Consumers gain from financial reform

After months of debate, Congress has approved the broadest rewrite of the rule book for financial institutions, investors and lenders since the Depression.

The Dodd-Frank Wall Street Reform and Consumer Protection Act is a major overhaul of U.S. financial regulations aimed at preventing future crises like the one that dragged the U.S. economy into recession two years ago.

“Broader financial stability is something we all care about,” says Greg McBride, senior financial analyst for “Nobody wants to go through another event like we went through in 2008 and early 2009. The question is, will this reform prevent another financial catastrophe or (just relieve the symptoms of) the last one? Is it designed to prevent the crash that already happened or is it designed to prevent the next crash?”

While the legislation mostly addresses banks and businesses, individual consumers will be affected directly and indirectly by several key provisions.

Consumer protection

The biggest news for consumers is the establishment of a new Consumer Financial Protection Bureau within the Federal Reserve to police consumer financial products such as mortgages and credit cards. The new bureau will enforce existing laws and set specific rules on certain financial products, including what interest rates payday lenders can charge and how credit card disclosures must be made.

This is good news for consumers, because it will create an agency that can keep up with the constantly evolving practices of financial firms better than legislators can, says Kathleen Day, a spokeswoman for the Center for Responsible Lending in Durham, N.C.

“This is a living, breathing agency,” says Day. “It can see (abuses) as they crop up but before they become pervasive, and stamp them out without having to constantly go back and reinvent the wheel in Congress.”

Numerous industries sought exemptions from consumer protection bureau oversight, with auto dealers being the biggest winners. They will continue to be regulated by the Federal Trade Commission.

In another compromise, a fiduciary standard for stock and insurance brokers in the Senate version of the bill was taken out. Instead, the SEC will study the issue and make further recommendations in six months.

An end to bailouts?

The rest of the act’s provisions focus on regulating the larger financial markets. For many Americans, one of the most troubling aspects of the financial crisis was the government bailout of major financial firms at the center of financial meltdown.

Under the new legislation, instead of being forced to prop up failing nonbank financial institutions like insurance giant AIG in an ad hoc manner, regulators will have the authority to take over and close them in an orderly fashion much as the FDIC does with failing banks now.

“Prior to the passage of this (act), the FDIC and bank regulators had considerable authority to resolve a troubled bank. They can come in, take it over, sell it off. They can do whatever needs to be done to deal with a distressed bank,” says Doug Elliott, a fellow at the Brookings Institution in Washington, D.C. “We’re widening the resolution authority so that large nonbanks that could threaten the system can be resolved in a similar way by federal regulators.”

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 crackdown

The 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 rule

The 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.

Perhaps, the biggest bombshell for banks may be limits placed on their investing activities. What began as the so-called “Volcker Rule,” for former Federal Reserve Board Chairman Paul Volcker, now restricts banks insured by the FDIC in how much proprietary trading of stocks and other potentially risky financial instruments they can do. They are also restricted in their investments in hedge funds and private equity funds.

Regulating the regulators

Flaws in the U.S. regulatory system played a key role in the crisis. Regulators are funded largely by the firms they oversee to minimize the cost to taxpayers. Unfortunately, because there were several financial regulators whose jurisdictions overlapped, regulators ended up competing with one another to regulate large firms that could become a rich source of funding. This meant financial firms were able to go “regulator shopping” for the most lenient regulator.

“The regulators became captive of the institutions they were regulating,” says Day. “They tended to pander to (large financial firms) because they didn’t want them to leave and take their money.”

The new legislation clarifies which regulators will oversee which types of firms. The Office of Thrift Supervision, or OTS, is the biggest loser. It was originally created to oversee savings and loan institutions, but it had expanded to cover several complex financial firms that eventually fell victim to the financial crisis. A recent Congressional Oversight Panel report found the OTS was largely responsible for the government’s failure to foresee and prevent the collapse of AIG, which received billions of dollars in the government bailout. Under the act, the Office of Thrift Supervision will be merged with the Office of the Comptroller of the Currency.

Regulators also fell short in their ability to assess risk in the economy as a whole. To help make sure they see the next crisis coming, the act mandates that regulators share information on financial firms that present a danger to the overall financial system and keep an eye on risk in the wider economy.

To help them do this, the legislation establishes a new entity called the Financial Stability Oversight Council. Under the act, the Council, made up of the Treasury secretary, the Fed chairman and the heads of the various financial regulatory agencies, will meet regularly to discuss the health of the economy.