Financial Reform: What Will Definitely Stick?

The Senate passed its financial regulation bill (.pdf) last night, but that's hardly the end of the legislative process. Now it must be reconciled with the House version (.pdf) passed in December, which has several very significant differences. Some of the more controversial provisions that are not shared by both bills could end up on the cutting room floor, but the essence of the regulation effort should endure. These bills are more similar than they are different. There are a handful of general concepts that are sure to make it into whatever final bill President Obama signs this summer. Here are the big ones:

Systemic Risk Regulator

A new prudential regulatory council will be created, consisting of the heads of existing regulators, such as the chairs of the Federal Reserve and Federal Deposit Insurance Corporation, the Treasury Secretary, and the Comptroller of Currency. Its job will be to discuss trends in the macroeconomic landscape and try to spot looming market shocks before they hit. Some believe that if such a council had existed prior to the financial crisis, regulators would have had a better chance at spotting the housing bubble and other structural problems that existed in the financial markets. If they had, they might have taking action to prevent some of the destruction that resulted.

Additionally, the Federal Reserve will take on the responsibility of day-to-day systemic risk regulation. That will likely mostly consist of accumulating additional data. But it will also create and implement regulations for large firms currently deemed 'too big to fail'. These are the ones that could bring down the economy with them if they collapse. The Fed, in conjunction with the council, will develop special regulatory requirements to ensure their stability.

Non-Bank Resolution Authority

One of the problems during the financial crisis was that the government had no way of winding down very large firms that posed systemic risk. Regular banks, however, had a resolution authority -- the FDIC. The new bill will provide the FDIC with the authority to wind down large non-banks as well. Big firms will also be required to submit failure plans which would detail how their particular wind-down process could be accomplished quickly and as painlessly to the broader economy as possible. While some details of the resources available to the FDIC need to be worked out in conference, there will definitely be a new resolution authority.

Consumer Financial Protection Agency/Bureau

There will be a new consumer financial protection -- something. The Senate likes to call it a bureau and the House likes to call it an agency. They also disagree about many of the details on precisely what firms should be under its jurisdiction, how it should be run, and whether it would be truly independent. But both bills agree on the need for a new consumer watchdog. It would make new rules that govern most consumer credit products.

Regulation of the Derivatives Market

Both bills call for a broad new framework for derivatives. Most will likely have to be cleared, and many put on exchanges. The intent is to provide greater transparency to the over-the-counter derivatives market. The Senate version's bill is far more aggressive, but the House version also calls for significant changes.

New Rules for Securitization

Considering that mortgage-backed securities were at the heart of the financial crisis, securitization was unable to escape regulation. Banks will have to retain at least a 5% interest in the assets they securitize, which could not be hedged. Proponents of this provision believe that if banks are required to keep some of the assets they originate, then their underwriting standards will be more conservative. Additional information and disclosure about the securitized assets will also likely have to be provided to investors.

Say on Pay

Both legislative efforts also provide shareholders with the ability to cast a non-binding vote on executive compensation. Some in Washington believe that this is important, because it could help firms to keep their compensation practices reasonable. Of course, the vote is non-binding, so it will be largely symbolic, and have no actual teeth.

There are other similarities between the two bills, but these are some important highlights. They serve as the foundation for the regulatory effort that is beginning to wrap up in Congress. According to House Financial Services Chairman Barney Frank, the President should have a final bill to sign by July 4th.