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President Obama has proposed “a sweeping overhaul of the financial regulatory system.” Given the mayhem caused by the lack of regulations, or the lack of enforcement of rules that do exist, massive reform seems appealing. Here’s a summary of the primary tenets of the Administration’s financial regulatory reform*:
- The Federal Reserve will have its power expanded significantly, adding “new authority and accountability.” The Fed will be responsible for “regulating bank holding companies and other large firms that pose a risk to the entire economy in the event of failure.” Before acting, in some cases, the Fed would require permission from the U.S. Treasury, which would alter the Fed’s historical apolitical role.
- Capital and liquidity requirements will become stronger. The total amount of minimum bank assets (deposits) permitted as a percent of the total amount of liabilities (loans) has diminished in recent years. This causes increased financial risk because banks lack the necessary resources to sustain large loan losses.
- An oversight council will be established. As planned, it will include Fed regulators along with regulators from across markets, although precisely what that means has not been defined. The purpose of this group would be to identify regulatory gaps and figure out how to fix them. AIG, the bailed out insurance giant, is a perfect example. Its insurance business was regulated impeccably by the insurance commissioner’s office. However, AIG’s financial products division was outside the purview of insurance oversight. AIG selected the Office of Thrift Supervision to regulate their financial products group. Yes, financial institutions have been allowed to choose which government agency oversees their operations. Thrift has a longstanding reputation for looking the other way and being unaware when abuses occur. Any financial institution that wanted no real oversight selected Thrift as their regulator. Unfortunately, the risks taken and failures reaped by the financial products group at AIG put the whole corporation on the brink of bankruptcy, including their insurance business. Since AIG insures trillions of dollars in assets held by many of the world’s major banks and corporations, you can see the vastly interconnected domino effect. Clearly, complex corporations need more comprehensive oversight. Whether this function should be a part of the Fed will be debated. An agency that appears to have performed admirably through the years is the Federal Deposit Insurance Corporation (FDIC). Perhaps their oversight functions should be expanded.
- A new consumer credit watchdog agency is proposed. As strongly as I abhor many practices of credit card providers, this proposal looks like slight of hand to me. New credit card legislation was recently signed into a law; it doesn’t come close to addressing abuses by financial institutions. There will be no limit on interest rates or fees. They’re simply required to notify you 45 days before an account change. And the needs of small businesses were ignored. The President said, “This agency will have the power to set standards…. The most unfair practices will be banned…. And enforcement will be the rule, not the exception.” Those words confer power to supplant Congress. If the agency’s intended role is to enforce laws which have been passed, current legislation falls far short of equitable credit card practices.
- The agency will also be charged with setting new, much needed, rules for mortgage lending and to hold mortgage brokers to higher standards. While a far-reaching overhaul of mortgage banking should be pursued, it is unlikely that an agency will be creating enforceable federal regulations without legislation as an underlying basis. Congress has refused to pass truly significant credit card or mortgage clean-up because financial institutions continue to be a major source of political contributions.
- Recognizing the immense failures by the Office of Thrift Supervision, the President recommends dismantling it and closing loopholes that allow “important institutions to cherry-pick among banking rules.” He wants only one federal bank charter, regulated by a strengthened federal supervisor.
- Increased capital requirements are suggested for all depository institutions.
- Hedge fund managers will be required to register with the Securities and Exchange Commission (SEC).
- Comprehensive new regulations for financial derivative products, such as credit default swaps, are being proposed. This may prevent future sales of misrepresented investments.
- Banks originating loans (your local bank) will be required to retain an economic interest in all loans so there’s local involvement and commitment to repayment. When loans are sold to investors, they leave a financial institution’s loan portfolio. Interest in the transactions dissipates, leaving borrowers in limbo as they attempt to work out new payment solutions.
These far-reaching proposals represent an admirable first step toward needed changes to scrub the grime and greed off our troubled financial system. However, it is unlikely that President Obama will gain the support of Congress to accomplish this sweeping overhaul. Congress is lobbied, heavily, by the many special interest groups who would feel financial impact from these transformations. It will be important to watch how financial regulatory reform unfolds in the months ahead because many changes can affect your financial life.
*Please note: The link to President Obama’s speech is a private website because the White House removed the document from public access.