Despite populist pressures to curtail its powers, the U.S. Federal Reserve System is now certain to remain fully independent of direct political interference in setting U.S. monetary policy. Moreover, its supervisory and regulatory powers will be extended to non-bank financial institutions (although it will have to work more collegially with other Federal regulators in this area).
This is the upshot of the Senate’s solid bipartisan approval of the reform bill led by Senator Christopher Dodd -- the most important changes in regulation of the financial industry since the Banking Act of 1933. The legislative process is now on track to become law by summer (after “reconciliation” of the different but similar bills passed by the Senate and by the House of Representatives). Federal regulation will be seriously tightened on commercial and investment banks and will be extended to non-bank financial institutions such as hedge funds and private equity groups -- as well as Too Big To Fail (TBTF) financial behemoths, derivatives, credit-rating agencies and insurance.
The rapid reform (of what is arguably the most important, and politically powerful, sector of the U.S. economy) is somewhat surprising as an outcome. A polarized Congress might have taken much longer to agree on key regulatory changes, especially because the finance industry had massively lobbied Senators and Congressmen. But voter anger at Wall Street carried the day. At the same time, law-makers declined to heed calls for some extreme measures liable to expose the Fed to political interference. That could have been damaging for long-term monetary and price stability. The outcome leaves the Fed in a comparable position to the European Central Bank’s independent status.
The rapidity of the reform owes much to President Obama’s success in March in energetically forcing through a major reform of health care – a political victory that energized Congressional proponents of financial reform. A strikingly large number of the changes proposed by the President proposed less than a year ago have been approved by the House and the Senate in separate but not too dissimilar bills. Developments in Congress were also influenced by a rash of cases that put Wall Street banks and firms under civil and criminal investigation for dubious practices alleged to have contributed to the financial crisis.
At this pace, the U.S. will move ahead of plans by the European Union and G-20 countries to reform their financial sectors. This could complicate international coordination of regulatory reform, an ambition aimed at reducing the risk of seeing financial players evade new constraints by going to less strict countries. Given the dominant role of U.S. financial markets and institutions, the imminent U.S. regulatory reform is likely to be the template for European and G-20 reforms – as described on this website.
Despite rearguard actions by lobbyists, key measures affecting the Federal Reserve seem clear: these include:
- The Fed’s independence to set monetary policy is reaffirmed. The Fed would have to submit to a one-time audit by the Government Accountability Office of emergency programs it launched to support the financial system since 2007. Efforts to impose regular GAO audits of Fed policies were defeated.
- The Fed would retain authority over nearly 5000 bank holding companies, state-chartered banks and 844 community banks which it currently oversees. It would also supervise large, inter-connected non-bank financial institutions. It would be empowered to break up large complex companies threatening the financial system.
- The Fed would be one of nine Federal regulatory institutions on the new Financial Stability Oversight Council (FSOC), a body created to guard against systemic risks. When the FSOC, chaired by the Treasury Secretary, identifies systemic danger, it can raise capital requirements for lenders and force divestments of holdings deemed too risky. The Fed would be deputized by the FSOC to impose tougher standards for disclosure, capital and liquidity on major financial institutions. The FSOC could also put broker-dealers and hedge funds under Fed supervision.
- There will be a ban on proprietary trading by banks (a form of investment in which banks add their own funds to high-risk investments by other traders – thus exposing these institutional players more to market volatility). This move was urged by former Fed Chairman Paul Volcker, but it is one of Wall Street’s biggest profit sources. So financial lobbyists will make an all-out attempt to delete such restrictions from the final bill. The “Volcker rule”, endorsed by President Obama, aims to reduce banks’ overall “speculative activity” in an effort to force them back to an essentially economic role in which lending returns as their core business – displacing recent trends to engage in highly-leveraged speculative plays in the markets.
- TBTF risks would be supervised by the FSOC, but the Fed would be required to ban bank mergers that would create entities with liabilities exceeding 10% of those of the U.S. banking system. The three biggest U.S. banks -- Bank of America, JPMorgan and Wells Fargo -- are today over 10% and could not expand further. The Fed’s emergency lending authority could only be used to help systemically important firms deemed to be still basically solvent.
- Swaps and similar derivatives-trading would, in the Senate bill, have to be separated by banks from their commercial banking and most of the $615 trillion in outstanding derivatives would have to be traded on regulated exchanges or electronic systems in the future. Financial firms with large swaps positions would have to put up more capital. This will be the most contentious issue in reconciling the Senate and House bills: the currently highly-profitable trading activity for banks – in-house derivatives trading – would have to be spun off as separate businesses. This seems likely to be the most contentious issue in the legislative end-game of “reconciliation” for the two houses’ bills because U.S. banks claim that it would damage their global competitive position.
- A Consumer Financial Protection Bureau (CFPB) -- another innovation fiercely opposed by the banks – will be set up. Under the Senate bill, the Bureau would be part of the Fed but have an independent head named by the President and approved by the Senate. It would be given some of the Fed’s existing powers to protect consumers (in doing business with banks and other non-bank financial players). Since the Fed conspicuously failed to use these powers during the housing bubble and financial crisis, this creation of a new agency will be a positive step in trying to ward off recurrent abuses liable to contribute to similar crises in future.
- Hedge funds will be required to register with and report to the SEC. Any hedge fund deemed too large or too risky would be put under Fed supervision.
- The Fed would set standards designed to curtail excessive executive compensation at banks and non-banks.
- The Fed would be authorized to limit fees paid by merchants to debt-card issuers and to ensure that debit and credit card fees are “reasonable and proportional.”
The overall change seems useful. The FSOC will have responsibility for systemic risk, but the Fed will be the principal active regulator and actually have its authority extended. Full implementation of the final bill’s measures will take years, but they will cause fundamental changes in the way U.S. finance functions.
Considering the breadth of these reforms of the U.S. banking and financial sectors, it is remarkable that the Fed’s independence has been so well safeguarded. On that crucial question, the U.S. and the EU seem set to remain in tandem.
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J. Paul Horne is an independent international market economist is based in Europe and the U.S. JPH12Econ@verizon.net