Saturday, April 24, 2010

Financial Reform 101: The Senate Bills

A Summary of the Restoring American Financial Stability Act and the Wall Street Transparency and Accountability Act of 2010.  

By: Jordan Young

In part two of our three-part Financial Reform 101 series, we'll be summarizing the actual language of the Senate financial regulatory reform legislation. These two bills have been proposed by the Senate Committee on Banking, Housing, and Urban Affairs and the Committee on Agriculture, Nutrition, and Forestry, respectively. 

For simplicity's sake, we'll refer to the Restoring American Financial Stability Act as the Dodd bill, after primary author Senator Chris Dodd, and the Wall Street Transparency and Accountability Act as the Lincoln bill, after Senator Blanche Lincoln. The Dodd bill is comprehensive, containing sections designed to address a variety of different areas needing reform, whereas the Lincoln bill contains only language pertaining to derivatives regulation. Because Ag (Senate Committee on Agriculture) has primary jurisdiction over derivatives, Dodd only wrote place-holder language in his bill's derivative section so we'll just focus on Lincoln's language during the corresponding section below. All other section will be summaries of the Dodd bill.

Consumer Financial Protection

The Dodd bill creates a new Consumer Financial Protection Bureau (CFPB) charged with protecting consumers from unfair, deceptive, and abusive financial products and practices. It also aims to provide Americans with clear, easy-to-understand information on loans, credit card contracts, mortgages, and other financial products. 

The need for such a watchdog existed long before the recent crisis, but advocates argue the bureau could have drawn attention to the initial catalyst for the crisis, the selling of subprime mortgages, by both providing individuals with clearer information on what they're being sold and monitoring the system-wide trends that can lead to major destruction. One of the many problems with our current system of regulation is the conflicting interests of many regulators. There is no agency primarily charged with looking out for the consumer right now, in fact those responsibilities are currently handled by the Office of the Comptroller of the Currency, Office of Thrift Supervision, Federal Deposit Insurance Corporation, Federal Reserve, National Credit Union Administration, the Department of Housing and Urban Development, and Federal Trade Commission. With so many agencies sharing authority it is difficult to hold anyone accountable for a failure.

Additionally, when a new unfair or abusive product or service is discovered, it often takes months or years for Congress to act. The CFPB would be able to act quickly without the drawn-out and politically-charged legislative process of Congress. 

The original proposal for consumer financial protection would have created a new stand-alone agency much like the Environmental Protection Agency. After some strong statements of opposition from Republicans and centrist Democrats, Dodd decided to shift the agency into a bureau of the Federal Reserve. The change created some backlash from the left, but I would argue that there are really a list of four specific qualifications for a worthwhile consumer financial protection effort. Whether housed in another entity or on its own, these qualification are the criteria we should use to judge the effectiveness of a proposal.

Elizabeth Warren, the Harvard economist who has become the chief advocate for consumer financial protection, has listed the following as the criteria for an effective regulator: 1) an independent director appointed by the President and confirmed by the Senate; 2) independent budget authority so it is not prone to the whims of the appropriation process; 3) independent rule-making authority; and 4) independent enforcement powers. A close reading of the Dodd bill shows that the proposed bureau largely meets these tests and Elizabeth Warren has cautiously praised the language.

However, one area of concern with the language as currently proposed is the veto power given to the Financial Stability Oversight Council, which could overrule the CFPB if two-thirds of its members find that the Bureau's actions increase systemic risk.

Here's a point-by-point summary of the Consumer Financial Protection Bureau:

- Headed by an independent director appointed by the President and confirmed by the Senate;
- Has a dedicated budget paid by the Federal Reserve Board;
- Has autonomous rule-writing authority for consumer protections;
- Has oversight authority over banks, credit unions, mortgage-related businesses, payday lenders, debt collectors, etc; and,
- Takes over and consolidates consumer protection responsibilities currently held by seven separate agencies.

The section also:

- Creates a new Office of Financial Literacy to educate consumers; and,
- Creates a national consumer complaint hotline.


The Lincoln bill creates a strong new system of derivatives regulations. In the current market, derivatives are often traded over-the-counter (OTC) with almost no regulation or transparency. In most cases the only individuals who know of the derivative's existence are the buyer and the seller. Many policy analysts agree that a two-pronged approach to the derivatives market is necessary. 

First, to address systemic risk, clearinghouses are needed to provide an additional, uninvolved participant in the trade. A clearinghouse is an institution that acts as the opposite legal party for all derivative contracts, sort of like a middle man. This new middle man is structured to regulate, monitor, and guarantee the trades it facilitates, insuring that both participants post the necessary collateral for their trade and that both parties can pay in the event they lose the bet.

Second, to address the lack of transparency, exchanges are needed. It is said that sunshine is the ultimate disinfectant, and the exchange shines light on both an individual trade and the market as a whole by creating price transparency. Any interested party can see the price being offered. The high-resolution audit trail created gives managers and regulators something to monitor and investigate, allowing them to see problematic trends in the market.

The Lincoln bill creates well-regulated versions of both. 

It also:

- Charges regulators with closing any and all loopholes they find in the system as they develop;
- Requires banks to spin off swaps desks if they are protected by federal deposit insurance or access the Federal Reserve discount window;
- Exempts commercial end users from mandatory clearing while prohibiting financial entities from opting out;
- Bans federal assistance, including federal deposit insurance and access to the Federal Reserve discount window, to swaps entities in connection with their trading in swaps or securities-based swaps; and,
- Allows the Commodity Futures Trading Commission, which overseas the futures markets, to impose position limits on swaps that perform or affect a significant price discovery function in the market.

Systemic Risk

The Dodd bill creates a new Financial Stability Oversight Council (FSOC). The FSOC is charged with identifying systemic risks posed by large, complex institutions as well as practices within those firms that pose risk to the firm. It will "make recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with significant requirements on companies that pose risks to the financial system." 

This Resolution Authority is extremely necessary to detect systemic risks and deter companies from risky endeavors, but many analysts would prefer the bill set hard limits on leverage and capitol requirements.

The FSOC will be chaired by the Secretary of the Treasury with nine members representing the Consumer Financial Protection Bureau, Federal Reserve, Securities & Exchange Commission, Office of the Comptroller of the Currency, Commodity Futures Trading Commission, Federal Housing Finance Agency, Federal Deposit Insurance Corporation, and an independent member. The Council is designed to encourage communication and information-sharing among regulators who proved too internalized in the recent crisis.

The FSOC also:

- Has authority to require regulation of nonbank financial institutions by the Federal Reserve if its complexity or size threatens systemic stability;
- Has approval authority to require a large financial institutions to divest some of its holding if it poses a risk;
- Creates a new Office of Financial Research within Treasury to be staffed with economists, accountants, lawyers, former supervisors, and other specialists to support the council’s work by collecting financial data and conducting economic analysis; and,
- Submits annual reports to Congress on the collection and analysis of data to monitor emerging risks.

Too Big to Fail

The Dodd bill responds to the Too Big to Fail problem created by the repeal of Glass-Steagall through the following provisions:

- Charges the FSOC with possible implementation of the Volcker Rule, which requires regulators to implement regulations for banks, their affiliates and holding companies, to prohibit proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and to limit relationships with hedge funds and private equity funds;
- Requires large institutions to periodically submit Funeral Plans, which are plans for how to conduct a quick and orderly shutdown should the institution fail; the plans will also provide regulators with an understanding of the structure of the organization;
- Creates a new liquidation procedure to unwind significant financial institutions; and,
- Creates a $50 billion pool funded by the largest institutions to be used to liquidate the institutions if needed. This pool reduces the likelihood that taxpayers will have to provide a future bailout.

Other regulations from Glass-Steagall are also reinstituted including language to discourage the excessive growth and complexity of the system, regulation towards liquidity provisioning, and reforms of the credit ratings agencies to bring new transparency and competition.

Improved Regulation and General System Reforms

- Requires large hedge funds to register with the SEC and disclose financial data. No regulator currently has jurisdiction or authority over hedge funds.
- Institutes efforts to strengthen and improve the competence of the SEC, including annual assessments and independent funding so the SEC isn't subject to the Congressional appropriations process.
- Draws clear lines of responsibility among regulators by streamlining the responsibilities of the FDIC, OCC, and Federal Reserve.
- Requires companies that create securities to retain a portion of the risk to discourage the sale of garbage and to disclose information about the reference asset.
- Strengthens the Federal Reserve while providing new transparency, such as audits of emergency lending facilities.
- Disallows any entity supervised by the Federal Reserve Board from voting for directors of the Federal Reserve Bank, and their past or present officers, directors, and employees cannot serve as directors. Currently the member banks elect directors, who choose the Federal Reserve Board president.
- Requires the president of the New York Federal Reserve Bank be appointed by the President with the approval of the Senate rather than election by the member banks the NY Fed is charged with overseeing.
- Establishes an Office of Credit Rating Agencies at the SEC and requires it to examine the agencies rating methodology and track record, and publicly disclose the findings annually.
- Gives all corporations' shareholders the right to a non-binding vote on executive compensation.


The Dodd and Lincoln bills are strong in many areas and provide a reasonable and comprehensive system of regulations and reforms to prevent future crises and abusive practices. From a policy perspective, I'm generally pleased with the language, but as the process is ongoing and there are further opportunities for amendment, I would submit the following as a list of ways to improve the language further:

- Set hard limits on leverage ratios within the bill to act as a floor for the FSOC's decisions.
- Institute the Volcker Rule outright, rather than leaving the decision up to the FSOC.
- Provide the CFPB with rule-writing authority over auto-lenders.

We hope this summary has been helpful. Please join us for the final installment of this series on the political process for passing financial regulatory reform. As always, questions and discussion are welcomed in the comments section.