Any costs to the taxpayer from such actions will later be recouped through additional fees on financial firms with assets of more than $50 billion.
Still, it remains to be seen how well the federal government can prepare for and manage the takeover and dissolution of an institution that's critical to the banking system.
Derivative crackdownThe act takes aim at the previously unregulated market in derivatives -- assets that derive their value from other assets -- that accelerated and deepened the financial crisis of 2008. The most problematic of these derivatives were credit default swaps.
Credit default swaps are a hedge against the risk of a certain security or debt instrument defaulting. At its most basic level, a credit default swap, or a CDS, has two parties: the insurer of the debt or security and the insured. The insured agrees to make a steady stream of premiums to the insurer. In exchange, the insurer agrees to pay a lump sum if a third party defaults on the debt or security. The contracts were intended to work like homeowners insurance, with the owner buying a policy to protect against the loss of his home from a hurricane or fire.
These credit default swaps became dangerous for the wider economy because insurers didn't judge the severity of the default risk of third parties. When those third parties went bust as the economy fell into recession and the housing bubble burst, insurers were overwhelmed by losses from their CDS contracts.
Making matters worse, these contracts were "swapped," or traded, from one investor to another, without regulators knowing whether losses could be covered in the event of default. The new legislation brings derivative contracts out into the open by largely confining their trading to public clearinghouses. Such clearinghouses will help ensure that government and financial institutions are aware of the derivative trading between institutions, and that the parties in a derivative contract have the reserves to cover losses.
The original Senate bill had an amendment from Arkansas Democrat Blanche Lincoln that would have required banks to spin off their derivative trading altogether. This was softened to allow banks to continue to trade in some categories of derivatives.
The Volcker ruleThe same factors that caused large investment banks such as Lehman Brothers and Bear Stearns to collapse -- risky investments and inadequate cash reserves -- also pushed many consumer banks into failure. The FDIC has taken over 249 insolvent banks since the beginning of 2008, including large consumer banks Washington Mutual and IndyMac.
To prevent a similar wave of bank failures in the future, the act increases the amount of cash that all banks must have on hand to cover potential losses from a sharp downturn -- from multinational giants like Citibank and Bank of America to small community banks.
"Systemically important banks are going to have the largest increases in safety requirements like capital, but the smaller banks will have significantly higher capital requirements as well," says Elliott.