US Congress Finalizes Bank Reform Bill

by Glen Shapiro, LawAndTax-News.com, New York

29 June 2010

A committee from both the House of Representatives and the Senate has finalized the terms of the bill that will make considerable regulatory changes to the United States financial system, and includes a levy on financial institutions to pay for the additional cost involved.

Apart from the section of the bill providing increased consumer financial protection, its important changes include: a restriction on US banks’ ability to trade derivatives and to take risks by trading on their own accounts; powers given to regulators to wind up failed institutions; stricter controls through a new regulatory body; and action on bankers’ remuneration.

The bill will create a Financial Stability Oversight Council to monitor the market to identify potential threats to the stability of the financial system. Through the Federal Reserve, that Council will subject financial companies that it judges to pose a threat to financial stability to much stricter standards and regulation, including higher capital requirements, leverage limits, and limits on concentrations of risk.

The proposed legislation, significantly, imposes risk retention on all lenders. For the first time banks will be required to retain a portion of the risk they generate, in order to provide real market discipline for underwriting decisions. New rules will require institutions to retain at least 5% of the credit risk associated with any loans that are transferred, sold or securitized.

Tough restrictions are to be imposed on government assistance in times of crisis so as to eliminate bailouts. Official guarantees will only be given to solvent banks in a liquidity crisis, and will be funded by fees paid by those banks.

The bill provides for the orderly dissolution of failing firms, ending “too big to fail”. When a firm enters the dissolution process, management responsible for the failure will be dismissed, parties that should bear losses - particularly shareholders and unsecured creditors - will do so, and the firm will cease as a going concern.

Any dissolution shortfall will be repaid by assessments on all large financial firms – not by the taxpayer. A Systemic Dissolution Fund, pre-funded by a levy on financial companies with more than USD50bn, and by hedge funds with more than USD10bn, in assets, would be used to pay creditors and help wind down failing financial institutions, but not to preserve them. It has been estimated that the total of that levy could reach around USD19bn.

There will be, for the first time, a comprehensive system of regulation of the over-the-counter derivatives market, requiring clearing and trading on exchanges or electronic platforms for all standardized transactions, including swaps and credit derivatives, between dealers and other large market participants. Counterparties will have to comply with transaction reporting requirements established by regulators.

Implementing a modified Volcker rule, banks will not be able to trade derivatives for their own account, unless they are considered low risk and necessary for their internal risk management purposes. Riskier derivatives, such as those linked to energy or commodities, will only be tradable by banks through subsidiaries, set up by them and using their own capital.

The bill also fills a hole that allows hedge funds and their advisers to escape regulation. Now, all investment advisers to private funds with over USD150m in assets under management will be required to register with the US Securities and Exchange Commission. Banks will also be limited to investing a maximum of 3% of their core capital in such hedge funds or private equity funds.

In addition, with regard to pay structures, all financial institutions with more than USD1bn in assets will be required to disclose remuneration arrangements that include any incentive based elements. Federal regulators would be authorised to ban inappropriate or imprudently risky compensation practices.

Overall, while some banks may be forced to restructure some of their business, the bill does not include some of the more draconian measures that had been previously mentioned, such as breaking the link between the banks’ commercial and investment banking operations.

However, the US Treasury Secretary, Tim Geithner, called the bill “strong”. He said that “it represents the most sweeping set of financial reforms since those that followed the Great Depression. It prevents financial firms from taking risks that will threaten the economy. And it provides the government with significant new tools to better protect taxpayers from the damage of future financial crises.”

President Obama reiterated that Congress had finalized a “strong Wall Street reform bill”, and urged it “to finish the job" and send the bill to his desk. It is now expected that Congress will approve the bill in its revised form in the next few days and send it to the President by July 4.

Recommended