Financial Reform’s Passage: It’s Just the Beginning

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By a 60-39 vote Thursday, the Senate passed legislation that re-calibrates the flow of capital through the American financial sector and provides new powers to the regulatory regime that oversees it. The final bill is the culmination of a near two-year effort launched after 2008’s Wall Street crisis thrust the nation into recession and marks the most comprehensive changes to government’s oversight of banks since the Great Depression. When Obama signs it into law next week, financial reform will join health care and the stimulus in the ranks of major Democratic initiatives enacted by the 111th Congress and boldface bullet-points on the president’s resume.

But in many ways financial reform’s passage is just the beginning. Here are five areas in which big questions linger now that the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is (almost) on the books:

1. The New Regulatory Regime

Dodd-Frank creates a bunch of new programs, councils and bureaus in the existing financial regulatory structure. There’s the Financial Stability Oversight Council tasked with identifying risky practices that may be threatening the economy. The Consumer Finance Protection Bureau, set up under the umbrella of the Federal Reserve, will police the individual market for loans and other financial products. (Much more on what the CFPB can do from our colleague Stephen Gandel here.) The Office of Thrift Supervision is being folded into the Office of the Comptroller of the Currency, expanding its power in overseeing banks. Then there’s the Federal Insurance Office that’s being set up at the Treasury Department to monitor the insurance industry and step in (in a limited role) if they think state regulators are dropping the ball. (See: debacle, AIG). And that’s to say nothing of the expanded roles of the Commodity Futures Trading Commission in overseeing the vast market for derivatives, the complex financial instruments that played a significant role in the recent crisis, or the Securities and Exchange Commission, the federal government’s beat cop on Wall Street.

But the mere existence of these new regulatory and oversight programs changes nothing. How this new regime is staffed, where it attracts its talent, who serves as the first heads of the assorted new organizations, how they see their responsibilities and accordingly write their rules, etc. will all determine how well Dodd-Frank works in practice. Why? Because this legislation fundamentally relies on the abilities of regulators, old and new, to carry out its goals.

2. Bailouts and Bureaucracy

The two most tossed around phrases in the financial reform debate were “taxpayer bailouts” and “Too Big To Fail.” Americans don’t like the idea of megabanks coming hat in hand to the government for help the next time they self implode, and the TARP (Troubled Asset Relief Program) will appear in plenty of political obituaries come November. But despite what proponents of this bill might tell you, there is no foolproof measure preventing a future Congress from repeating the actions of 2008 and rescuing Wall Street on the taxpayer’s dime. What Dodd-Frank does do is establish an alternative to bailouts through a “resolution authority” that seeks to recognize when a firm is on verge of failure, swoop in, seize assets and unwind the bank at the expense of the financial industry rather than the government. It doesn’t end the “big” part of Too Big To Fail like some wanted (Russ Feingold voted against the bill in part because it didn’t break up the megabanks); instead it opts for Hopefully Not Too Big To Fail Gently. Less catchy, I know.

Anyway, the efficacy of this process totally hinges on two things: the ability of regulators to recognize an impending problem and the willingness of the bureaucracy to act on those warnings. As mentioned before, exactly who staffs the new regulatory regime is paramount, but even if their foresight is perfect, the seizure of a bank under the new resolution authority will require the approval of the Federal Deposit Insurance Corporation, the Treasury Department, the Federal Reserve and a special panel of three bankruptcy judges. If the bureaucracy is uninterested, unwilling or even just hesitant, the potency of the resolution process may be compromised. Dodd-Frank provides regulators with better tools to do their job, but it can’t do their job for them.

3. Capital Requirements and International Rules

Not all the ideas discussed for financial reform depend on fallible human decision-making. Capital requirements — rules requiring banks to hold a certain ratio of assets to debt — are basically an automatic brake on risk; the less leveraged a firm is, the less potential for damage it possesses. (They have other implications, such as affecting the availability of credit, but we’ll skip that for now.) Back in March, when discussing what financial reform needs to accomplish, Treasury Secretary Timothy Geithner said this: “The top three things to get done are capital, capital and capital.” So, are capital requirements in Dodd-Frank? Nope.

Here’s the thing; banks don’t operate in just one country, and the global nature of the financial system complicates regulation and oversight. A hard and fast setting on capital requirements was left out of the bill in part because the administration is in the midst of international negotiations on this very matter. Officials from governments worldwide and representatives of the international banking community are currently meeting in Basel, Switzerland to hammer out guidelines that can cast a wider net on a more even playing field. They hope to have an agreement on capital requirements (among other things) by the time the G20 economic summit convenes this November in Seoul, but that won’t necessarily be the end of it. How international rules end up being enforced domestically is another question altogether.

4. Studies

What else isn’t in the bill? Lots of stuff! Dodd-Frank commissions some 68 government studies to determine what needs to be done about a slew of issues Congress didn’t want to tackle right away. It’s some combination of sidestepping sticky situations, hopeless uncertainty about lurking variables, a legitimate need for more information and kicking the can down the road that leads to these things, and they’re not studying minor matters. Much of the complete garbage Wall Street was peddling in the run-up to the ’08 crisis was gilded with perfect AAA ratings. Many ascribe this to a perverse incentive system established when banks acting as middlemen, not end buyers, pay rating agencies such as Moody’s, Fitch and Standard and Poor’s for ratings. Senator Al Franken dreamed up a fairly creative way of dealing with this problem, but it was changed from hard and fast rule to mere “recommendation” with the use of a study. What else got the study treatment? CNNMoney’s greatest hits:

…short selling, reverse mortgages, improved insurance regulation, private student loans, oversight of carbon markets and the “feasibility of requiring use of standardized algorithmic descriptions for financial derivatives.”

And the big one: Government Sponsored Entities. If you listened to a Republican talk about financial reform at any time in the last six months, you probably heard the words “Fannie and Freddie” more than a few times. Fannie Mae and Freddie Mac are the government-backed mortgage giants that flooded the market with cheap home loans over the past decade and, while claims that they were a primary contributing factor in the crash are gross exaggerations, they are certainly a problem. They’re currently hemorrhaging cash, the government is picking up the tab and reform is a matter of when not if. As Democrat Mark Warner said Thursday on the Senate floor: “We will have to come back and deal with GSEs.” But only after a study.

5. Unknowns

The rest we can’t know. It may be cliché, but with any legislation this complex, there are bound to be unintended consequences. Some provisions may go too easy, overreach or miss the mark altogether. It’s an unpredictable world, especially when it comes to the financial sector, and if you still believe the wizards on Wall Street or in Washington can see trouble coming, I have some subprime mortgages you may be interested in. But I’ll make one prediction: This won’t be the last financial regulatory reform measure taken up by Congress this decade.