Financial Reform Preview

Posted in Financial Markets, Politics and Policy at 3:59 pm

Over the next week or so, I intend to do a series of somewhat detailed looks at the various components of the nascent financial reform legislation.  It’s a bit premature at the moment, since all we have are the versions of the bill originally passed by the House and Senate along with comments made to the media regarding agreements reached in negotiation late last week.  Since the announced intent is for the reconciled bill to be put up for a final vote before the Independence Day weekend, we should see something tangible soon.

Here are some preliminary comments on the key components of the bill, with more to come:

  • Resolution Authority – Much of the discussion during the negotiation focused on whether or not the resolution authority would be pre-funded.  This was just a giant red herring in reality.  It appears that the FDIC will end up with jurisdiction over resolutions, and I anxiously await details on the exact structure.  It’s hard to see how the approach the FDIC has historically taken with depositories will work with the large financial conglomerates.  When the FDIC takes over an insolvent deposit bank, it first tries to sell the bank to another bank, with the buyer assuming all assets and liabilities of the failed bank.  That’s the quickest and easiest approach with the least disruption.  If that doesn’t work, then the FDIC responsibility for insured deposits (it has its own fund paid for by member bank premiums) and sells the failed bank’s assets at market to recover funds paid.  This works because the failed bank’s funding source (deposits) is already insured by the FDIC, and given the history of insured depositors never having lost a penny, there’s no reason for depositors to rush for the exits.  The large conglomerates use repos and other funding sources, so it will be interesting to see how the FDIC attempts to deal with such a failed institution without locking up entire markets.  It will also be interesting to see how the FDIC will approach foreign subsidiaries of these firms.
  • Proprietary Trading/Volcker Rule – Preliminary information suggests banks will be allowed to invest up to 3% of Tier 1 Capital in hedge funds.  This significantly weakens the proposed ban on proprietary trading.  What will be of particular interest is how the final legislation defines customer trading and market making activities.  This will largely determine the effectiveness of these provisions.  It’s likely there will be significant room for interpretation in the definitions, such that many activities that do in fact objectively represent trading for the bank’s books will be allowed.
  • Derivatives Reform – Some types of derivatives trades will end up having to be moved to separate subsidiaries of the bank holding company, and these susbs will have to raise their own capital.  There appear to be exemptions for interest rate swaps, foreign currency swaps, and exchange traded Credit Default Swaps, among other instruments.  The legislation also requires many derivative instruments currently traded OTC to have to be traded through a clearinghouse and possibly on an exchange (this is an area where the media has been sloppy, essentially using clearinghouse and exchange interchangeably when they are not).  There appear to be exemptions in the legislation for “legitimate hedgers”, and there will be a two year transition period.
  • Consumer Protection – It appears there will be an exception for auto dealers, due to fairly intense lobbying.  I won’t spend much time on this one.  While consumer protection is important, it’s not something that is central to preventing another crisis.
  • Credit Ratings Agencies – I’ve seen conflicting reports here.  The latest seems like the legislation will likely establish a commission to study the issue further rather than implementing change now.  Ultimately, the conflict of interest inherent in having a security issuer pay for the rating needs to be resolved.
  • Leverage, Capital, and Liquidity Requirements -  Again, lots of conflicting reports.  We’ll see what develops over the week, but this is a crucial area for reform, and it should not simply be left to the discretion of the regulators to determine.

The latest reports indicate there will not be any hard size caps on financial institutions, though regulators may be given some discretion here over institutions they deem systemically important.  It also appears that there isn’t anything in the latest version of the legislation regarding the GSEs.

Much more to come……..

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