Last week marked an important milestone for banking and financial regulation in the US. The Obama administration has undertaken possibly the most drastic overhaul of the financial regulatory legislation since the Great Depression of 1930’s. Two somewhat dissimilar versions of the Restoring American Stability Act were passed by the House and Senate this past week, and will soon become the new law after reconciliation. A new and comprehensive re-regulation of finance has been anticipated ever since the day Lehman fell and caused an avalanche of financial failures. The existing law as well as the quality of regulation was found wanting, and hence the need to revamp the regulatory framework. The large fiscal response to the crisis was unprecedented, bipartisan and immediate, and hence the reform Bill was expected to be swift and harsh. Early recommendations of elders like Paul Volcker indicated that Congress might seek to severely curtail the scope of activities of the financial sector. The current version, however, stops short of sweeping changes that Wall Street had feared. Thus there is no re-introduction of the Glass Steagall-type separation of investment and commercial banking, nor is there a cap on the size of firms, to prevent the “too big to fail” syndrome. There has been great anger among the American public, that much of the bailout funds went into large corporations that were the perpetrators rather than victims of the financial crisis. The bailout of financial institutions was necessitated partly by the too-big-to-fail syndrome. Any such implicit guarantee of bailout causes moral hazard and excessive risk-taking. The new Act eliminates an explicit bailout possibility by the creation of a resolution agency. Such an agency will step in and attempt an orderly liquidation of large, troubled firms, and prevent those costs from hitting the public treasury. Whether such an orderly liquidation is possible in the face of severe dislocations of the type seen during Lehman is an open question.
The new law has not explicitly limited the scope of activity of financial firms, but there are some restrictions nevertheless. For example, banks will be banned from owning hedge funds. The Volcker rules will apply, prohibiting banks from doing proprietary trading. In fact, trading in derivatives will now have to be done through a separate subsidiary with much more additional capital. Charges on debit cards have been capped. Profits of some large firms will be down by about 15 per cent, thanks to this increased cost of compliance. Hence, on balance this new law is a strange mix, which has managed to give something to both sides — those supporting very active and interventionist regulation, and those opposing drastic, 1930’s-style overhaul. It is doubtful whether the new law will drastically reduce the probability of a Lehman-type disaster, which is after all the purpose of rewriting the law. The actual, detailed rules, to be put in after the final passage of the Bill, might make it even less effective. This Bill is important to the Obama administration as it addresses the financial anxiety of the Main Street and seeks to build confidence in the system. It also rides on the momentum created by the administration’s victory in passage of the bitterly disputed health care reform. By comparison though, the health reform Bill was much more radical and transformative than the Bill to restore financial stability.
