Dodd-Frank: What it Means

We have a pretty good discussion on tap focused on the Dodd-Frank financial reform bill. You can attend, tune in live or watch it later. While there has been debate about whether the bill goes far enough and addresses some the conditions that brought on the Great Recession, my belief is that a presidential signature will actually go a long way to create a necessary but not sufficient basis for meaningful reform. Much of this promise lies in the creation of two new regulatory bodies, one focused on Wall Street and the other on Main Street, which through their collective action can remake the financial services landscape. Call it the rise of the regulators.

The creation of new oversight authority is certainly no guarantee of success, but it does signal the arrival of an entirely new regulatory regime. Here are the primary features of the likely financial reform bill which have the potential to fundamentally change the nature of business as usual on both Streets.

Wall Street

Financial Stability Oversight Council

Under the previous (and still current) regulatory regime, the risks of financial instability were exacerbated rather than contained. Regulators were focused on the safety and soundness of particular firms rather than the system as a whole. The financial reform bill will create a Financial Stability Oversight Council with a mandate to be on the lookout for threats to the broader economy. When it identifies risks, it will have the power to force action on the part of specific firms regardless as to whether they are classified as banks or not.Capital Requirements

One action that the Council will be able to pursue is the imposition of increasing capital requirements. This is the money that bank owners have to hold which does not have to be paid out to investors. If the value of a bank’s assets fails, this capital can serve as a buffer to protect a bank from defaulting on its obligations. Raising capital requirements lowers the risk of bank failure and also lowers it leverage, which means they have less money to put at risk. While some have derided this new authority as a technical regulatory fix, it is one of the primary tools a regulator has for capping the size of large financial institutions.

Resolution Authority

And if failure occurs, the legislation creates an alternative to bailout or traditional bankcruptcy. Enhanced resolution authority will be granted to the regulators which will empower the FDIC to step in as a bank fails and oversee its timely liquidation. The goal of this process is to limit the time it takes to wind down the firm, so it can’t be held up for years in bankruptcy court, and make sure that the shareholders and management on the hook for losses rather than the public purse. Furthermore, banks will be required to draft their own funeral plans, which is their best guess of how they would be broken up and viable pieces of the business sold off should they fail down the road.

The Volcker Rule

It lives.Under the previous regime, banks would buy and sell securities with their own money to generate a profit. This proprietary trading generated large degrees of risk. Former Fed Chair Paul Volcker proposed banning this practice by the big banks as a well of limiting their exposure. This was previously pushed in Senate by Jeff Merkley (D-OR) and Carl Levin (D-MI) by an amendment that never got a vote, much to the pleasure of the bank lobbyists. But in the conference committee, it looks like the Volcker rule will carry the day. Like the original Glass-Steagall Act, this provision will separate (and protect) retail banking from other riskier endeavors and also cause firms to become smaller.

Main Street

Empowered Watchdog

One of the biggest problems on Main Street in recent years has been the growing practice of peddling complex financial products to consumers who don’t need them or understand their basic terms. The runaway growth of this fringe financial system made up of payday lenders, subprime mortgage purveyors, and check cashers not only destabilized family balance sheets but undermined the larger economy as a whole. For the first time, there will be a single and empowered agency focused on shutting down the latest scams and gimmicks. Nothing in the bill mandates that the fringe, alternative financial sector immediately has to close up shop. But a new consumer watchdog with a broad and powerful mandate should make life more difficult for the bad actors.

New Accountability Standards

After the financial reform bill is passed, accountability will be defined by a set of principles and standards rather than a description of product terms and conditions. Since people are easily overwhelmed by information and, of course, the fine print is intentionally written in unintelligible legalese, there are severe limits to the impact of disclosure rules. The transition from framework defined by disclosure rules to one based on principles will be a significant paradigm shift in the oversight of the financial marketplace. When future product regulations are governed by the principles of transparency, simplicity, and fairness, there is a better chance that consumers will be matched up with more appropriate financial services and products. This can go a long way to bringing trust and integrity back to the Main Street marketplace.

Leveling the Playing Field

The proliferation of subprime mortgages, the payday lenders, car title loan shops, and check cashers created a bifurcated financial services system. To conduct basic financial transactions families with fewer resources were often steered away from traditional banks toward the more expensive and largely unregulated fringe financial sector. Competitive pressures and uneven standards allowed bad business practices to spread from one sector to another. In the future consumers should be protected through common oversight of both traditional banks and nonbank financial providers. This should cut down on unfair and deceptive practices but also create a more predictable regulatory environment, which is a key ingredient for business success that can also strengthen the entire financial sector.

Rulewriting and Enforcement

The new agency will be able to write rules and ensure they are enforced. This would connect the work of this new agency to existing consumer finance laws, such as the Truth in Lending Act and the Equal Credit Opportunity Act, and empower action when it identifies practices that are deemed unfair or deceptive. When such unfair or deceptive conduct is identified, the agency will be empowered to act. It will have the ability to sue, seek damages, and issue cease and desist orders. Through these actions, the new consumer watchdog has the potential to transform the provision of financial services on Main Street from a growth industry into a low-margin but respectable business. Banking has become expensive and exciting; it should be simple, boring, and cheap.

For this new regime to take hold, the new regulators will have to act aggressively on both Wall Street and Main Street. We learned the hard way that there is no autopilot setting that guarantees the best outcomes. Political will and leadership are still required. Like all types of oversight, effectiveness is achieved through a blend of empowerment, competence, and vigilance. The bill will create a new set of tools, but they will have to be deployed. Screws will have to be turned and hammers swung. As a legislative package, it is not the end of the road but the beginning of a construction project to remake the financial services landscape in ways that better protect consumers and address the endemic problem of too big to fail. The next step is recruiting some powerful general contractors to oversee the work.