Financial reform will probably happen – but will it work?

Charles Horn Contributor
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Over the past several weeks, the odds of major financial reform legislation being enacted in 2010 have gone from uncertain to probable. The Obama Administration and the Democratic-controlled Congress have ramped up substantially their efforts to move a comprehensive financial reform bill through the Congress and onto President Obama’s desk this year, possibly by Memorial Day. The Senate leadership is working actively to move the Dodd bill to the Senate floor for debate and passage—possibly within the next few days—amidst recent reports that Republican opposition to the current reform legislation may be abating.

We cannot assume that financial reform legislation is a sure thing. There are a number of events that can derail the reform effort at any time, but the chances of that occurring are rapidly decreasing. Because there really are not a lot of major differences between the House legislation passed last December, and the current version of the Senate legislation, there will be fewer core issues that will need to be worked out in any House-Senate conference on the legislation. Assuming that the Dodd bill passes a Senate vote in substantially its current form, we now have a good general sense of what any final bill will look like. So, it is not too early to take a look at the likely legislation and ask whether it will perform as advertised in stabilizing the financial economy, improving our regulatory system and reducing the likelihood of future financial meltdowns.

The reform legislation is being touted by many as the “fix” that will fundamentally alter how Wall Street and the financial services industry do business, bring stability and confidence to our financial markets, and usher in a new era of increased protection for financial products consumers. There is much in the legislation that will profoundly affect how financial business is done: among other things, previously under-regulated markets such as over-the-counter derivatives, structured securities and private fund managers will be subject to new and potentially intrusive oversight, and the financial services industry will be regulated by a powerful independent consumer regulatory authority.

But the core of the legislation lies in its promise to regulate systemic risk and end “too big to fail.” Will that promise be fulfilled? The probable reform legislation create a large committee of regulators (oversight council) to oversee and monitor systemic risk and a process for designating financial firms as presenting a systemic risk, and allows the oversight counciland primary regulators to impose higher capital, liquidity and other regulatory restrictions, and force divestitures, on systemically important firms. Both the House and Senate versions create a financial firm resolutions mechanism with the FDIC basically put in charge of resolving failed or failing financial firms. Past regulatory history, however, does not hold out much hope for the effectiveness of “regulation by committee,” particularly in cases where an developing financial crisis requires a quick and coordinated response. Further, the existing regulators already have the authority to impose enhanced financial regulatory requirements, so the creation of additional regulatory authority smacks of unnecessary and expensive redundancy.

More fundamentally, however, the new legislation will not abolish “too big to fail”. Although a broader and more cohesive resolutions scheme may help facilitating financial firm reorganizations and resolutions, it is hard to see how this mechanism would deter the Federal government from stepping in, with wallet in hard, to rescue a large financial firm if the government believed that the alternative would be a general financial markets collapse. This is particularly true given the fact that both the House and Senate bills give the primary rescue and resolution authorities—the Federal Reserve Board and the FDIC—substantial discretion in how their powers can be used. And if too-big-to-fail cannot be ended, how can we be certain that we will not be vulnerable to another general financial meltdown in the future?

Other provisions of the proposed legislation either are basically ineffective or threaten to cause substantial unnecessary mischief. The regulatory reorganizations proposed in both the House and Senate bills would do little to reduce the number of regulators or streamline the existing regulatory structure, which can be accomplished only by scrapping the current system and starting over. The addition of a new federal consumer protection agency will only add a new and potentially intrusive regulatory structure to the existing system, which if not deftly managed could stifle innovation in consumer financial products and decrease product choices for consumers. The provisions that erect artificial barriers between certain lines of business (e.g., the Volcker Rule) also are ill-advised efforts to regulate business activities that in large part did not contribute to the current crisis, may unnecessarily disrupt established lines of business and business relationships, and could place US financial firms at a global competitive disadvantage.

So is this legislation worth it? I am not sure it is. In key respects, the legislation overpromises on what it can accomplish that cannot already be done under existing regulatory authority, may not effectively address the key issue of moral hazard, and may unnecessarily interfere with established and legitimate financial services activities. Moreover, the legislation would not deal at all with the “elephant in the room”—the roles of Fannie Mae and Freddie Mac in contributing to the current crisis and what their functions going forward should be. While there is a benefit to bringing greater regulatory transparency to unregulated markets and creating a mechanism for more orderly financial firm wind-downs, there is little doubt that the reform bill will substantially increase the costs of doing financial business across the board. So in the final analysis, we may end up with more regulation, but not necessarily better regulation. I wish we could do better.

Charles Horn is a regulatory and transactional attorney whose practice focuses primarily on banking and financial services matters. Charles represents domestic and global financial services firms of all sizes on regulatory and transactional issues affecting their organization, structure, governance, management and operations