The Dodd-Frank Financial Reform Bill

Last Updated Oct 7, 2010 12:52 AM EDT

Legislation to reform the financial sector has cleared the House and the Senate, and the President is expected to sign the bill soon. Here is a quick reaction highlighting some of the positives and negatives in the legislation:

Consumer Protection Agency This agency will provide consumers with the information they need to make good financial decisions, and it will protect consumers from predatory, unfair, and/or fraudulent credit practices. This agency is a needed to help consumers navigate the often confusing world of financial products. The only possible problem is that the oversight council housed in the Treasury has the ability to veto any actions the agency takes, and this council may not be willing to grant the agency the freedom it needs.

Derivatives Traded on Exchanges One of the problems that was evident when the financial crisis hit is lack of transparency. When problems first became evident in the financial sector, it was difficult to assess the degree of risk financial institutions faced because many of the transactions did not pass through standard markets and hence were not tracked. Forcing derivatives to be traded on exchanges helps to solve this problem. But the legislation allows for exceptions to this requirement, and the worry is that these exceptions will be widely exploited undermining the attempt to increase the transparency of these markets.

Resolution Authority A big problem when the financial crisis hit was that regulators did not have the authority to force financial institutions in the shadow banking system into the type of resolution process the FDIC uses for banks in the traditional banking system. This solves that problem, and this is an important change.

Too Big to Fail The legislation does very little to reduce systemic and other types of risk by reducing bank size. I think this is a shortcoming in the legislation as discussed here.

Fed Audits of Special Lending Facilities, Open Market Operations, Discount Window Loans This is intended to give Congress more oversight of the Fed. I don't think this was needed, more Congressional oversight is not necessarily a good thing, and I doubt that it will do much to change Fed behavior. This was mostly a political change, the economic effects will be small.

Volcker Rule Too Weak The Volcker rule, which attempts to prevent firms from engaging in risky transactions with proprietary money and prevent banks from owning more than a small part of hedge funds and private equity firms was weakened to the point where it was likely to be ineffectual.

Limits on Leverage I don't believe that we can prevent of financial crisis from ever happening again, but we can limit the damage if one does occur. One way to do that is through limits on leverage and the legislation comes up short in imposing these limits.

Capital Requirements Banks will be required to increase their capital cushions, something that should help to limit the amount of risk that banks take on. However, for my taste, the caps are not strict enough and too much is left to the discretion of regulators.

Monitoring Systemic Risk The legislation creates a council to monitor systemic risk. While there is some controversy over whether the Fed is the right place to house this council, the agency itself was certainly needed.

Executive Pay Under the legislation, shareholders will vote on executive pay arrangements, but the votes are not binding so it's not clear how effective this will be. I don't see executive pay arrangements as a central cause of the crisis, but there are problems here and the legislation does not go far enough to address them.

Credit Ratings Agencies The bill directs regulators to study the conflict of interest that occurs when ratings agencies are paid by the firms issuing the assets they are rating. Something needs to be done about this, there is a clear conflict of interest, and I would have preferred that the bill take stronger action.

Overall The bill is a step forward, but it does not go far enough. It will be important that legislators view this is the first step in the process of fixing the problems in the financial sector, not the final word.

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