obama administration financial advisor Paul Volcker, instructs regulators to study whether or not a proprietary trading ban would work in practice and if it would undermine the stability of financial firms, and then design and implement a ban based on the findings. An amendment from Sens. Jeff Merkley (D-OR) and Carl Levin (D-MI) that would have institutionalized the ban never came up for a vote and is therefore not on the conference committee’s agenda, but they are still pushing for it to be included in the conference committee.

The House bill does not contain a version of the Volcker rule, as the concept wasn’t introduced by the Obama administration until after the House had passed its bill. But the House’s legislation does allow the Federal Reserve Board to prohibit companies from engaging in such trading.

Preventing banks that benefit from a federal backstop from engaging in proprietary trading is a key part of creating a safer, more stable financial system. Giving regulators too much leeway could lead to bans that either aren’t enforced or are too narrow to be effective. As Volcker himself has said, “In my opinion, it’s very unlikely that the regulators and supervisors would evoke a strict prohibition until a crisis came and then it’s too late.” Banks that benefit from federal guarantees should not have their risky trading supported by a government safety net.

Auto dealer exemption

The Senate bill does not contain an exemption for auto dealers from rules written by the Bureau of Consumer Financial Protection. But the Senate did pass a “motion to instruct,” stipulating that it would like conferees to push for such an exemption. The House bill explicitly exempts auto dealers from rules written by the Consumer Financial Protection Agency.

Providing any exemptions from new consumer protection rules gives the providers of a particular financial service a competitive advantage over all of the others. And the auto finance market, as the Cambridge Winter Center for Financial Institutions Policy has pointed out, “is demonstrably susceptible to unfair and deceptive practices” including hosts of markups and fees. According to the Center for Responsible Lending, “consumers spend more than $20 billion a year in excess interest by borrowing through a dealership instead of through a bank or credit union.” The Department of Defense strongly disagrees with an exemption for auto dealers, due to the plethora of service members who have fallen pray to predatory auto loans. The choice facing the conferees is clear.

Resolution fund

The Senate bill does not contain a fund for resolving a failing, systemically risky financial firm. Any money necessary for the unwinding will be fronted by the Treasury Department and recouped through sales of the failed company’s assets and an after-the-fact levy on the biggest financial institutions. The House bill levies a fee on the biggest financial institutions (those with more than $50 billion in assets) that will go toward creating a $150 billion resolution fund, which would be tapped in order to unwind a failed institution.

As Federal Deposit Insurance Corporation Chairman Sheila Bair agues, a pre-funded system “has significant advantages over an ex-post funded system.” In fact, an ex-post levy could be dangerously pro-cyclical, as it’s a safe bet that if one large financial firm has failed, others are in trouble. “I worry about the politics of trying to extract the costs from the industry if it might have a negative effect on the economy—that could become the problem,” said Stephen Lubben, a bankruptcy professor at Seton Hall Law School.

A pre-paid fund, meanwhile, acts like FDIC deposit insurance, ensuring that the industry, not taxpayers, pay the cost of an unwinding. That said, the Senate’s resolution authority is stronger and lays out a more specific mechanism for taking apart a failed firm. Combining a fund with the Senate’s design for the resolution authority may be the best route.

Corporate governance

The Senate bill includes provisions regarding “say on pay,” which mandates that shareholders hold an annual nonbinding vote on their company’s compensation practices, and proxy access, which makes it easier for shareholders to nominate candidates for their company’s board of directors. It also requires that publicly traded companies provide both clear descriptions of their compensation and the relationship between that compensation and their financial performance.

The House’s bill also includes both proxy access and “say on pay,” requiring financial companies to disclose incentive-based compensation arrangements. Federal regulators are allowed to determine if such compensation structures align with sound risk management.

Both “say on pay” and proxy access are key corporate governance reforms ensuring that directors are accountable to their shareholders. They should help companies rein in risk structures that are unbalanced and pay packages that incentivize undue risk taking.

Conclusion

This is by no means an exhaustive list, as there are plenty of smaller differences between the bills, including the way in which they address capital requirements, preemption of state consumer protection laws, interchange fees, and auditing the Federal Reserve. But it is in these areas that financial reform’s ultimate success or failure will largely be determined.

Pat Garofalo is an Economics Researcher at the Center for American Progress and a Blogger at the Center for American Progress Action Fund.

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