6 Financial Reform Compromises Republicans May Demand

Now that Senate Republicans have allowed the financial reform debate to begin, what demands will they have for a bipartisan compromise? Until this week, there were only several vague notions of changes they wanted. Reports included concern with the resolution fund, a push for less aggressive rules for derivatives, and a desire for the prudential regulator to overrule the consumer protection agency. But through the leak of the summary of their financial reform alternative, we can gather a little more specificity of the kinds of changes Republicans might call for.

No Resolution Fund

The Republicans intend to eliminate the $50 billion resolution fund which would be paid for proactively by large financial institutions to cover costs in winding down big firms that fail. But until the Republican alternative was leaked, we didn't know how Republicans wanted the resolution authority to cover resolution costs without the fund. Now we know that they want to do this through loans to creditors to be paid back through after bankruptcy proceedings end.

As mentioned yesterday, this is a strange idea, as it could result in a taxpayer bailout if creditors end up not being able to pay back those loans. You can certainly imagine a situation where Lehman got a loan due to the Bear Sterns failure, for example, and defaulted on it. Alternatively, the Republicans might settle for after-the-fact assessments on financial firms to pay for any shortfall. This also seems a poor alternative, however, since the financial firms who didn't fail would be forced to pay for the poor performance of their competitors.

Mandatory Liquidation

Republicans worry that the Senate bill allows a little too much wiggle room to regulators to bail out firms. That's why it takes great care in its alternative bill to forbid the Federal Reserve or FDIC to keep alive failing firms. It orders liquidation if any government involvement -- other than temporarily liquidity for firms that can prove their solvency -- is required.

It's a little unclear how well this would have worked during the financial crisis. When there's a great deal of uncertainty in the market around asset values, how can a firm prove its solvency? At first, AIG was thought to be a mere liquidity problem. With this standard, the government likely would have found itself winding down several other major firms, possibly including Citigroup and Bank of America. It's hard to see how the economy could have handled that, even with a resolution mechanism in place.

GSE Reform

There's a gaping hole in both the House and Senate reform bills when it comes to Fannie Mae and Freddie Mac. Neither addresses the problem. Republicans, however, have made clear that they believe that the GSEs were a chief cause of the financial crisis and need major supervision and new limits.

This will be a hard sell to Democrats, who likely want no part in dealing with a mess of this size at this time. The Treasury has also said that it has no intention of approaching GSE reform until 2011. Republicans could be more willing to let this point drop, however, as Democrat's refusal to address the GSE problem could make for a nice political talking point come midterms.

Federal Reserve Reform

The Republicans want to more aggressively rein in the freedom of the Federal Reserve. They would create a Presidential appointee to supervise the central bank. They would also prefer if it had less flexibility in deciding how to run its credit programs and how to conduct its emergency lending operations.

While the Republicans' distaste in bailouts is understandable, jeopardizing Fed independence and tying the central bank's hands in stabilizing credit market is inadvisable. At most, Senate Democrats could revise their bill to include some of the enhanced Fed oversight found in the House bill's amendments.

Consumer Financial Protection Agency Changes

Interestingly, there was nothing explicit in the Republican plan that would significantly water-down a consumer financial protection agency. In fact, what Republicans want here looks sort of like what the House version calls for. Unlike Senate bill author Chris Dodd's surprising decision to have a sort of all-powerful consumer protection czar, the House would have a council of regulators decide how to protect consumers.

The Republicans want something similar. But more specifically, they appear to have many of the same figures sitting on the CFPA council as would sit on the prudential regulation council. That would presumably eliminate the worry of regulatory conflict, since the power would be condensed to mostly the same group. It might not be too likely that you see this approach fully adopted, but Senate Democrats would meet Republicans in the middle and have a committee head the CFPA like in the House bill.

Less Agressive Derivatives Regulation

The Republican and Democrat plans don't actually differ that much on derivatives. They both seek to better utilize clearing and exchanges. They would both allow regulators to exempt some derivatives from clearing. They also both provide for special consideration of so-called end-users -- firms with businesses that have a natural exposure a derivative could help hedge.

The main difference, of course, comes in the more controversial measures Democrats want to take, the most extreme of which includes forcing banks to spin off their derivatives desks. Republicans will likely fight this. But some Democrats might find this provision goes too far as well. Also look for a regulation exemption for existing derivative contracts, which will make Warren Buffet happy, and could get Senator Ben Nelson (D-NE) on board.

It remains unclear how many of these demands Republicans can get Democrats to agree to, but they'll likely get at least a few. Other of their priorities, where the House and Treasury concur, could be ironed out through conference after a bill passes the Senate.