New Financial Regulations

After months of intense debate and extensive media coverage, Capitol Hill and the White House have finally agreed upon a plan to overhaul financial regulations in the US. The bill still must pass through both chambers of Congress before it becomes law, but this is all but assured as President Obama and Democrats from the House and Senate are on board. Major last-minute concessions, such as allowing banks to trade swaps and derivatives to hedge against their own risk, had to be made to gain support of the bill from moderate and conservative Democrats so that the proposed bill could be finalized in time for Obama to present it to the G-20 meeting in Toronto. The provisions of the 2,000-page bill can be broken down into four categories: expanding the power of the government, tightening regulations for financial companies, protecting consumers from institutional banks and protecting investors from bad deals.

Regulations on financial companies are greatly increased in the financial reform bill. The provision that will likely have the most significant impact on how banks do business is the Volcker Rule, which prevents financial institutions from making risky trades with their own funds. This rule, similar to the Glass–Steagall Act of 1932, protects taxpayers from having to bail out institutions that risk (and lose) funds that are protected by the FDIC. It should be noted, however, that the ban on proprietary trading is not total: banks can still invest up to 3% of their funds in hedge funds and similar vehicles. Swaps will now have to be done through affiliates of banks, with the exception of trades that are tied into the banks’ business and necessary for hedging risk (interest-rate swaps, foreign-exchange swaps, gold and silver). Swaps relating to agriculture, uncleared commodities, most metals and energy will have to be traded by affiliates, since these trades do not directly pertain to banks’ business. Banks will also be required to meet more stringent capital standards, and will no longer be allowed to include trust-preferred securities in their calculations of capital. Also, financial institutions and hedge funds with more than $50 billion and $10 billion in assets, respectively, will be assessed fees over the next five years that will total $19 billion (to offset the cost of the bill). These fees will be collected by the FDIC, with any leftover funds going towards paying down the national debt.

The other goal of the bill is to protect investors and consumers from being taken advantage of by financial institutions and related businesses. Under the Federal Reserve, the new Consumer Financial Protection Bureau will oversee banks and other non-bank financial firms (including mortgage-related businesses and credit unions) and enforce regulations as needed. Mortgage lenders will now have to verify a borrower’s income, credit history and job status before giving them a loan. Banks will have to keep 5% of the credit risk from packaged loans on their own balance sheets, which should incentivize them to issue loans only to worthy borrowers. Also, the bill established a Financial Stability Council, which will monitor large financial firms and advise the Fed of any potential threats to these companies and their business. If necessary, the council, along with the FDIC, would have the authority to wind down failing firms, and the bill addresses this liquidation procedure. The bill also gives states the power to impose additional consumer protection laws against banks if they feel it necessary. For investors, the bill gives the SEC the authority to hold broker-dealers to a fiduciary standard similar to the one that investment advisers, including KCS, are currently held to. Hedge funds and private-equity firms will now have to register with the SEC as investment advisers and provide more information on their trades than currently required.

If signed into law, the financial reform bill would be the most dramatic financial regulatory overhaul in the US since the 1930s. But at this point, given that it is still just a bill and there are a number of details to be dealt with yet, it is hard to say at this point how it would affect our financial system and the way we do business in the long term. And while it seems like a lock that the bill (now being referred to as Dodd-Frank) will pass through the House and Senate, even after the death of Senator Robert Byrd (D-WV) over the weekend, we know how quickly things can change.