U.S. House-Senate Conference Hammers Out Financial Reform Bill: A Thread of Common Sense Prevails

• A modified "Volker rule," whereby banks could engage in propriety trading through investments in hedge and private equity funds up to 3% of Tier 1 capital.
• "Standardized" derivatives transactions to take place on registered exchanges under CFTC supervision with enhanced reporting requirements. Customized derivatives still need to be reported to regulators. Overall derivative prudential standards would be tightened up.
• Banks still allowed conducting derivatives and swaps for interest rates, foreign exchange, gold and silver, but trading in other commodities would be pushed out to affiliates.
• Revamped bank capital standards, including the removal of trust-preferred securities as Tier 1 capital with a five-year phase-in period.
• Treasury to form a "Financial Stability Oversight Council" to oversee the broader financial markets and monitor systemic risks to the financial system and the economy.
• Establish an "Orderly Liquidation Authority" that creates mechanisms for liquidating systemically important firms under the FDIC. Banks with assets over $50 billion would have to pay fees to cumulate a fund of $19 billion over 10 years.
• The role of the SEC will be substantially expanded, with additional registration and systemic risk reporting requirements for derivatives traders and large hedge funds. The SEC is also mandated to oversee credit rating agencies, and study conflicts of interest with a view to potentially greater supervision.
• Originators of mortgage-backed securities and other CDOs to hold at least 5% of the credit risk.
• Establish an "Office of National Insurance" under the Treasury to monitor industry, identify national insurance issues, and establish standards and report on insurance industry systemic risk issues. A "Bureau of Consumer Financial Protection" would be created under the Federal Reserve.
• Federal Reserve supervisory authority over banks remains intact, including thousands of community banks. Congress requires only a one-time audit of all of the Fed's emergency programs from the financial crisis. Details of loans through the discount window and open market operations to be released after two years, while bankers would not be allowed to select the presidents of the regional banks.

The proposed bill, which will be signed by President Obama within days, addresses key issues such as revamping and streamlining the structure of the financial and regulatory system, the role of the Federal Reserve, systemic risk mitigation, "too big to fail," and stabilizing the massive financial derivatives market.

The final version of bill stripped out many of the more controversial proposals—including regular audits of the Federal Reserve, restricting the Fed's supervisory ambit, carving all proprietary and derivatives trading from the banking systems, and overly punitive fees.

The "Volker rule" was substantially watered down, with banks retaining the ability to conduct proprietary trading up to 3% of Tier 1 capital, and banks are still permitted to engage in a wide range of core derivatives trading including interest rate, foreign exchange, and gold/silver. Only the most risky commodity derivatives would have to be spun off into affiliates.

The bank fee to cover future large bank failures to be collected by the FDIC was scaled back from $50 billion to only $19 billion.

Bottom Line: The financial reform bill addresses a number of key weaknesses in the U.S. financial regulatory structure that led to the financial meltdown in 2008 and early 2009. The most important of these elements is to streamline the existing regulatory structure, expand regulated frameworks for standardized derivatives, subject the credit rating agencies to greater accountability, and create a mechanism for liquidating systemically important firms.

In addition, the bill attempts to accomplish all of this without severely handcuffing the major banks or seriously undermining the preeminent competitive position of the U.S. money center banks in global financial markets. Thus, there is at least a thread of common sense in this bill—a thread which was difficult to detect in the early stages of negotiation.