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Reinventing financial regulation

By Brady Dennis and Alberto Cuadra
The Washington Post

The landmark legislation approved by Congress represents the most profound restructuring of financial regulation since the Great Depression. Here are some of the highlights of the bill, which was born out of the wreckage of the recent financial crisis, and the problems it is designed to address.

HIGHLIGHTS: 

Consumer Protection

The problem:

In the lead up to the financial crisis, seven regulators shared responsibility for looking out for consumers of mortgages, credit cards, and other such loans, but none treated consumers as a top priority. The result was that home loans grew ever more risky and complex -- precipitating the mortgage meltdown -- credit card interest rates and banking fees ballooned, and non-bank lenders such as mortgage brokers and auto finance companies operated virtually without federal oversight. 		How the bill tries to solve it:

A new Consumer Financial Protection Bureau would be set up to safeguard borrowers.
  • The new agency will have the power to write and enforce new rules governing mortgages and other financial products.
  • Banks with more than $10 billion in assets would be subject to examination.
  • While it would be housed inside the Federal Reserve, the bureau would have an independent head appointed by the president and a dedicated source of funding.
  • Opponents warn that the agency could impose burdensome regulations and increase costs for consumers.

Too Big to Fail

The problem:

When large financial firms began to falter in 2008, federal officials faced an unenviable choice: let these companies fall into a messy and drawn-out bankruptcy, which would upend markets around the world, or use taxpayer money to bail them out. Lehman Brothers was allowed to fail and the result was nearly a worldwide depression, while American International Group was bailed out by the government with nearly $200 billion in loans, investments and guarantees. 		How the bill tries to solve it:
  • The government will be given the power to seize and close down large failing firms in an orderly fashion, just as the Federal Deposit Insurance Corp. can shut down ordinary banks that run into trouble.
  • The Treasury, FDIC and the Fed would agree to seize and liquidate a faltering company, and the FDIC would close it down.
  • Shareholders and unsecured creditors would bear losses, and management would be removed.
  • In addition, a new council of regulators could recommend that large, complex companies hold more capital to cover potential losses.

Derivatives

The problem:

The market for financial derivatives -- essentially bets on the future price of something else -- exploded in recent years, growing into a $600 trillion industry largely without federal oversight. When the financial crisis hit, investors panicked because they didn't know whether parties on the other side of the bets would be able to pay. This uncertainty amplified the upheaval, because thousands of firms were bound together in a disastrous web of potential defaults. 		How the bill tries to solve it:
  • Nearly all derivatives deals will have to be conducted through central clearinghouses, so investors can be confident about settling their bets, and firms will have to raise money to cover any unexpected losses.
  • In addition, most derivatives would be traded on public exchanges, not in private side deals. A few exceptions would be granted for special derivatives contracts.
  • Large Wall Street banks will have to spin off some of their trading of derivatives.

Risk to the global financial system

The problem:

Ahead of the crisis, there was no agency in the government responsible for monitoring the financial system as a whole and looking for potential threats to its health. So officials were largely blind to potential time bombs such as insurance giant AIG, which had grown so large and interconnected with other companies that its collapse in September 2008 put the global economy in jeopardy. 		How the bill tries to solve it:
  • A Financial Services Oversight Council, composed of a handful of existing regulators and chaired by the Treasury secretary, will be set up as an early warning system.
  • The council will seek to identify systemic risks posed by large, complex financial firms, as well as focus attention on certain practices and products that magnify risks facing multiple companies.
  • It could also encourage regulators to tighten rules for companies that grow so big or interconnected that they threaten the nation's financial stability.

Regulator shopping

The problem:

Financial firms have been able to shop around for a regulator that gives them the best deal. This practice, called regulatory arbitrage, has been possible because of a patchwork system of agencies with overlapping jurisdiction. In some cases, regulators don’t have the expertise or staffing to keep tabs on the firms they end up with. These failings have been most visible with the Office of Thrift Supervision, which sought to recruit banks under its umbrella and then suffered some of the largest bank failures of the financial crisis. 		How the bill tries to solve it:
  • Clearer lines of responsibility would be established, reducing the chance for arbitrage.
  • The Fed, FDIC and Office the Comptroller of the Currency would each have jurisdiction over different types of banks, with the FDIC, for instance, regulating state banks while the OCC would be responsible for national ones.
  • The Office of Thrift Supervision will be eliminated.
  • Opponents warn, however, that confusion will continue because the number of regulators was streamlined further.

SOURCE: Staff Reports; Graphic by Alberto Cuadra and Sisi Wei - The Washington Post, May 21, 1010

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