US FINANCIAL SYSTEM REGULATORY REFORM: Dodd-Frank Wall Street Reform and Consumer Protection Act

As I have argued before, US legislation has a similarly direct comparable impact on UK legislation as does legislation from Brussels via the UK's EU membership. In practical or empirical terms the UK political-economy behaves like a semi-autonomous region of the USA more intensely than as an integral part of the EU; the UK economy often follows the ups and downs of the US economy more predictably than Canada, or even Texas or California!
Of course, Brussels legislation is influenced by the USA too and vice versa; there is a two-way flow, which in financial services arena is also because of coordinated legislation from the G20 agenda that has nearly 100 tasks to complete most of which will result in new laws as well as new rules and new prudential supervision powers for authorities to intervene early as well as ensure back-stop measures are a collective cost to banks, or to the financial services sector more broadly.
Last week, a House-Senate conference committee agreed a compromise version of financial services legislation. Both Houses will soon debate and will vote to pass the new H.R. 4173, the "Dodd-Frank Wall Street Reform and Consumer Protection Act", also called the 'Frank-Dodd' or 'FinReg' Bill.
H.R. 4173 is intended to protect consumers and investors, to enhance Federal understanding of insurance issues, to regulate the over-the-counter derivatives markets, and to create a number of powers such as breaking up banks that cannot deliver an adequate 'living will' i.e. a streamlining of big bank group structures so that if at risk of insolvency they can be efficiently fixed in any number of several ways. The ideas include make resolution and state aid measures or 'regimes' more transparent, more on-budget, and thereby ensuring no banks are technically too big to fail. Such matters to work require international coordination of laws so that if a bank like Citicorp fails in the future there will not be international legal barriers or complexities standing in the way of breaking up the bank!
The Euro Area's Stabilisation Fund is a back-stop for the sovereign risk aspects of indirectly resolving bank failures in the EA, and a new EU bank resolution fund and or national funds will provide what I call 'undertaker of last resort' funding to complement central banks' 'lender of last resort' liquidity provision. Several countries are setting up national funds via special bank taxes because saving banks remains a national member states more than a multinational EU responsibility.
In the UK, the FSA has been ahead of others in requiring banks to build up liquidity risk reserves, and the break-up of banks and related issues are to be examined by the new UK Banking Commission to report by September 2011, and resolving the split between micro- and macro- prudential supervision is to be ended by creating a new Consumer Protection and Markets Authority (CPMA) when the FSA is split in two, with its micro-prudential supervision of banks coming becoming a department of the Bank of England, which must more actively exercise its responsibility for macro- or 'systemic' risk. It will be 2012 before legislation is passed for the new institutional structure to begin, but the implications of the new arrangement of responsibilities are already with us.
The USA is perhaps with the Frank-Dodd Bill 2 years ahead of UK in equipping the Federal Reserve, SEC and the Fed's FDIC. A few thousand new financial supervision hires will see many poachers turn gamekeepers. The USA's 2,300-page bill has 15 separate new laws dealing with issues raised by the financial system crisis. The measures are under review or closely echoed already in UK legislative changes currently in plan or subject to a Banking Commission review, whose work begins this Summer. Key decisions in watering down aspects of the original bill will influence the UK banking Commission to follow suit.
Rather than forcing banks to spin off all derivatives trading as separate businesses to stop them supposedly "gambling" with depositors’ funds, which they didn'y except very indirectly if at all - Congress let banks keep trading derivatives if hedging their own risks or for interest rate and foreign exchange swaps, which is all they claimed to be doing anyway? Banks have up to two years to move derivatives that can’t be cleared through a clearing house, including credit default swaps, into separately capitalised subsidiaries.
The Volcker rule, named after its proposer and former chairman of the Federal Reserve who is an Obama adviser, stands, almost. Banks are prohibited from trading for their own account, but not banned from investing in hedge funds and leveraged-buyout funds; allowed to invest up to 3% ratio to Tier 1 capital in such funds. That, for example, lets JP Morgan Chase invest $4bn that way. The ban on proprietary trading is intended to shift bank culture back to transmission mechanism banking and to protect bank shareholders from speculative risk-taking with their money. Banks also lose their setting of prices on derivatives they write; that goes to central markets where prices are set by all traders. Otherwise, the banks continue as before, focusing on trading not just traditional banking, important to windfall profits and bonuses.
Cost estimates by the Congressional Budget Office (CBO) for H.R. 4173 has just been published. An earlier estimate placed the government budget cost of the bill at c.$70bn. I usually find CBO projections to be simplistic. The latest is not that.
see; http://www.cbo.gov/ftpdocs/115xx/doc11560/hr4173senatepassed.pdf
CBO and the Joint Committee on Taxation (JCT) estimate that H.R. 4173 will increase tax revenues by $12.1bn in 2011-2015 and by $33.5bn over the 2011-2020, and increase direct spending by $25.0bn and $53.2bn over the same periods. CBO estimates those changes would increase budget deficits by net $12.9bn over the 2011-2015 period and by $19.7bn in 2011-2020.Implementing the act should increase Federal spending by $4.6bn in 2011-2015 and $13.2bn in 2011-2020 period.
Similar measures in the UK would not be proportionately less relative to UK's GDP as 1/7 of USA given the proportionately larger UK finance sector. We could assume the costs for total EU of similar measures would exceed the USA cost estimates.
US House of Representatives will also examine a bill to spend additional funds in fiscal year 2010. The Senate will debate H.R. 5297, the Small Business Lending Fund Act of 2010 to create a Small Business Lending Fund and authorize the Treasury Department to invest up to $30bn in small financial institutions that plan to increase lending to small businesses. The UK version of this is only worth over $2bn. But, these depend on how the funds are used to pump-prime related lending.
H.R. 5297 will create the Small Business Lending Fund Program to direct the Secretary of the Treasury to make capital investments in eligible institutions in order to increase the availability of credit for small businesses. Also envisaged is a Small Business Credit Initiative to authorise $2bn to assist states to increase the amount of capital made available by private lenders to small businesses. Presumably the effect intended is pump-priming such as via credit insurance guarantees so that the gross effect may be to boost lending by about $30bn.
Questions have been raise in UK and Europe about how consumer protection and quality of wholesale financial markets can be culturally, institutionally, conjoined in a single regulator entity? It is case, however, that the custom is to view quality of price discovery and general transparency of the markets in consumer and small investor terms, with consumer interests also expressed via the rights of pension and insurance funds.
But, there is more at stake in wholesale markets including solvency and transparency about what brokers and dealers are doing in how they handle risks, innovate new instruments, dilute the integrity of markets, relate to global markets trading and pricing and so on. In capital markets (fixed income and derivatives) central banks with macro-prudential concerns intervene. In security markets (equities and derivatives) some exchanges continue to retain responsibility for quality, but increasingly due to the fragmentation of markets this has to be undertaken by multi-market, multi-exchange, regulators, especially in Europe, and including commodities amrkets, over-the-counter, on-exchange, and via third party and internal crossing networks, 'dark pools' and inter-dealer brokers.
These are hugely complex issus requiring massive computer analytics engine tools that regulators lack leaving them dependent on market data providers such as Thomson-Reuters and Bloomberg, and the clearing houses. How these matters are regulated by SEC in USA or various equivalents elsewhere cannot be subsumed merely within consumer protection principles, even if those take us a long way forward. Therefore there is bound to be a large overlap with macro-prudential regulators as well as micro-prudential investigators chasing breaches by individual firms.
The technology and opportunity for market distortions and anti-competitive practises are legion, and far beyond the mind of individuals or small teams to get to grips with. The misunderstanding of how stocks and markets may be 'shorted' and how rumours and insider-trading can be tracked, rogue traders etc., all after-the-fact ex-post, are instructive. Insider trading int he USA can be widely interpreted and furnishes the biggest single crime for arrest and arraignment of bankers and dealers. The same cannot be said in Europe.