Two years after the global financial system nearly collapsed, a vast revamping of regulation has been signed into law. The measure targets the risky banking and oversight failures that led to the last crisis. The goal is to make another crisis less likely – and, if it does happen, less costly for taxpayers.
Most of the new rules won’t take effect right away. The Obama administration has a full year, for example, to empower a Bureau of Consumer Financial Protection that is being created.
Regulators will take months to study dozens of issues in the 2,300-page law before drafting rules. Among them: Should the government limit the size of banks? How should stockbrokers be held accountable for advice they give to clients? How can credit ratings be made more reliable?
All of that means the real-world impact of the law will depend on how it’s interpreted by regulators – the same regulators who were blamed for failing to head off the financial crisis.
Still, the bill is now law. And regulators must enact rules consistent with Congress’ blueprint.
Here’s a look at the framework they will operate from:
EYES ON THE ENTIRE FINANCIAL SYSTEM
- A council of regulators will identify threats to the system. The Treasury secretary will lead the council.
- One potential threat: Big, interconnected financial companies. The council will have authority to review both banks and nonbank companies, such as insurers and credit unions, that haven’t faced bank-style regulation, to see if they could threaten the system. All such companies must meet tougher standards. For example, their use of borrowed money will be limited. Fuller disclosures, onsite supervision by Federal Reserve regulators and stiffer accounting rules will apply, too.
- The law provides an orderly way to close big companies. Companies the council feels could eventually pose a threat must write a “funeral plan.” If regulators decide a company is endangering the system, they could dismantle it and sell off the pieces.
- The idea is to prevent panic from spreading. The Treasury would pay the bank’s obligations. Treasury would be repaid with industry fees and money raised from the failed company’s shareholders, bondholders and asset sales. But taxpayers could end up on the hook, the Congressional Budget Office says. Republicans complain this system “makes bailouts permanent.”
Some further complications:
- The shutdown plan isn’t certain to prevent panics. Regulators might hesitate to close a financial services company until the system already is in crisis. Still, regulators will be better able to defuse threats. And the system’s health might be restored more quickly.
- The bill won’t fix the “too big to fail” problem. During the financial crisis, the government refused to let the largest banks collapse. Officials wanted to contain the crisis. So they propped up faltering banks or helped sell them off. Trillions of taxpayer dollars were put at risk. The law aims to make such failures rarer and less jarring to markets. But a handful of megabanks still dominate the industry. None would be allowed to fail because officials still fear that could spark panic.
CHANGES TO BANK REGULATION
- A national bank regulator will replace the two agencies that oversee national banks and thrifts: the Office of the Comptroller of the Currency and the Office of Thrift Supervision. Before the crisis, the OTS offered loose oversight. For example, it let banks avoid setting aside money for future losses. The banks were allowed to assume that the riskiest mortgages would be repaid. That’s why many risky lenders chose the OTS as their main regulator. The overhaul would prevent such “regulator shopping” by creating one regulator for national bank and thrifts.
- But as before, no one regulator will monitor the entire banking system. And there still will be different standards for different types of companies – one for credit unions, for instance, and another for thrifts. Take state-chartered banks. They’re regulated by both state and federal agencies. But their federal regulation is split between two agencies: the Federal Deposit Insurance Corp. and the Federal Reserve. That won’t change.
- Banks must keep a sturdier financial base – what’s known as capital. Capital is the stable money banks sit on. It includes money not at risk, such as shareholder equity. Think of it as an expanded rainy day fund.
Regulators decide how much capital banks must have to cover unexpected big losses. The law instructs regulators to raise these standards. But they’ll have broad discretion. And they will be influenced by international negotiations about how bank capital should be calculated.
LIMITING BANKS’ ACTIVITIES
- The bill bans “proprietary trading.” That’s when banks place bets for their own profit, rather than for their clients. It’s unclear how strictly the ban will be enforced. It can be hard to tell, for example, whether an investment is intended to benefit a bank or its clients and whether federally insured deposits could be put at risk by these trades. Regulators will draft rules after doing a study.
- The ban is part of the Volcker Rule, named for Former Fed Chairman Paul Volcker. Volcker, now a White House adviser, says banks should stick to taking deposits and making loans. He thinks dealmaking and investment banking should be left to firms that taxpayers wouldn’t have to bail out.
- Another part of the Volcker Rule will limits banks’ investments in hedge funds and private equity funds. These are lightly regulated investment pools. Banks can’t own more than 3 percent of such a fund. And a bank’s investments in such funds can’t exceed 3 percent of its capital. But banks can still put clients’ money into the funds.
- Many financial derivatives will be regulated for the first time. Derivatives are investments whose value depends on the future price of some other investment. Stock options and corn futures are examples. Many companies use derivatives to reduce risk. A company might hold a derivative whose profit would allow it to recoup part of the cost if a raw material’s price soared. Before the crisis, some investors used derivatives purely for speculation: They arranged side bets on the housing market. Once the market crashed, their bad bets magnified the crisis.
- Under existing rules, many derivatives are traded outside the view of regulators. The new law will require that most derivatives trade openly on exchanges.
- Derivatives for the first time will also trade through clearinghouses. These intermediaries settle trades and are on the hook if the owner can’t pay off its derivatives contracts. Clearinghouses will require derivatives sellers to set aside money for each contract in case their bets go bad.
- Banks won’t be able to trade derivatives that are thought to pose the most risk. These include those based on energy and most metals. The ban is designed to protect taxpayer-insured bank deposits from being used to cover losses caused by derivatives. If derivatives bets wiped out a bank’s capital, taxpayers could have to pay up.
- But banks can still trade most derivatives. Examples include those based on gold, interest rates and foreign currencies.
- Other derivatives operators will face tougher oversight. Examples include companies that sell purely speculative derivatives to hedge funds and wealthy investors.
- Derivatives companies must set aside money to cover possible losses. And the companies can be punished for using derivatives to mask the health of a business or government. The idea is to block deals like the one Goldman Sachs was accused of arranging to help Greece hide its deficit.
- There are exceptions to the clearinghouse and exchange-trading requirements. One is for nonfinancial companies that use derivatives solely to offset business risks. They can still trade derivatives outside exchanges and clearinghouses. And they won’t have to set aside money to cover possible losses. They’ll have to report their trades to regulators, however.
- Some derivatives are custom-made to meet a buyer’s business needs. Custom derivatives can’t be traded on exchanges. This creates a loophole: Derivatives dealers could steer buyers into custom-made contracts, making those trades less transparent.
MONITORING OTHER FINANCIAL PLAYERS
- Credit rating agencies will be held more accountable. Before the crisis, they gave high ratings to investments that turned out to be worthless. Under existing case law, the agencies can’t be sued for ignoring an investment’s risks – only for fraud. The overhaul ends that protection; investors can sue agencies for recklessly ignoring risks. Also, the agencies must explain more fully how they assign ratings. If an agency performs poorly over time, the Securities and Exchange Commission could cancel its registration.
The law will also reduce the influence of the three big rating agencies – Moody’s, Standard & Poor’s and Fitch Ratings. Regulators and government agencies have used their ratings to decide which investments are appropriate for, say, banks and pension funds, which enjoy some government backing. But the overhaul lets the SEC and others develop new ways to grade investment risk.
- Still undecided is how to address the agencies’ conflict of interest: They’re paid by the banks whose investments they rate. Before the crisis, the agencies lowered standards to compete for banks’ business. One option: Randomly assigning investments to agencies to rate.
- Shareholders of public companies can weigh in on pay packages for top executives. They can vote to approve or disapprove of pay deals as part of the proxy process. That’s the annual ballot that shareholders use to elect boards of directors. The votes on pay will be held at least once every three years.
But shareholders won’t be able to block pay packages they see as excessive. Their votes will be nonbinding.
- Shareholders will find it easier to nominate board members and have a chance to influence a board’s decisions. Fewer shares will qualify a stockholder to nominate a director. Directors who represent shareholders are more likely to vote to limit pay or reduce the company’s financial risks.
- Brokers offering personalized investment advice must act in clients’ best interests. The rules will hold brokers to the same standard that investment advisers already must meet. The change won’t occur until regulators have studied the issue.
- Hedge funds must register as investment advisers. Retirement funds, money managers and wealthy individuals often invest in hedge funds, which use complex trades to seek big returns.
- Once hedge funds have registered with the SEC, they’ll undergo periodic examinations and be required to disclose more information about their trades. This is a big change for hedge funds. But it’s not nearly as rigorous as bank supervision.
- Insurance companies escaped with few changes. A new office at Treasury will monitor the industry and help decide if an insurer is big enough to warrant tighter oversight. Today, insurers are regulated by the insurance commissions of each state in which they operate.
- Regulators can limit the fees retailers pay when shoppers use debit cards. Merchants argue that the fees – often up to 2 percent of the transaction cost – are too high. Still, the fees help defray losses on credit card loans. Debit cards carry no such risk for the issuer.
The law also lets retailers give discounts to customers whose payment methods generate lower fees. Some savings could be passed on to shoppers.
A NEW CONSUMER WATCHDOG
A new agency will oversee consumer products and services, from mortgages to check cashing. It will regulate many nonbank companies, such as payday lenders. Before the crisis, no regulator with financial expertise oversaw the most reckless mortgage lenders.
- The regulator will police companies that dominate consumer finance, such as credit card companies and the biggest banks. The agency will write rules and ban products it deems unsafe, such as mortgages that require payment of interest only. It can ban confusing language in documents. And the agency can punish companies that don’t comply.
- The agency’s rules apply to community banks, too. But its enforcement won’t. Instead, existing regulators will oversee the community banks’ compliance. These regulators failed to protect consumers before the crisis. Community banks weren’t involved in the risky investing that shook Wall Street. But they issued some high-risk mortgages that consumers couldn’t repay. And their lending practices caused the previous banking crisis – the savings and loan crisis of the 1980s and 1990s .
- The biggest loophole is for auto dealers that provide loans financed by banks. The bureau can’t scrutinize or punish them. It can’t even ban misleading fine print.
- The agency won’t police companies the SEC regulates, such as stockbrokers.
- Some other groups that won exemptions from the consumer agency’s oversight: Mobile-home sellers, real estate brokers, accountants and insurers.
OVERHAULING MORTGAGE RULES
The law revamps the mortgage system to protect consumers and discourage risky lending.
- Before the crisis, lenders funneled trillions into the overheated housing market. Many lenders didn’t care if borrowers couldn’t repay because they quickly resold the loans to investment banks. Banks bundled the loans, then sliced them into bonds. Investors, such as insurers and pension funds, bought the bonds. When borrowers stopped paying, those investors suffered deep losses.
- The biggest change: Lenders must verify that borrowers can afford their mortgages. The lenders can be punished if they fail to review borrowers’ income and credit histories.
- Any company that pools loans into mortgage investments must keep at least 5 percent of the investments on its books. That way, banks know they will lose money if they sell too many investments backed by poor-quality loans.
- The bill doesn’t include a fix for Fannie Mae and Freddie Mac. Those two companies are at the heart of the mortgage finance system. They buy mortgages from lenders and resell them to investors. When their investments lost money, the government had to intervene. The bailouts have cost taxpayers $145 billion so far.
- Now banned: Bonuses for brokers based on the cost of a mortgage. These payments encouraged brokers to stick borrowers with higher rates and fees.
GIVING THE FED MORE POWER AND TRANSPARENCY
The Fed gained some power. It will be the lead regulator for the biggest, most interconnected financial companies – those whose failures could threaten the system. But its independence was also reined in, to an extent:
- The Government Accountability Office will conduct a one-time audit of the emergency lending programs the Fed used to stabilize markets during the crisis. The audit will include the Fed’s discount lending to banks.
- The Fed’s emergency lending powers will be more transparent and subject to greater oversight. During the crisis, the Fed used this authority to craft huge bailouts behind closed doors. It withheld details about programs that rescued individual companies. The overhaul bans lending programs designed to save individual companies. The Fed must also disclose details of the programs, typically a year after they expire. And the Fed can’t invoke its emergency powers without the Treasury secretary’s permission.