Both the House of Representatives and the Senate will soon vote on the Dodd-Frank Wall Street Reform and Consumer Protection Act, a financial regulatory reform bill aimed at correcting the deficiencies in our nation’s financial regulatory system that led to the financial meltdown of 2008. If enacted, the bill will put in place the most significant improvements to the nation’s regulatory framework since the New Deal.
There were many reasons for the economic collapse of 2008, the effects of which are still being felt by families across the country, but chief among them was a financial system that worked in the interests of Wall Street and too-big-to-fail financial institutions, and against the interests of consumers, especially homeowners, but including all kinds of Americans in need of consumer finance. Adequate safeguards were not in place to protect consumers from predatory financial products and Wall Street excess, and these products were then securitized and sold around the world, amplifying risk while minimizing the responsibility of the culpable lender.
Huge markets in complex financial instruments were allowed to grow exponentially, out of the watchful eye of regulators. Those regulators that did speak up about the growth of this “shadow banking system” were drowned out by others who believed in the conservative regulatory philosophy that the market would self-correct all ills. Companies that had previously confined their activities to traditional financial products, such as the global financial insurance giant American International Group, were allowed to mix those with riskier products and to balloon in size, as Treasury Secretary Tim Geithner said, “without any adult supervision.” AIG, of course, had to be rescued by the U.S. government after the collapse of investment bank Lehman Brothers amid the crisis of 2008.
The Dodd-Frank bill is an important step toward crafting a financial system that doesn’t allow for that sort of excess and that reinstates consumer protection as a key ingredient of fairness and financial stability. It creates a new Consumer Financial Protection Bureau, housed within the Federal Reserve, which will be solely tasked with policing consumer lending. It will have a presidentially appointed director, an independent source of funding, and the ability to ban financial products that are deemed unfair and predatory.
No longer will consumer protection be left to federal bank regulators torn between dual mandates of consumer protection and bank safety and soundness. As Harvard Law Professor and consumer advocate Elizabeth Warren explains, the new agency “will have the tools to rein in industry tricks and traps and to cut out the fine print. For the first time, there will be a financial regulator in Washington watching out for families instead of banks.”
The bill also bring the $600 trillion market in over-the-counter derivatives, which is almost entirely unregulated, out of the dark by forcing standardized derivatives trades onto public exchanges (like those used for stocks) and putting customized trades through central clearinghouses (which ensure that the two parties in a trade have adequate collateral backing it up). As we have pointed out before, these are key reforms that will give investors a much clearer picture of derivatives prices and give regulators transparent paths to follow as they police fraud and abuse in the market.
Due to a reform known as the Volcker rule—named after former Federal Reserve chairman and current Obama administration adviser Paul Volcker—big financial institutions will no longer be able to engage in risky trading for their own benefit with federally insured dollars. And should they get into trouble due to making bets that don’t pay off, federal regulators will be empowered with a new resolution authority for dismantling failed firms without resorting to the ad hoc bailouts of 2008.
Of course, the legislation isn’t perfect. For instance, the Volcker rule includes an exemption allowing banks to invest in risky hedge funds and private equity firms and to continue managing those funds, which undermines the original intent of the rule. A reform suggested by Sen. Blanche Lincoln (D-AR) that would have forced banks to place their derivatives trading desks into a separately capitalized entity was weakened, with the banks allowed to retain trading related to interest rate swaps, foreign exchange swaps, credit, gold and silver, investment-grade credit default swaps, and any transaction used to hedge risk.
A pre-funding mechanism for the resolution authority—favored by, among others, Federal Deposit Insurance Corp. Chairman Sheila Bair—was discarded in favor to an ex post facto levy on the biggest financial firms. And auto dealers were given a blanket exemption from the consumer protection agency’s rules, creating an uneven playing field in the area of consumer credit and setting up the opportunity for regulatory arbitrage.
But these compromises should not detract from the significant achievement that Wall Street reform would be under the Dodd-Frank Act. The current set of rules governing consumer lending and the tools available for reacting to a financial crisis are severely limited in scope and totally inadequate in practice. Adhering to the principles of putting consumers first, keeping taxpayers out of the business of rescuing failed firms, and keeping a watchful eye on the riskiest financial instruments will change for the better the way in which Wall Street does business.
Pat Garofalo is an Economics Researcher at the Center for American Progress and a Blogger at the Center for American Progress Action Fund.