Christopher Dodd, Connecticut Democrat and chairman of the US Senate banking committee

In the process of attempting to win support for regulatory reform within the US banking industry from both Republicans and financial institutions, concerns are being raised that too many concessions are being made, thus limiting the intended impact of the proposals. Writer Jane Monahan

Two years after Lehman Brothers' devastating bankruptcy and the US Federal Reserve's $30bn rescue of Bear Stearns, legislation to overhaul the US financial regulatory system to reduce the risk of another disastrous crisis is finally gaining traction in Congress.

Christopher Dodd, the Connecticut Democrat who chairs the Senate banking committee, moved a bill though his committee in mid-March with support from Democrats only. However, following accusation by US authorities against Goldman Sachs of securities fraud during the 2007 credit bubble, many believe the chances have increased of a full Senate vote on a tougher draft in April; Timothy Geithner, the US Treasury secretary, and others have expressed confidence that Republicans would vote in favour of the legislation. (At least 60 senators must vote in favour of the bill for it to pass in the Senate. Democrats, who lost their Senate majority earlier this year, now effectively have 59 Senate seats so they need at least one Republican to vote with them.)

Further reasons for the momentum include the broad consensus on the need for many of the reforms. Secondly, it is not clear that all 41 Republican senators would be willing to stand up and filibuster the legislation. That action would be portrayed as siding with the bankers, and poll after poll shows banks, bonuses and bailouts continue to spark voter anger.

The next step will be to reconcile the Senate text with a House of Representatives bill that Mr Dodd's counterpart, Barney Frank, the Massachusetts Democrat, shepherded through a rumbustious committee and a full House of Representatives vote five months ago. Mr Frank has said he expects president Barack Obama to sign the bill into law in June, near the third anniversary of the onset of the crisis.

Missing pieces

All that increases the likelihood of one of the biggest changes in financial regulation since the 1930s being enacted soon. However, some of the legislation's key proposals, such as the establishment of mechanisms to wind down failing but systemically important financial institutions and the creation of a multi-agency council to oversee risks to the financial system, have become increasingly complex in the process of attempting to win support from Republicans and banking and financial industries.

This raises a key question as to whether the reform will make the government and regulators more agile in future in detecting and preventing emerging threats to the financial system. On top of that, experts say, key pieces are missing in the reform.

Regulators repeatedly warn that having too-big-to-fail - or too-interconnected-to-fail - financial institutions poses a major threat to economic stability, but neither the White House version, nor the House or the Senate version of the reform, includes proposals to limit the size of financial institutions. "In fact, all the proposals in the legislation are built around the assumption that there will continue to be some group of entities that are too big or too interconnected to fail," says Professor Emma Coleman-Jordan, a banking specialist at Georgetown University's law faculty.

Douglas Elliott, a former investment banker at the Brookings Institution think tank, says: "There isn't an effective solution. The country needs a small number of banks to be fully global and to have true economies of scale. We are stuck with too-big-to-fail."

Some experts also fear that any real regulation of derivatives will be absent from the reform. What is agreed is that more bilateral over-the-counter trades in derivatives - financial instruments such as the credit default swaps that blew up giant insurer AIG in 2008 - will be channelled onto electronic exchanges and through central clearing houses to both reduce risk and increase transparency. The rule applies to all derivatives contracts that can be standardised.

However, there is a loophole in that customised bilateral contracts, which may include some of the riskiest 'naked' credit default swaps - where there is no insurable interest based on an underlying stock - do not have to be traded through clearing houses. Instead, these trades will be subject to margin (collateral) requirements and swap dealers and major swap participants will be subject to capital requirements to offset the greater risks they pose.

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Gary Gensler, chairman of the Commodity Futures Trading Commission

Sticking point

After the Goldman Sachs charges from the Securities and Exchange Commission, the final derivatives proposals in the legislation are expected to be tougher. Republicans have argued that many contracts and many corporate end users should be exempt from the new central clearing derivatives trading rules. However, Mr Geithner, other regulators and Democratic lawmakers are now urging a maximum use of exchanges and minimal exemptions, using the allegations that Goldman Sachs committed fraud in marketing complex financial instruments to push for more transparency.

Meanwhile, Gary Gensler, chairman of the Commodity Futures Trading Commission, which regulates derivatives, said, when addressing a Chamber of Commerce conference on March 24, that he was not convinced corporate end-users of derivatives would be well served, as the business group suggested, with exemptions from the new clearing rules. He asked: "How can you know that the costs charged by the dealers - embedded and opaque - are less than the margin [collateral] associated with clearing houses?

"The only parties that benefit from a lack of transparency are Wall Street dealers," he said. "Right now we have a dealer-dominated world, and that nearly drove us off a cliff."

Among drafted proposals where agreement has been reached, one group deals with an organisational rearrangement of US regulators, having the Federal Reserve supervise big bank-holding companies; the Office of the Comptroller of the Currency (OCC) supervises smaller banks; the Federal Deposit Insurance Corporation (FDIC) supervises state-chartered banks; and the Office of Thrift Supervision is eliminated. And while this organisational overhaul is considered interesting and perhaps necessary, it is quite neutral in terms of addressing the core purpose of the reform, ie, the flexibility of the government and federal regulator to anticipate and respond to future financial crises.

Clean-up plan

A second group of proposals focuses on ensuring that in the event of another failure, the clean-up can proceed faster and with more structure than was the case in the ad hoc response to the current situation.

One idea is for a fund to be established, paid for by the financial industry, to cover the costs of a clean-up and speed up the process. How big this fund needs to be, to rule out taxpayer support, is a moot point. The House of Representatives bill proposes a $150bn fund, the Senate just $50bn. Splitting the difference, it is likely the size of the fund in the final bill will end up at $100bn. However, many think this will not be nearly enough, considering the trillions of dollars of public money deployed in the current financial crisis.

Also in this 'clean-up faster' category is a proposal for an expanded resolution authority to ensure the orderly winding down and liquidation of failing - but systemically important - financial firms, to prevent a repeat of Lehman Brothers' damaging bankruptcy or the massive bailout of AIG.

But what started as a straightforward proposal by the Obama administration, to expand the existing expertise of the FDIC in bank insolvency resolution to large financial firms, has been substantially transformed. To meet Republican objections in the Senate about a government-ordained resolution regime, and allegations of the government exerting too much power over business, the proposal has been changed to include a requirement that the Fed and the Treasury (in addition to the FDIC) also sign off on using the expanded resolution authority, and that a so-called 'expedited' review of their decision is carried out by a panel of three bankruptcy judges.

Professor Anna Gelpern of the Washington law faculty of American University says: "I think it is a fine idea, this expanded resolution authority. It's good to have checks and balances." However, Brookings' Mr Elliott says it is not clear whether in incorporating a role for the judiciary, the unwinding of a company can be done quickly enough to prevent contagion spreading through the entire system. "It is one of the things that is weakest in the reform and that worries me," he says.

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People power: consternation over the impact of the credit crisis and the level of national debt in the US is still a concern for financial reformers

Risk assessment

Meanwhile, a third category of proposals in the area of prevention includes the establishment of a risk council that will focus on identifying, monitoring and addressing systemic risks posed by large, complex financial institutions, including their financial products and activities that spread across firms. For example, the council "will follow a mortgage transaction from the kitchen table to underwriting to securitisation to credit default swaps", says Mr Talbot of the Financial Services Roundtable. "It will look at the entire transaction."

Having a watchdog look at the big picture, including the risks posed by asset price bubbles - and with the authority to instruct systemically important companies to adjust accordingly to protect the system from those types of risk - is considered a positive. However, there is concern among experts that such a risk council will not allow the government and regulators to be more agile in their response to a financial crisis, fundamentally because the council's composition, with nine banking and financial services regulators - a veritable duck soup of initials - is clunky.

Moreover, the agencies on the council have very different perspectives and clients. For instance, the Federal Reserve, according to reform proposals, will be responsible for regulating non-commercial banks in future and will be working with a diverse set of regulatory subjects, including investment banks, insurance companies and brokers - "the whole melange of the shadow banking system", says Ms Coleman-Jordan.

In contrast, the FDIC is always primarily going to be looking at resolution-related issues, in which it has specialised since its foundation in 1933. Conversely, the OCC is generally considered as an agency that is quite congenial for the interests of the banks it regulates.

Indeed, the potential difficulties of such a wide variety of decision-makers reaching an agreement raises serious questions about whether the new council's response will be swift enough to match the rapid evolution of new systemic threats. Added to this, many other prevention measures, according to agreed proposals, will depend on the council reaching a decision.

For instance, 'significant' increases in capital and reserves at systemically important financial firms, over and above such increases for the banking system as a whole, are a matter that the council has to decide and recommend to the Federal Reserve.

The financial industry needs "even higher capital and liquidity requirements for its biggest banks", according to Mr Elliott. "This doesn't remove the moral hazard but it does imply there will some cost for becoming a too-big-to fail - or a too-interconnected-to-fail - institution."

The Volcker rule, named after Paul Volcker, a former Federal Reserve chairman and chairman of President Obama's Economic Recovery Advisory Board, is also a prevention measure whose fate depends on council regulations.

This rule, included in the Senate bill but which will have to be added to the House of Representatives bill because it was introduced late, proposes that banks benefitting from government guarantees, such as deposit insurance and access to Fed discount funds, should be prohibited from sponsoring and investing in hedge funds, private equity funds and proprietary trading operations.

As such, the rule harks back to the Glass-Steagall Act of 1933, a post-depression era law, repealed in 1996, that was a structural limitation of risk categories to separate investment from commercial banks. However, moving in the other direction, the acceptance of the too-big-to-fail concept implicit in the current reform proposals has led to a proposed merger of the regulation of commercial and investment banks and their holding companies under the Fed, blurring the distinction between the two.

"Even after the repeal of Glass-Steagall we had a different set of ideas about what role these financial intermediaries would play in our economy. But what this (new) set of rules does is to simply treat investment and commercial banks as all the same," says Ms Coleman -Jordan.

A final proposal with which President Obama is closely associated - the establishment of a financial consumer protection bureau, independent of bank regulation, to prevent the mis-selling of mortgages, credit cards and other financial products - also risks a botched outcome after starting out with good intentions.

Michael Calhoun, president of the Center for Responsible Lending, a consumer advocacy group, says keeping financial consumer protection and bank prudential (safety and soundness) regulation under the same roof and having one regulator for both, which is the current situation, leads to consumer protection being "a very low priority and continually falling between the cracks".

"The past 20 years are littered with examples where the failure to have effective consumer protection has been bad, not only for consumers, but for the whole banking and financial system - and the economy," says Mr Calhoun. Despite that, special interest groups, such as the Financial Services Roundtable and the Chamber of Commerce, have lobbied hard against the proposal and the idea has also sparked debate in Congress.

Compromising situation

To break the deadlock and get the 60 votes needed to pass his bill, Mr Dodd, the Senate banking committee chairman, agreed two compromises, says Mr Calhoun. The first is that the consumer protection agency need not be a standalone body and can be housed elsewhere. Mr Dodd suggested the Federal Reserve, which provoked an immediate backlash from Democrats, especially Barney Frank, chairman of the House of Representatives financial services committee, who called the idea " almost a bad joke".

The comment was made considering the Fed's bad record in not curbing subprime lending before the housing bubble burst, even though it was the only regulator in the country with the power to impose consumer protection rules that would apply to all mortgage lenders.

Second, Mr Dodd agreed to allow some degree of oversight of the new agency's rules by a council (another one) that would have bank regulators among its members.

But, experts many say, adding another layer of bureaucracy on top of the financial consumer protection bureau is almost certain to slow its capacity to respond quickly. And this would be a significant impairment in terms of an agile government regulator keeping pace with new financial products and market innovations, and the risks they may pose when they go awry.

"The experience we had with subprime mortgages, and the proliferation of lending practices and products we now understand were completely abusive to consumers, tells me it takes time for regulators to get a whiff of exactly what is going on in the market. It takes them time to figure out what is happening to craft a response. It is that time lag I am most concerned about," says Ms Coleman-Jordan.

Bill Schneider at Third Way, a centrist think tank, says: "Wall Street is endlessly creative in figuring out more and more risky schemes for making money, and the law and the regulatory system has trouble catching up. That has always been true in this country's history."

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