Post-Crisis Regulatory Reforms in the U.S.

Background:

Following a financial crisis deeper than any since the Great Depression, the Obama administration signed into law a sweeping reform of the financial industry that aims to curb institutional bad behavior and prevent any recurrence of the conditions that led to the 2007-09 storm. The Dodd-Frank Wall Street Reform and Consumer Protection Act garnered heavy criticism from a public angered by bailouts while addressing severe Republican opposition during its seven-month gestation.

While the recession caused by the crisis has technically ended, the regulatory response is just beginning. The Obama administration must now focus on November’s mid-term elections while Treasury and other departments write regulations that forbid banks from operating hedge funds and private equity funds for their own profit, cap the share of market liabilities owned by any one firm, introduce changes to the regulation of credit rating agencies and the remit and powers of the Federal Reserve and strengthen consumer protections against predatory lending.

Perhaps the most controversial element of the bill is the “Volcker rule”—named after its architect, former Fed chairman Paul Volcker—designed to stop banks from becoming sufficiently big or interconnected that the failure of one could bring about the collapse of other key institutions. Banks are prohibited from trading with their own money but are allowed to invest up to 3% of their Tier 1 capital in third-party hedge fund and private equity. That investment cannot exceed 3% of a third-party hedge fund’s total capital. An earlier iteration of the proposal allowed banks to invest up to 2% of tangible common equity. The bill also prohibits all banks from using M&A to become larger than 10% of the total liabilities of all U.S. financial institutions.

The legislation also abolishes the historical protection credit rating agencies previously enjoyed from lawsuits when underwriters include ratings in deal prospectuses. In response, rating agency trifecta S&P, Fitch and Moody's is refusing to allow bond issuers to use their ratings. Adding insult to injury, the newly vulnerable agencies are now required to register with the SEC while the commission examines the inherent conflict of interest when a bank selects and pays an agency for ratings.

The Federal Reserve—via a newly minted 10 member Financial Stability Oversight Council reporting directly to Congress—will monitor firms’ stability and if necessary, break up firms that pose urgent threats. Originally, the Senate favored limiting the Fed’s powers through the creation of new institutions to monitor systemic risks and federal banks over concern that extending regulatory responsibilities would complicate any judgments regarding the Fed’s future performance.

Hoping to avoid messy situations such as the Lehman Brothers 2008 bankruptcy filing that effectively froze global markets, financial firms are now required to have living wills detailing protocols for an “orderly liquidation” process instead of bankruptcy or governmental support. Other elements of the bill include a newly created Consumer Financial Protection Bureau housed under the Federal Reserve. The bureau—led by a presidentially-appointed director—has the authority to write and enforce regulations on lending to consumers by banks with more than US$10 billion in assets, mortgage-related businesses, student lenders and other large non-bank financial companies (excluding auto-dealers).

This contentious legislation was first proposed on January 5,2010, and on July 15, the Senate ended a Republican filibuster of the bill with a 60-38 vote. The House voted 237 for, and 192 against. While partisans lick their wounds and Wall Street digests the implications, Republicans maintain that the bill is a vast overreach of government power that will do little to prevent future bailouts of failing financial institutions.