Financial Regulatory Reform?
WSJ: “The sweeping overhaul, which could be signed into law by July 4, would put U.S. banks and financial markets under tighter government control for years to come. Wall Street executives and analysts said the legislation was not as tough as they had feared, but tougher than they had hoped.”
Unfortunately, it is a stretch to deem the financial reform bill a “sweeping overhaul”. The passage of this legislation will be no more of a “mission accomplished” than the invasion of Iraq. Just as Bush leveraged the appearance of success to gain politically, Obama will look to do the same by touting the accomplishments of his domestic agenda. Unfortunately, similar to the wars overseas, the problems in the financial system and the economy will persist and worsen as time passes without adequate leadership and meaningful solutions.
NY Times:“Industry analysts predicted that banks would most likely adapt easily to the new regulatory framework and thrive. As a result, bank stocks were mostly higher Friday, prompting some skeptics to question if the legislation, in fact, would be tough enough to rein in the industry and prevent future shocks to the economy as a result of bad gambling.”
As for a ban on proprietary trading, the bill does not accomplish much. While firms may be forced to shift some trading activities to subsidiaries, the ability to continue trading interest-rate swaps and foreign exchange swaps, which constitute roughly 80-90% of their holdings, means that little will be changed. In addition, trading activities that serve the purpose of “hedging risk” are acceptable. In essence, why bother with this legislation?
For example, the “Volcker Rule” has been reduced to 3% limit on the amount of tier 1 capital that can be invested into private equity and hedge funds. In effect, the limit for JP Morgan, based on current figures, totals $3.9 billion. For Goldman Sachs, $2.1 billion, and for Citigroup, $3.6 billion. Firms rarely invest above the proposed 3% ceiling in the first place.
The ban may have some impact on bank profits. Goldman Sachs generated $1.17 billion in revenues in 2009, or 10% of its annual revenue, from “principal investments” or prop trading. Although, I would not be surprised to learn that what GS reports understates the extent of its prop trading.
The reform takes aim at the $615 trillion over-the-counter derivatives market. Requiring derivatives to be traded through clearinghouses is an obvious necessity. This improves transparency and disclosure as well as increases capital and margin posting requirements. Selling OTC derivatives contracts is the most lucrative line of business for the big banks. JP Morgan, Goldman Sachs, Bank of America, Citigroup, and Morgan Stanley hold 97% of the $212.8 trillion in derivatives that exists in the U.S. commercial banking system.
As for the government’s role in the financial system, not much will change. An oversight council is established with the authority to fix the system but that does not mean that it will be competent. The consumer protection bureau, located in the Fed, has some power but it is subject to the review of the oversight council. Basically, this means that the duty to protect consumers, which already existed within the Fed, will continue to be an after thought.
While some useful and important provisions have made their way into the reform bill, it is a far cry from the “sweeping overhaul” that the politicians claim to have reached. With financials in the S&P gaining 2.7% following the news of the reform bill, it is difficult to remain optimistic.
Newsweek: “Financial Reform Makes Biggest Banks Stronger” Dodd-Frank effectively anoints the existing banking elite. The bill makes it likely that they will be the future giants of banking as well. Legislators touted changes that would restrict proprietary trading by banks and force them to spin off their swaps desks into separately capitalized operations. But banks get to keep the biggest part of their derivatives business, which is dominated by interest-rate and foreign-exchange swaps. Some 80 to 90 percent of that business will remain within the banks, and J.P. Morgan, Goldman Sachs, Citigroup, Bank of America, and Morgan Stanley control more than 95 percent, or about $200 trillion worth of that market. These same banks may end up controlling or at least dominating the clearinghouses they are being pressed to trade on as well, since language proposed by Rep. Stephen Lynch, D-Mass., to limit their ownership stakes to 20 percent, was dropped in the final version of the bill, according to Lynch’s spokeswoman, Meaghan Maher. “No numerical limitations were set; regulators were given the ability to do so,” she said.
The bill leaves many other future decisions, for example on pay structure and incentives, to regulators as well. “The bottom line: this doesn’t fundamentally change the way the banking industry works,” says a former U.S. Treasury official who has followed the legislation closely but would give his judgment only on condition of anonymity. “The ironic thing is that the biggest banks that took the most money end up with the most beneficial position, and the regulators that failed to stop them in first place get even more power and discretion.”
Dodd-Frank Wall Street Reform and Consumer Protection Act Summary
NY Times: Financial Regulation: The Hope and the Worry
WSJ: What’s in the Bill?
The Big Picture: Grading Financial Regulatory Reform