How Financial Reform Falls Short -- Way Short, In Some Cases

Last Updated Jun 25, 2010 6:14 PM EDT

While President Obama predictably heralded the new financial reform bill, eleventh-hour changes to the legislation weakened it considerably. So pop those corks back into the champagne bottles.

Take the Volcker Rule, which as originally drafted sought to prevent banks from investing in hedge and private equity funds. That was intended to stop banks -- which are insured by the U.S. government and have access to low-cost federal funding -- from exploiting these protections to speculate in the markets. In effect, it would've forced Wall Street banks to spin off these lucrative businesses.

The agreement thrashed out in the wee hours of Friday morning makes two key concessions to banks. First, as HuffPo's Shahien Nasiripour explains, lawmakers on Thursday agreed to allow banks to invest up to three percent of their "tangible common equity," a key measure of a bank's financial health, in hedge and PE funds. Then, unable to seal the deal, conference committee members agreed to substitute "Tier 1" capital for TCE in calculating how much banks can invest as part of their proprietary trading.

Here's why that matters -- banks have far more Tier 1 capital than they do TCE. That means banks can invest more money in risky investment funds. And we're talking significant dough here. Nasiripour writes:

Using JPMorgan Chase (JPM), the nation's second-largest bank by assets with more than $2.1 trillion, as an example, the bank would be able to invest an additional 40 percent of its cash, or an extra $1.1 billion for a total of $4 billion, in the activities that Volcker wanted to prohibit banks from engaging in, according to the firm's latest annual filing with the Securities and Exchange Commission.
Bank of America (BAC) could pour $4.7 billion in hedge and PE funds; Citigroup (C), $3.6 billion; Goldman Sachs (GS), $2.1 billion; Morgan Stanley (MS), $1.5 billion. Plenty of powder, in other words, meaning plenty of risk.

Another disappointment (although it could've been worse) were the changes made to Sen. Blanche Lincoln's plan to prohibit commercial banks from dealing swaps. The Arkansas Democrat's original proposal amounted to a blanket ban on bank derivatives trading. The goal was to stop the firms from speculating on credit default swaps and other kinds of derivatives.

But pressure from conservative Democrats and unanimous Republican opposition forced Lincoln to give ground. Under the agreement in Congress, banks may continue trading certain credit derivatives and interest rate and foreign exchange swaps; they'll also be allowed to use swaps to hedge their own risks. By contrast, the companies must spin off into a separately funded unit, or cease trading, credit default swaps and certain commodities-related derivatives.

This is how sausage is made, as Lincoln conceded in remarking on the deal over her derivatives measure:

Our financial system is complicated and integrated and our time so limited that we couldn't afford to dig in our heels, but must do something.
For banks, as their efforts to soften the proprietary trading and swaps rules show, the main concern is whether the new regulations will hurt business. Although the bill could still change before landing on Obama's desk, some experts think not. Indeed, shares of major U.S. banks rose this morning after news of the reform pact surfaced. The broader KBW Bank Index also saw gains.

Said Richard Bove, a banking analyst with Rochdale Securities:

I don't see there being a tremendous clampdown on the ability of banks to make money. The banks will have numerous methods of getting around the most onerous provisions in this bill to maintain their earnings growth.
The big question, of course, is whether the legislation is really the "landmark" that some media outlets, along with the White House, say it is. Does it really prevent financial firms from "taking risks that will threaten the economy," as Treasury chief Tim Geithner claimed in a statement?

It's hard to see how. The reform bill doesn't eliminate "moral hazard" or fundamentally confront the problem of "too big to fail." Bank accounting practices, particularly the use of off-balance-sheet entities, remain highly dubious. Crucially, global financial markets remain dangerously interconnected. While capital and liquidity requirements may rise for commercial banks, it's unclear whether the large securities firms that have increasingly moved to the center of our financial system are any safer than before the financial crisis.

Writes William Black, a former bank regulator who now teaches law and economics at the University of Missouri:

The fundamental problem with the financial reform bill is that it would not have prevented the current crisis and it will not prevent future crises because it does not address the reason the world is suffering recurrent, intensifying crises....

The bill continues unlawful, unprincipled, and dangerous policy of allowing systemically dangerous institutions to play by special rules even when they are insolvent.

And yet perhaps this is the best we could've expected. Financial firms retain enormous clout in Washington. November's mid-term election adds another dynamic, emboldening lawmakers like Lincoln to press for change while encouraging others, including prominent New York pols, to hold the line.

Will it be sufficient? Will the new financial rules even withstand the inevitable efforts to roll them back after Obama signs the measure into law? We'll see. Blanche Lincoln may be right in saying that, at least politically, we can't afford to dig in our heels. The danger is that we can't afford not to.

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