Obama Signs Financial Reform Law

On Wednesday, July 21 2010, US President Barack Obama signed the historic bank reform bill, the largest overhaul of the US financial industry regulation since the Great Depression.  The legislation is named the Dodd-Frank Wall Street Reform and Consumer Protection Act.

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The main items of the bill include measures aimed to regulate the industry and protect consumers:
– Ban proprietary trading by banks.
– Oversight of the derivatives market.
– Powers to wind down big firms (whose collapse might threaten the financial system).
– Surveillance of hedge funds.
– Consumer protection (credit/debit card fees, credit rating agencies).
– Curb overall risks.
– Emergency powers to avoid taxpayer-funded bailouts of large (“too big to fail”) firms.

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Whether the measures takes the right steps, or goes far enough, is still a matter of debate.

Changes to proposals which was approved by the House and Senate on June 30, 2010, included alteration of language, modifications to appease Senate concerns, add or reduce the amount of regulator influence on certain issues, and more clearly defining limits/rules/policies.  There was compromise of more restrictive language, and language that is more open and allows more flexibility.

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Below is a summary of the main provisions:

‘VOLCKER RULE’

Nick named after former Federal Reserve Chairman Paul Volcker.
– Banks will be banned from proprietary trading, and limited to providing no more than 3% of any private equity or hedge fund’s capital, of which they invest in. Banks also would not be able to invest more than 3% of their Tier 1 capital.  These provisions are meant to prevent firms that underwrite asset-backed securities from conflicts of interest.

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DERIVATIVES
– A regulatory structure will be created to oversee the over-the-counter derivatives market ($615 trillion market), and to force banks to place some of their swaps-trading (uncleared default swaps) into separately capitalized subsidiaries.  The subsidiaries would not have access to Federal Reserve’s discount lending window. Heightened capital requirements will be imposed on companies with large swaps positions, and limits may be placed on the number of contracts a single trader can hold.

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FINANCIAL STABILITY & RISK:

Bank Capital
– Some banks may be forced to increase their capital. Bank holding companies will not be allowed to keep less capital than their bank subsidiaries. There will be a transition period for large firms and grandfathering of the securities for smaller lenders.  In addition US holding companies of overseas banks would also have to follow the same capital rules as domestic lenders.

Risk Retention
– Lenders will be forced to hold at least a 5% stake in securitized / asset-backed debt they package or sell. Some mortgage providers will be exempted.  The exemption does not apply to debt that have features that increase the risk (negative amortization, interest-only payments, balloon payments).

Unwinding Failed Firms
– The Federal Deposit Insurance Corporation (FDIC), will be able to seize and unwind large failing financial firms whose collapse would adversely affect the economy. Costs of unwinding failing firms will paid through fees imposed on the financial industry after a firm collapses, and not from the taxpayer.

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SUPERVISION & OVERSIGHT:

Private Equity and Hedge Fund Surveillance
– Large hedge & private equity funds will be forced to register with the SEC, and be subjected to federal oversight.  Venture capital funds are to be exempted.  Any hedge fund that have been determined to have grown too large, or become too risky, would be placed under federal supervision.

Broadened Supervisory Role
– The Federal Reserve will have a broadened supervisory role and be subject to more transparency. Bernanke will have a seat on a Financial Stability Oversight Council which will direct the Federal Reserve to set more strict standards for disclosure, capital, and liquidity. The rules will apply to banks as well as non-bank financial companies, and insurance companies.  US central banks will undergo a one time audit of emergency loans and other actions taken to combat the financial crisis. Central banks, must identify firms that borrow through its discount window and firms that participate in the Fed’s purchases/sales of assets (such as mortgage-backed securities).

Insurance Industry
– A new Federal Insurance Office within the Treasury (a national regulator) will monitor insurers.  A study will be required to recommend further overhaul regulation of the insurance industry.  Currently State insurance commissioners regulate the industry.

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CONSUMER PROTECTION:

Consumer Financial Protection
– A consumer financial protection bureau with independent authority will be created at the Federal Reserve.  It will write and enforce rules related to credit card and mortgage lending abuse for banks and other firms (with more than $10 Billion USD in assets) that offer financial services or products.  Bank regulators will monitor consumer practices at smaller financial institutions.

Credit and Debit Cards
– The Federal Reserve will limit “swipe” fees (interchange fees) that merchants pay for each debit card transaction, allowing retailers to refuse credit cards for purchases under US $10 and offer discounts for other forms of payment.  This directs the Fed to issue rules that will allow merchants to route debit card transactions on more than one network, creating competition (previously non-competitive market).

Credit Raters
– Congress’ proposed liability provision, will make it harder for investors to sue credit rating agencies including Moody’s Corp and Standard & Poor’s. Language has been redefined for what investors must show to prevent a judge from dismissing a lawsuit against a credit rater. Investors must demonstrate a company behaved knowingly or recklessly, or failed to conduct a reasonable investigation before issuing a rating.

Fiduciary Duty
– SEC is required to study (6 months) whether changes are necessary which would make securities firms (stock brokers who offer investment advice) more accountable to individual investors.  This includes disclosure of all conflicts of interest, and restrictions of the marketing products (in the best interests of clients).

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The financial & insurance industries have expressed concerns regarding the new rules, restrictions, requirements, and reporting.  The concern is that the new provisions will curtail lending and credit availability, while tying up more capital than necessary.  This may result in loss of flexibility, profit margins, increased costs, and increased costs associated with labour/resources.  New layers of oversight may complicate compliance resulting in slower speeds of service and inefficiencies. “A number of provisions within this legislation will impact our company by either lowering revenue, increasing expense and/or raising capital requirements,” US Bancorp Chief Executive Richard Davis said in a statement.  There is concern that in the end the increase in costs and lower profit margins will lead to higher interest rates and fees.  However, it is even more of a concern for small banks and financial businesses.

Investors should look at each bank individually, to assess how the new provisions affect their profits & costs, and overall business. For example, Goldman Sachs had said proprietary trading generated about 10% of its annual revenue, and a ban on such trading will definitely affect them.  JPMorgan Chase, Citigroup, Bank of America, Goldman Sachs, and Morgan Stanley which held 97% of the total notational value held by US banks, will see significant impacts.   Mastercard and VISA will also see impacts from the new credit card rules.  On the other hand, banks such as Wells Fargo and US Bancorp will still see some impacts as noted by Richard Davis, but not to the same extent as some of the others who took much larger business risks.

There are many other examples, but it is important to note that the banks will adjust and change their businesses/operation strategies to deal with the new provisions.  Many banks will remain profitable without much earnings impact or changes to their businesses, while others will require larger changes to remain profitable without taking unnecessary risks.

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Related Articles:
Investment & Economic Outlook 2010

Thanks & Happy Investing! — The Investment Blogger © 2010

Author: The Investment Blogger

I’m a private investor, who developed the “function-centric investing” paradigm. I am an investor who blogs a little here and there, rather than a blogger who invests a little here and there. I'm passionate about investing and sharing investment knowledge!

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