Pros and cons of financial regulatory reform

The near collapse of our financial system that surfaced near the close of President George W. Bush's second term brought about the $787 billion dollar bailout of Wall Street in 2008, spurred the salvation of the auto industry sponsored by the Bush and Obama administrations in 2008 and 2009 and required the Obama economic stimulus plan in 2009.

But action to reform our financial system was not taken until this past June with passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The title and unprecedented complexity of this legislation suggest the narrow political support and lack of resolution that accompanied its enactment.

The act is the product of piecemeal construction by the Obama administration and congressional Democrats and of lock-step opposition by the Republicans in both houses of Congress to virtually each proposed reform. This led to unproductive argumentation, dubious dealmaking and inflammatory exchanges in which the opposition party refused to consider repeated offers of the administration to collaborate in fashioning the act.

In the end the act came out too long and detailed, while leaving to regulators the difficult job of defining its intended pattern of regulation. Its surpassing sweep will likely lead to jurisdictional conflicts and overlapping rulemaking by the six regulatory agencies empowered to supervise the financial system -- the Federal Reserve Board, Securities and Exchange Commission (SEC), Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation (FDIC) and the newly created Financial Consumer Protection Bureau and Financial Stability Oversight Council.

Despite its shortcomings, Dodd-Frank is an important step forward in financial regulation and will serve as the basis for future rulemaking and legislative improvements. Among its positive elements, the act:

•Requires full and fair disclosure by lenders to credit consumers.

•Creates a framework to put failing banks and other financial institutions into receivership, allowing for their orderly reorganization or dissolution. The receivership provisions permit the SEC and FDIC to cause renegotiation or to void contracts that would be against the public interest (which presumably would have precluded the use of government funds by the insolvent insurer AIG to redeem credit default swaps at their full face value of $80 billion, rather than at the their real value -- a substantially discounted price.)

•Requires most derivative securities to be traded on publicly visible and government-regulated exchanges. The SEC and FDIC are, in addition, authorized to ban derivatives that are "abusive," a term sure to give rise to enforcement disputes and litigation.

•Provides that banks must be "well capitalized" and "well managed," words also destined to be the subject of dispute.

•Amends the Sarbanes-Oxley Act to eliminate imposition of its most costly accounting requirements on small, publicly held companies.

•Empowers the Financial Stability Oversight Council to identify and seek solutions to systemic financial risks. This is one of the most vital and least defined provisions of the act.

Dodd-Frank fails to provide a solution for many crucial problems, including the following:

•There is no reinstatement of the Glass-Steagall Act, which separated investment from commercial banking. To address this problem, banks are subjected to a watered down "Volcker Rule," (named for the former Fed chief) prohibiting banks from making risky trades with customer funds. This is going to be a problem. The big banks, beginning with Goldman Sachs, have sought to avoid it by reclassifying their risk traders as money managers and taking the position that trades made by money managers are, by definition, approved by their customers. The banks will either voluntarily abandon this fiction or the securities regulators must force them to abandon it.

•The act fails to forbid operation of hedge and equity funds by banks unless they use more than 3 percent of the institution's assets.

•The act does not break up banks that represent a risk to our economy because of their large size. But it makes a modest improvement to the "too-big-to-fail" problem by confirming that banks cannot accomplish acquisitions that result in their owning 10 percent or more of total U.S. financial assets insured by the FDIC. There is also a prohibition on acquisitions that result in one bank owning 10 percent or more of total U.S. financial institution liabilities.

•Safe leverage ratios are not effectively dealt with by the act. However, regulators will have limited authority to demand adequate bank capital, and the act also provides that banks with assets of $50 billion or more and large nonbank financial institutions can be required to beef up their capital if they are deemed to pose a systemic risk to the financial system.

•Executive compensation is not effectively controlled by the act, although it does give shareholders a say on pay (a right to vote on the salaries, bonuses and severance benefits of principal officers) and it does subordinate executive compensation for institutions in receivership to all but claims of common stockholders.

•No regulations are imposed by the act on credit rating agencies to address the problem of banks shopping for favorable ratings on debt securities that they underwrite.

Also, the act doesn't treat the Fannie Mae and Freddie Mac problem -- the lenders that have been excessively enabled by government to grant mortgages to encourage homeownership at ruinous cost to taxpayers. This must be separately addressed.