The financial reform legislation approved by the Congress today represents a welcome and far-reaching step toward preventing a replay of the recent financial crisis. It strengthens the consolidated supervision of systemically important financial institutions, gives the government an important additional tool to safely wind down failing financial firms, creates an interagency council to detect and deter emerging threats to the financial system, and enhances the transparency of the Federal Reserve while preserving the political independence that is crucial to monetary policymaking. Even before passage of reform legislation, the Federal Reserve has been overhauling its supervision and regulation of banking organizations and working to strengthen financial market infrastructures and practices. We will be focused and diligent in carrying out our responsibilities under the new law.
Legislation to reform the financial sector has cleared the House and the Senate, and the President is expected to sign the bill soon. Here is a quick reaction highlighting some of the positives and negatives in the legislation:
Consumer Protection Agency This agency will provide consumers with the information they need to make good financial decisions, and it will protect consumers from predatory, unfair, and/or fraudulent credit practices. This agency is a needed to help consumers navigate the often confusing world of financial products. The only possible problem is that the oversight council housed in the Treasury has the ability to veto any actions the agency takes, and this council may not be willing to grant the agency the freedom it needs.
Derivatives Traded on Exchanges One of the problems that was evident when the financial crisis hit is lack of transparency. When problems first became evident in the financial sector, it was difficult to assess the degree of risk financial institutions faced because many of the transactions did not pass through standard markets and hence were not tracked. Forcing derivatives to be traded on exchanges helps to solve this problem. But the legislation allows for exceptions to this requirement, and the worry is that these exceptions will be widely exploited undermining the attempt to increase the transparency of these markets.
Resolution Authority A big problem when the financial crisis hit was that regulators did not have the authority to force financial institutions in the shadow banking system into the type of resolution process the FDIC uses for banks in the traditional banking system. This solves that problem, and this is an important change.
Too Big to Fail The legislation does very little to reduce systemic and other types of risk by reducing bank size. I think this is a shortcoming in the legislation as discussed here.
Fed Audits of Special Lending Facilities, Open Market Operations, Discount Window Loans This is intended to give Congress more oversight of the Fed. I don’t think this was needed, more Congressional oversight is not necessarily a good thing, and I doubt that it will do much to change Fed behavior. This was mostly a political change, the economic effects will be small.
Volcker Rule Too Weak The Volcker rule, which attempts to prevent firms from engaging in risky transactions with proprietary money and prevent banks from owning more than a small part of hedge funds and private equity firms was weakened to the point where it was likely to be ineffectual.
Limits on Leverage I don’t believe that we can prevent of financial crisis from ever happening again, but we can limit the damage if one does occur. One way to do that is through limits on leverage and the legislation comes up short in imposing these limits.
Capital Requirements Banks will be required to increase their capital cushions, something that should help to limit the amount of risk that banks take on.
Monitoring Systemic Risk The legislation creates a council to monitor systemic risk. While there is some controversy over whether the Fed is the right place to house this council, the agency itself was certainly needed.
Executive Pay Under the legislation, shareholders will vote on executive pay arrangements, but the votes are not binding so it’s not clear how effective this will be. I don’t see executive pay arrangements as a central cause of the crisis, but there are problems here and the legislation does not go far enough to address them.
Credit Ratings Agencies The bill directs regulators to study the conflict of interest that occurs when ratings agencies are paid by the firms issuing the assets they are rating. Something needs to be done about this, there is a clear conflict of interest, and I would have preferred that the bill take stronger action.
Overall The bill is a step forward, but it does not go far enough. It will be important that legislators view this is the first step in the process of fixing the problems in the financial sector, not the final word.
"The final bill passed by the Senate today and already approved by the House of Representatives will improve regulation in the financial sector. However, given the severity of the economic crisis caused by past regulatory failures, the public had the right to expect much more extensive reform."On the positive side, the creation of a strong independent Consumer Financial Protection Bureau stands out as an important accomplishment. Such an agency would have prevented some of the worst lending practices that contributed to the housing bubble. It will be important that President Obama choose a strong and effective person, such as Elizabeth Warren, as the first head of the Bureau to establish its independence."The requirement that most derivatives be either exchange-traded or passed through clearinghouses is also an important improvement in regulation. However, important exceptions remain, which the industry will no doubt exploit to their limit."The creation of resolution authority for large non-bank financial institutions is also a positive step, although the fact that no pre-funding mechanism was put in place is a serious problem. Also, the audit of the Federal Reserve's special lending facilities, as well as the ongoing audits of its open market operations and discount window loans, is a big step towards increased Fed openness."On the negative side, there is little in this legislation that will fundamentally change the way that Wall Street does business. The rules on derivative trading will still allow the bulk of derivatives to be traded directly out of banks rather than separately capitalized divisions of the holding company. The Volcker rule was substantially weakened by a provision that will still allow banks to risk substantial sums in proprietary trading."More importantly, there is probably no economist who believes that this bill will end the risks of too-big-to-fail financial institutions. The six largest banks will still enjoy the enormous implicit subsidy that results from the expectation that the federal government will bail them out in the event of a crisis."Also, the fact that no regulators, most obviously Ben Bernanke at the Fed, were fired for failing to prevent the crisis leaves in place serious doubts about the structure of incentives for regulators. Cracking down on reckless behavior by politically powerful financial institutions will always be difficult for regulators. On the other hand, if regulators know that failing to crack down carries no consequences, even when it leads to disastrous outcomes, we can expect that regulators will have a strong bias toward ignoring reckless behavior."It is possible that Congress may eventually take stronger steps toward restructuring the financial sector, most obviously in the context of a financial speculation tax. While this was not included in the Dodd- Frank bill, in the context of severe budget pressures, a tax that can raise $150 billion a year in revenue may look more appealing than most alternatives. Such a tax would do far more to restructure the industry than this financial reform bill."
Economists surveyed by The Wall Street Journal this week were evenly split on whether they would have voted in favor of the financial-regulatory bill that passed in the Senate on Thursday.
Some 21 of those surveyed said they’d vote yes; 22 said they’d vote no.
Asked how much the legislation will do to prevent a repeat of the global financial crisis, the majority (58%) said the overhaul would reduce the risks “just slightly and only 6% think it will have a “significant” impact.
Among those who said they would vote against the bill, Diane Swonk of Mesirow Financial raised concerns about moving too fast. “The legislation is outpacing our understanding of the crisis, and I would like to make sure that we learn something from what went wrong before we legislate a new problem,” she said.
Others echoed concerns about unforeseen risks resulting from the overhaul. “Minor reduction in financial risk is not worth a major overhaul, which will generate unintended consequences,” said Brian Wesbury of First Trust Advisors.
Many of those who said they would vote to pass the legislation weren’t enthusiastic . “Better it than nothing,” said Allen Sinai of Decision Economics, “though [the proposal] is very imperfect.”
“Human nature makes more financial crisis inevitable. Hopefully the legislation will make them milder,” said Dana Johnson of Comerica Bank, who supported passage. “It does much more good than harm,” he added.
On the impact of the bill, some, such as Mark Nielson of MacroEcon LLC, were skeptical that any regulation could help. “Anything Congress puts in place will in the short run be undone at the trading level and in the long run will become captive of the cozy high finance industry,” he said
Michael Niemira of International Council of Shopping Centers raised concerns that the bill is too busy fighting the last war. “It is unlikely that the source of the next financial crisis will be identical to the last — it rarely is,” he said.
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