What Impact Will the Election Have on Financial Reform?

Last Updated Nov 4, 2010 3:37 PM EDT

How will the takeover of the House of Representatives by Republicans affect recent regulation to reform the financial sector, in particular the Dodd-Frank bill and the recent Basel III agreement?

Since the Senate remains in Democratic hands, we shouldn't expect any significant changes to the Dodd-Frank bill, particularly since Obama would likely veto any attempts to significantly alter the bill if it somehow reached his desk.

But the election does bring to mind questions about potential changes in financial regulation over the next few years, and over the longer-run, particularly if this is a sign of larger Republican gains in the future. One question is whether existing changes to financial regulation in the Dodd-Frank bill that appear to be working to restrict financial markets will be enforced and preserved. A second is whether we'll be able to fix holes in the existing regulatory structure that Dodd-Frank left unfilled. And a third question concerns the extent to which we will continue to participate on the international stage as we did in the Basel III process.

What are the most important parts of the legislation to reform the financial sector? And are they out the window now?
The most important change in regulation is the resolution authority regulators now have over large financial institutions that get into trouble. When the crisis hit, regulators did not have the authority they needed to take over a failing financial institution. That authority exists for traditional banks, and is used frequently, but it had never been extended to financial institutions that are part of what is known as the shadow banking system. That left regulators with only two choices, neither of them good ones. They could let large institutions fail and risk a meltdown of the entire system, or they could bail out the banks and, in the process, reward those who caused the problems in the first place. If a traditional bank had been involved, they would have had other options that allowed them to minimize the costs of a meltdown while imposing losses on equity holders and removing management, but no such option existed for shadow banks.

Will resolution authority survive? I don't expect that resolution authority will be impacted much if at all by the change in the political atmosphere. Both sides of the political fence are in general agreement that this is a good idea.

The second important regulatory change in the Dodd-Frank legislation is the Volcker rule. This rule limits the ability to make speculative investments with government insured money. The regulatory restrictions the legislation imposes are weaker than many people would prefer, and banks are already pushing against the boundaries.

Will the Volcker rule be changed? Republicans would like to weaken the Volcker rule, but any attempt to further weaken this provision would likely be vetoed (though after two years all bets are off). However, Republican opposition will prevent anything from being done to strengthen the bill should banks discover ways to bypass the legislation's intent.

A third feature to highlight in the Dodd-Frank legislation is the attempt to make derivative markets more transparent by forcing the trades through organized markets. Again, I don't expect big changes here, but Republicans have, in general been more sympathetic to arguments that some derivatives must be traded outside of over-the-counter markets. They will likely push for exceptions, and the more exceptions that are granted, the more likely it is that banks can find creative ways to bypass the legislation. So this could, over time, weaken this provision of the bill.

What is the biggest remaining issue in terms of financial regulation? And will the election results help or hurt our chances of fixing it?
The most important thing left to do is to stop the bank run problem in the shadow banking system. As I explain here, the problems we experienced in the financial system can be viewed as a traditional bank run on the modern banking sector.

We are still vulnerable to these runs, and hence to the type of financial meltdown that we just experienced. The problem is that deposits in the shadow banking system are not insured the way the FDIC insures deposits in ordinary banks. Instead the deposits are backed by high quality collateral.

Or at least it was supposed to be high quality. As the recent crisis unfolded the collateral turned out to be relatively worthless, a AAA rating didn't mean AAA after all, and as people realized their deposits were at risk they rushed to get their money out of these financial institutions. The result was severe liquidity problems in the financial system, and a financial crash.

One way to fix the problem is to improve the quality of the collateral standing behind deposits in the shadow banking system. Another, and probably better way, is to extend a version of FDIC deposit insurance and the regulatory regime that comes with it to the shadow banks. However, extension of deposit insurance to the shadow banking system was unlikely even before Republicans made political gains, and it is even less likely now. Treasury is working on a proposal to improve the collateral, but the Treasury proposal is not, in my view, enough to get the job done. Improving collateral will help some, however, and it is unlikely to be challenged by Republicans, and it's the best we can get for now.

Will recent international agreements on financial reform survive the election?
In September, financial officials from 27 major countries endorsed what is known as Basel III. The most important thing that the Basel III agreement does is to specify bank capital requirements, and, as a consequence, place limits on bank leverage.

Though many people feel the provisions are too weak, and that they come online too slow, the fact that there is an agreement at all is an accomplishment. The agreement requires that banks hold 7% of common equity against the risky assets in their portfolios. This is better than under Basel I and Basel II, but it is still not strict enough in the opinion of many observers, and the phase in period for the new capital requirements that is not complete until 2019 is much too slow.

Will the election change this? The Basel III agreement is already in place, so the question is whether the existing agreement will be honored, and whether the US will push for changes in the future.

The agreement will be honored, particularly since enforcement of the capital requirements is not up to Congress. I don't expect there will be any attempt to alter the agreement, but if there is, the balance would shift somewhat toward weakening rather than strengthening what has been done so far. Republicans were not in favor of the legislation in the first place, and they would be unlikely to support higher capital requirements, a faster phase in period, or any other attempt to impose stricter regulations on financial institutions.

What's the bottom line?

At least for the next two years, we should not expect any big changes. If there are changes, they will likely be incremental and move toward less rather than more strict regulation and enforcement. In the longer run, i.e. beyond the next two years, if there is divided government then gridlock is likely to persist and there will be no big changes. If Democrats retake control, the tilt will be toward stricter regulation and enforcement, but I wouldn't anticipate any major new regulatory initiatives. However, if Republicans take broad based control, we should expect an attempt to undue many of the more restrictive provisions of recent bills, regulations, and agreements as the free market approach they favor would be likely to prevail.

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