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Congressional Overhaul Maps the Future of Financial Regulation

July 15, 2010

The regulatory overhaul Congress sent today to President Barack Obama will prompt federal agencies to rewrite rules for how financial companies conduct business with each other, with other industries and with consumers.

The bill’s provisions include new oversight of the over-the-counter derivatives market, a ban on proprietary trading by banks and creation of a new consumer financial protection bureau to oversee mortgage and credit-card lenders.

In coming months, regulators will use the broad outlines in the legislation to conduct dozens of studies and create hundreds of new rules. It may take a decade, or more, to fully impose some measures.

What follows is a summary of the scope, impacts and impetus for some major sections of the bill:

‘Volcker Rule’

The Obama administration’s proposal to ban banks from proprietary trading, nicknamed the Volcker rule after former Federal Reserve Chairman Paul Volcker, was softened by congressional negotiators.

Under a measure that may not take full effect for as long as a dozen years, banks can invest in private-equity and hedge funds, though they will be limited to providing no more than 3 percent of the fund’s capital. Banks also can’t invest more than 3 percent of their Tier 1 capital. The change alters language in a bill the Senate approved in May, which would have barred banks from sponsoring or investing in private-equity and hedge funds.

The legislation defines proprietary trading as engaging as a principal for a trading account of a bank or non-bank financial company supervised by the Fed “in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative or contract, or any other security or financial instrument” that regulators designate through rule-writing.

Negotiators also agreed to give regulators less say than previously proposed to define a ban on proprietary trading. Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, backed a change offered by Democratic Senators Jeff Merkley of Oregon and Carl Levin of Michigan that “more clearly defines the limits on proprietary trading” by writing the ban into the legislation. The earlier Senate bill would have let regulators write it.

The ban on propriety trading, in which a company bets its own money, may reduce profits. Goldman Sachs Group Inc. (GS:US), the most profitable firm in Wall Street history, has said proprietary trading generates about 10 percent of its annual revenue. The firm made $1.17 billion in 2009 from “principal investments,” which include stakes in companies and real estate, according to a company filing.

Dodd backed a Merkley-Levin plan to prevent firms that underwrite an asset-backed security from transactions that would result in a conflict of interest.

The conflict-of-interest provision seeks to address fraudulent conduct alleged in a Securities and Exchange Commission lawsuit against Goldman Sachs. The SEC claims the bank created and sold collateralized debt obligations linked to subprime mortgages without disclosing that hedge fund Paulson & Co. helped pick the underlying securities and bet against the vehicles. Goldman Sachs has denied wrongdoing.


After spending months crafting legislation, lawmakers reached a deal on what they termed the most challenging part of their task -- establishing for the first time a regulatory structure for the $615 trillion over-the-counter derivatives market.

The most contentious part of the derivatives rules is a provision that will force banks to push some of their swaps-trading into subsidiaries, on the theory it would reduce taxpayers’ risk if the trades are walled off from depositary institutions that enjoy federal benefits such as access to the Federal Reserve’s discount lending window.

The original proposal by Senator Blanche Lincoln, an Arkansas Democrat who is chairman of the Senate Agriculture Committee, would have banned all swaps-trading by commercial banks. It touched off intense lobbying from opponents including the banking industry, banking regulators, the Obama administration and lawmakers of both parties who said the proposal could drive up costs for businesses and send business to foreign lenders.

In the end, parties agreed that banks will be able to maintain their trading operations so long as they are used to hedge risk or trade interest rate or foreign exchange swaps, a victory for banks that were on the verge of losing the desks entirely. The proposal will force a fundamental shift in the industry, giving federally insured banks up to two years to send instruments such as un-cleared credit default swaps off to a separately capitalized subsidiary.

Derivatives took a central role in the debate over Wall Street regulation after losing bets on swaps tied to mortgage-backed securities pushed New York-based insurer American International Group Inc. (AIG:US) to the brink of bankruptcy in 2008. Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather.

Beyond the swaps-desk provision, the Senate legislation will push most over-the-counter derivatives through third-party clearinghouses and onto regulated exchanges or similar electronic systems, a measure that will make it easier for the market and regulators to track the trades. It will mean higher margin costs on some transactions.

Regulators also will be required to impose heightened capital requirements on companies with large swaps positions, and would be given the authority to limit the number of contracts a single trader can hold.

Businesses that use derivatives to hedge risk from producing or consuming commodities, deemed “end users,” will be exempt from the clearing requirements if the activities were being undertaken as a way to hedge legitimate business risk.

Selling over-the-counter derivatives is among the most lucrative businesses for the largest financial companies. U.S. commercial banks held derivatives with a notional value of $212.8 trillion in the fourth quarter, according to the Office of the Comptroller of the Currency. JPMorgan Chase & Co., (JPM:US)Citigroup (C:US) Inc., Bank of America Corp (BAC:US)., Goldman Sachs and Morgan Stanley (MS:US) hold 97 percent of that total.

Consumer Bureau

A consumer financial-protection bureau will be created at the Federal Reserve to police banks and financial-services businesses for credit-card and mortgage-lending abuses. The plan was approved over the objections of Republicans and the financial industry.

Obama originally proposed a stand-alone consumer agency, saying it would play a central role in reorganizing regulation to prevent future financial crises.

While the bureau will be housed at the Fed, it will have independent authority. Led by a director appointed by the president and confirmed by the Senate, the bureau will write consumer-protection rules for banks and other firms that offer financial services or products. It will enforce those rules for banks and credit unions with more than $10 billion in assets. Bank regulators will continue examining consumer practices at smaller financial institutions.

The bureau could require credit-card lenders, including JPMorgan and Citigroup, to reduce interest rates and fees. Mortgage lenders, including Bank of America (BAC:US), may be subject to tougher rules including more upfront disclosures to borrowers about loan terms.

Automobile dealers won an exemption from oversight by the bureau after lobbying from the industry. Dealers said the rules would place unnecessary restrictions on their financing business. The Obama administration had opposed the exemption.

The idea for a new agency grew out of criticism from lawmakers and consumer groups that bank regulators, including the Fed, failed to properly exercise their consumer-protection authority during the housing boom. The consumer bureau will assume much of that oversight. The bureau’s rules could be overridden by the new Financial Stability Oversight Council if the panel decided that they threatened the safety, soundness or stability of the U.S. financial system.

The financial-services industry lobbied against the new bureau, saying it would raise costs, limit choice, and improperly separate oversight of consumer issues and safety and soundness.

Credit, Debit Cards

The Federal Reserve will get authority to limit interchange, or “swipe” fees, that merchants pay for each debit-card transaction. The measure, pushed by Senator Richard Durbin, lets retailers refuse credit cards for purchases under $10 and offer discounts based on the form of payment.

The measure also directs the Fed to issue rules that let merchants route debit-card transactions on more than one network. That “provides additional competition to a previously non-competitive part of the market,” Durbin, an Illinois Democrat, said June 21.

Visa Inc. (V:US) and MasterCard Inc. (MA:US), the world’s biggest payments networks, set interchange rates and pass that money to card-issuers including Bank of America (BAC:US) and JPMorgan. Interchange is the largest component of the fees U.S. merchants pay to accept Visa and MasterCard debit cards. The fees totaled $19.7 billion and averaged 1.63 percent of each sale last year, according to the Nilson Report, an industry newsletter.

The industry fought off earlier efforts to regulate interchange fees, including a Durbin-sponsored bill that remains in committee, by saying the income is needed to offset the risk of lending money. That argument doesn’t apply to interchange on debit cards, which tap funds in consumer checking accounts. Shifting the focus to debit cards may have helped win support from some Republicans, with Senator Susan Collins of Maine calling the scaled-down version a “reasonable approach.”

The amendment directs the Fed to ensure that debit-swipe fees are “reasonable and proportional” to the cost of processing transactions. The provision will take effect a year after enactment.

Durbin altered his proposal to exempt lenders with assets of less than $10 billion, or 99 percent of U.S. banks. That failed to win the support of trade groups representing community banks and credit unions, who said the measure will make their cards more expensive than those issued by bigger lenders. -- Peter Eichenbaum

Oversight Council

The bill will establish the Financial Stability Oversight Council, a super-regulator that will monitor Wall Street’s largest firms and other market participants to spot and respond to emerging systemic risks. The Treasury Department will lead the panel, which includes regulators from other agencies.

“The idea of the council is to look at the interconnection of highly leveraged financial firms,” said Jim Hamilton, a senior law analyst at Riverwoods, Illinois-based CCH Inc., which provides information to businesses about regulatory changes. “No one was able to do that before the financial crisis.”

With a two-thirds vote, the council can impose higher capital requirements on lenders or place broker-dealers and hedge funds under the authority of the Fed. The council also will have authority to force companies to divest holdings if their structure poses a “grave threat” to U.S. financial stability.

The nine-member council will include regulators from the Fed, SEC, Federal Housing Finance Agency, Commodity Futures Trading Commission and other agencies. State securities, insurance and banking regulators and credit unions lobbied for and won non-voting seats.

The Federal Home Loan Banks system, a financing co-operative for mortgage lenders, also won an exemption from council oversight after saying limits on credit concentration could cut its lending capacity in half.

Trade groups including the American Bankers Association supported the measure. Consumer groups including the Center for Responsible Lending objected to the council’s power to overrule the consumer financial-protection bureau at the Fed. --Lorraine Woellert

Bank Capital Rules

The bill may force some banks to shore up capital. An amendment introduced by Senator Susan Collins, the Maine Republican who joined Democrats in voting for the broader bill, will bar bank holding companies from keeping less capital than their bank subsidiaries. That will have an impact on the use of trust preferred securities, known as TruPS. Lawmakers bowed to pressure from banks, agreeing to a transition period for large firms and grandfathering of the securities for smaller lenders.

Banks with assets of at least $15 billion will get five years to replace TruPS with common stock or other securities that count as capital. Community banks that have raised cash through TruPS since 2000 will, in effect, get 20 years to make the switch because most of the securities have 30-year maturities. Smaller lenders sold roughly $45 billion of the $150 billion in TruPS issued by U.S. banks, which packaged them into collateralized debt obligations.

TruPS now count toward equity when calculating capital ratios -- a bank’s cushion against losses -- while being treated like bonds for tax purposes.

Regional banks such as McLean, Virginia-based Capital One Financial Corp. (COF:US) and Buffalo, New York-based M&T Bank Corp. (MTB:US), which rely heavily on TruPS, will be hurt most, according to Richard Bove, an analyst for Rochdale Securities. Banks unable to replace the TruPS will have to shrink their balance sheets to stay within the minimum capital rules dictated by regulators.

“It will disadvantage not just U.S. banks, but U.S. businesses and consumers as well,” Barclays Plc (BARC) President Robert Diamond said in Washington before the rule was completed. Removing the TruPS held as capital could restrict lending by as much as $1.5 trillion, Diamond said, echoing a point made by bank lobbying groups.

The Collins language also will require the U.S. holding companies of overseas banks, such as Barclays, to comply with the same capital rules as domestic lenders. For now, they’re exempt as long as their foreign parents are regulated by an entity recognized by the U.S.

The FDIC backed the Collins amendment, saying TruPS don’t provide the cushion they were meant to. Banks couldn’t use them as capital during the crisis because deferring dividends would have been seen as a sign of weakness, the FDIC has said. The regulator challenged Diamond’s analysis as being too simplistic. It assumes banks lend $10 to consumers and companies for every dollar of capital they get, ignoring the complicated instruments such as collateralized debt obligations that they invested in during the boom years, FDIC Chairman Sheila C. Bair said.

“This analysis ignores the ample transition period given the industry to replace TruPS with true equity capital,” Bair said last month. “Because of the demands of the market, most bank holding companies have already built capital cushions well above regulatory minimums even without TruPS. The Collins amendment will strengthen, not weaken, the capacity of the banking system to lend.”

Moody’s Investors Service said in a report last month that the rule will have “minimal, if any” impact on banks’ ratings because TruPS are already being disqualified as capital by analysts. --Yalman Onaran

Federal Reserve

The Federal Reserve will have a broadened supervisory scope and be subject to the most transparency in its 96-year history after negotiators rejected threats to its political autonomy and bank-oversight powers.

Chairman Ben S. Bernanke will have a seat on a newly created Financial Stability Oversight Council. That board will deputize the Fed to set tougher standards for disclosure, capital and liquidity. The rules will apply to banks as well as non-bank financial companies, such as insurers, that pose risks to the economic system.

Earlier drafts of Senate legislation would have curtailed the Fed’s bank supervision. Lawmakers approved an amendment by senators Kay Bailey Hutchison, a Texas Republican, and Amy Klobuchar, a Minnesota Democrat, maintaining the powers. That avoided a clash with House members over the issue. Under the bill, the Fed will keep supervising larger banks including Bank of America (BAC:US) and Goldman Sachs and smaller firms such as Central Virginia Bankshares Inc.

U.S. central bankers face a one-time audit of emergency loans and other actions taken to combat the financial crisis since 2007. Under another change, the Fed, after a two-year delay, will have to identify firms that borrow through its discount window and participate in its purchases or sales of assets such as mortgage-backed securities.

Senators and House members voted down a tougher audit measure, which would have removed the Fed’s 1978 shield from examinations of interest-rate decisions. That plan, previously approved by the House, was opposed by Bernanke and other Fed officials as a step that might politicize monetary policy.

Central bank governance will also change. Commercial banks will be ineligible to participate in selecting all 12 regional Fed chiefs, leaving the task to non-bankers chosen by lenders and the Fed’s Board of Governors. One of the seven Fed governors will be a second vice chairman in charge of supervision. Conferees rejected a Senate plan to make the New York Fed president a political appointee. --Scott Lanman

Credit Raters

Ratings companies, including Moody’s Corp. (MCO:US) and the Standard & Poor’s unit of McGraw-Hill Cos., may avoid a plan to have regulators help pick which firms grade asset-backed securities. Congress also softened a proposed liability provision, making it harder for investors to sue credit raters than under language approved by the House in December.

The overhaul legislation requires the SEC to conduct a two-year study on whether to create a board to decide who rates asset-backed securities. That curbed a Senate proposal to establish the board with SEC oversight. After the study, the board would be established only if regulators can’t come up with a better alternative.

Profits grew at Moody’s and S&P, both based in New York, during the U.S. housing boom because Wall Street paid them to assess the creditworthiness of mortgages packaged into bonds. After the housing market collapsed in 2007, pension funds and banks that lost money on the securities blamed credit-rating companies for assigning the assets their highest AAA rankings.

Lawmakers also adopted language that redefines what investors must show to prevent a judge from dismissing a lawsuit against a credit rater. Litigation may proceed if investors demonstrate a company “knowingly or recklessly” failed to conduct a “reasonable” investigation before issuing a rating. The ratings firm could also avoid being sued by hiring an independent company to do the investigation.

Legislation approved by the House in December would have required investors meet a lower threshold of evidence, showing that a rating company was “grossly negligent” in issuing a grade. Current law requires investors to demonstrate they were intentionally misled. --Jesse Westbrook

Private Equity

Large private-equity and hedge funds will be forced to register with the SEC, subjecting them to mandatory federal oversight for the first time. Venture-capital funds were exempted from the registration rule.

Hedge funds, in particular, pushed for the registration requirement, which is less burdensome than regulations being imposed on banks. In lobbying Congress, representatives of hedge funds said the private pools of capital shouldn’t be heavily regulated because they didn’t cause the financial crisis and didn’t need to be bailed out by taxpayers.

Registration subjects funds to periodic inspections by SEC examiners. Any firm with $150 million or more in assets, such as ESL Investments Inc. and Soros Fund Management, will be covered by the law. Funds also must hire chief compliance officers and establish policies to avoid conflicts of interest.

Private-equity and hedge funds will be required to report information to the SEC about their trades and portfolios that is “necessary for the purpose of assessing systemic risk posed by a private fund.” The confidential data could be shared with the new Financial Stability Oversight Council.

Complying with registration rules may cost hedge funds as much as $500 million in the first year, said Judith Gross, founder of JG Advisory Services LLC, a New York-based consulting firm to the hedge-fund industry. The estimate is based on 2,000 new registrants and reflects the cost of implementing necessary compliance procedures.

Should the government determine a fund has grown too large or is too risky, it would be placed under Fed supervision.

Restrictions on banks’ ability to own private-equity and hedge funds and trade for their own accounts may benefit the funds that are subject to less regulation. The bill could push new investment and trading talent toward the industry. Limits on leverage and stiffer capital requirements for banks may also give private-equity and hedge funds an edge landing investors chasing bigger returns. --Robert Schmidt

Unwinding Failing Firms

The bill gives the FDIC, which already has authority to liquidate failed commercial banks, power to unwind large failing financial firms whose collapse would roil the economy.

Regulators will have clout they lacked during the financial crisis when, instead of seizing flailing companies such as AIG, the government kept them afloat with a $700 billion taxpayer-funded bailout. Had such authority existed in September 2008, it might have been applied to Lehman Brothers Holdings Inc., whose bankruptcy that month froze credit markets and helped spur Congress to approve bailouts under the Troubled Asset Relief Program.

The House approved a version of the bill in December that proposed a $150 billion fund, to be paid for by the financial industry, to cover the government’s cost of unwinding failing firms. Dodd proposed a similar fund of $50 billion in a Senate version of the bill, which was assailed by Republicans as a perpetual bailout of Wall Street firms. The protests stalled consideration of the legislation on the Senate floor.

Dodd agreed to drop the fund to allow debate on the bill to begin. Under the revised measure, the costs of unwinding failing firms will be borne by the financial industry through fees imposed after a firm collapses. The bill explicitly bars the use of taxpayer funds to rescue failing financial companies.

Risk Retention

The legislation will force lenders to hold at least a 5 percent stake in debt they package or sell. The provision is designed to rein in the trade of easy credit blamed for fueling the financial crisis.

The rule will affect credit-card debt, auto loans, mortgages and other securitized debt. Issuers of asset-backed debt and the originators who supply them with pools of loans, including credit-card companies such as Riverwoods, Illinois-based Discover Financial Services (DFS:US), will be forced to retain some of the credit risk. The goal is to align the issuers’ interests with those of the investors who buy their financial products.

Lawmakers exempted lower-risk mortgages from the rules after lobbying by brokers and community banks, who said forcing lenders such as Bank of America (BAC:US) to keep safer loans on their books would tie up capital and lead to higher interest rates.

To be exempted, a mortgage must be “qualified,” a term that will be defined by regulators. Loans with features that increase risk, such as those with balloon payments or certain adjustable rates, may not qualify.

Loans guaranteed by the Federal Housing Administration, Department of Agriculture and Department of Veterans Affairs also will be exempt from retaining risk. The three agencies last year guaranteed more than 30 percent of new mortgages as private capital fled the market after the collapse of the housing bubble.

Sellers of commercial mortgage-backed securities won language giving regulators flexibility to tailor risk-retention rules to specific products. For example, regulators could set underwriting standards as a form of risk retention. --Lorraine Woellert

Fiduciary Duty

Lawmakers scrapped a proposal that would have made securities firms more accountable to individual investors. Instead, the SEC is required to study whether changes are necessary.

The debate focused on whether stock brokers who offer clients investment advice should have a fiduciary duty that requires disclosure of all conflicts and restricts marketing to products that are in customers’ best interest. Currently, brokers must only ensure that a stock or bond is suitable before selling it to a client.

Consumer advocates have said the fiduciary obligation is needed because investors are sold products they don’t understand or can be confused by titles used by financial advisers. Banks and insurance companies lobbied against the change, saying people selling securities shouldn’t be regulated the same way as professionals who invest money for clients.

The House-Senate panel agreed to let the SEC impose a fiduciary duty on brokers once the regulator completes a six-month study. House lawmakers had earlier proposed implementing stiffer rules without an SEC review, prompting opposition led by Senator Tim Johnson, a South Dakota Democrat. --Jesse Westbrook

Insurance Industry

The bill creates a new Federal Insurance Office within the Treasury Department to monitor insurers for systemic risk to the economy. Industry groups say a new layer of oversight may complicate compliance and increase costs.

The measure was prompted by the near-collapse of AIG in 2008. The insurer, then the world’s largest, got $182.3 billion taxpayer bailout funds after failing to set aside enough money to cover obligations on credit-default swaps (AIG:US) linked to subprime mortgages.

Insurers, which are mainly regulated by states, will now deal with a national watchdog. State insurance commissioners have expressed concern that federal oversight will interfere with rules already in place. Insurers say they will have to devote more resources to answer to multiple officials.

A national regulator may coordinate agreements with counterparts in other countries. --Sarah Frier

To contact the editor responsible for this story: Lawrence Roberts at

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