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Experts explain new financial regulatory reform

July 19, 2010

Congress has just passed a measure hailed as the most important financial legislation since the Great Depression, but how does this affect the average American and the financial system in the United States? Two experts explain the main points of the financial regulatory reform designed to put an end to big bailouts, create an early warning system about systemic risk to the U.S. economy and provide new consumer protections, among other things.

"People are irate about the bailouts and the economy, so something had to happen," said W. P. Carey School of Business finance professor Anand Bhattacharya, who is a former managing director for a wholly owned subsidiary of Bank of America and a former managing director and global head of fixed-income research for Prudential Securities. "People are losing their jobs and homes, so they wanted something done by Congress. In general, this is good for the consumer. At the same time, the banks will be able to live with it since the most onerous provisions of the bill were removed before it passed – a few that might have driven some business for the financial industry overseas."

Bhattacharya’s colleague at Arizona State University, W. P. Carey School of Business professor emeritus Herbert Kaufman, has consulted for the New York Stock Exchange, commercial banks, savings and loan associations, and government agencies, including the U.S. Treasury, the World Bank and the Congressional Budget Office. He believes the best part of the new reform measure is that the Federal Reserve will maintain its independence and stabilizing regulatory influence over the American financial system. He says the worst point is that it creates a new layer of bureaucracy.

"For example, the new consumer protection agency might be positive; the intentions are good, but consumer protection could have been improved under existing agencies like the Fed," Kaufman says. "The devil is in the details, so we’ll have to see how all of this is implemented."

The new consumer protection bureau will examine and enforce regulations for banks and credit unions with assets of more than $10 billion, all mortgage-related businesses and large non-bank financial companies, such as payday lenders and consumer reporting agencies. It will also create a national consumer complaint hotline for reporting problems with financial products and services. Bhattacharya likes the concept of this agency.

"We have, for the first time in this country at the national level, a consumer protection agency that can write rules, if needed," Bhattacharya said. "If the new agency thinks a particular financial product is too risky, it can write rules to regulate the situation. One of the problems we have in this country is that we have a hodgepodge of agencies – the SEC, the FDIC, the Fed – so with one agency dedicated to this, the protection element gets strengthened. For example, if it had been made clearer to people that their mortgage rates were eventually going to climb much higher, maybe they wouldn’t have taken the deals. Also, for the first time, people will be able to get, not just an occasional credit report, but their actual credit scores. Consumers should still understand, though, that banks will likely pass on some of the costs of the new regulatory compliance to their customers."

Another new entity will be the Financial Stability Oversight Council, which will focus on identifying and addressing systemic risks to the U.S. economy. It will consist of a 10-member council of representatives from existing regulatory agencies, such as the Federal Deposit Insurance Corp. (FDIC) and the Securities and Exchange Commission (SEC). This group will recommend new rules for capital, risk management and liquidity as companies grow and pose risks to the financial system. It will also be able to vote on whether certain non-bank financial companies need to be regulated by the Federal Reserve because they represent a systemic risk. As a last resort, it can even vote to require a big company to divest some of its holdings, if it poses a big enough threat.

"You should have an agency like this to look at systemic risk, but in reality, it’s an interagency task force with representatives from the other existing regulatory agencies," Bhattacharya said. "My experience shows that task forces are great for coming up with recommendations, but they may not have the teeth to implement them. One concern here is whether the council members will be assigned to this agency full-time or just as a sideline to their regular jobs at the other organizations."

Both Kaufman and Bhattacharya agree with the removal of an original bill provision that would have taxed banks $19 billion to help pay for implementing the reform measure. They both believe the cost would ultimately have been passed on to bank customers in the form of fees.

Both experts also agree it’s good that hedge funds will have to register with the SEC, providing more transparency about their activities and probably assuring less volatility in the markets. Kaufman also likes that companies selling risky investments, such as the asset-backed securities that caused so much trouble in the financial system, will have to keep a portion of the risk themselves.

"Any time there’s skin in the game, that’s a good thing," said Kaufman, referencing the new rule that such companies will have to retain at least 5 percent of the credit risk.

Kaufman believes the new rules on executive compensation are essentially meaningless because stockholders will only be able to provide advice on pay for top executives through a non-binding vote, nothing mandatory. However, Bhattacharya says much of the problem with executive compensation had been addressed before when companies replaced the pay structure of offering a base salary and a big cash bonus, with offering a larger salary with bonuses paid over time through incentives like stock that required a stake in the firm. In the end, he says market conditions will dictate executive pay, anyway.

"Through the whole measure, Congress did a great job of putting down what they’d like to see," Bhattacharya said, "but they’re just headers and not actionable until these agencies are formed and we see if regulators use the framework to stymie business with a maze of bureaucracy or if they implement this in the spirit of the legislation. The regulators are getting a lot of power, but it’s important to think about who will be watching the regulators."

"It’s a tough balancing act," Kaufman said. "When Roosevelt proposed major changes in the 1930s, he was accused of dismantling the free-market system, and obviously, that didn’t happen. However, to reiterate, the rules governing the implementation will determine the effectiveness of much of the legislation. There will be considerable pressures generated by the financial services industry in trying to shape these rules."