Congress Forging Ahead on Financial Regulatory Reform

New rules will require far more disclosure and reduce the ability to take highly leveraged risks.

By Renuka Rayasam, Associate Editor, The Kiplinger Letter

April 6, 2009

Within a year, there will be tough new financial regulations as Congress and the White House work together to reform securities laws. Until the meltdown, policymakers assumed markets would self-correct. Now they know better, and the G-20 summit pact gives them another reason to get going quickly.

Washington can't prevent future bubbles. But it's determined to be more vigilant. A lot more transparency is a given. It'll help regulators keep watch and use sunlight, a powerful disinfectant, to clean up bad practices and remove bad players from the financial markets. But we don't expect policymakers to revert to old-fashioned rate setting regulations or to bar commercial banks from selling stocks. "I don't think that new regulation will simply be lip service, but we won't be rolling back to an earlier era," says William Isaac, former chairman of the Federal Deposit Insurance Corporation (FDIC) and now chairman of the Secura Group, a financial services consulting firm.

Here's what we see coming in the weeks and months ahead. Regulators will require that there be even more trading of derivatives on exchanges. In addition to currency and interest rate hedges, they'll require the standardization of more exotic contracts, such as credit default swaps and collateralized debt obligations. When standardization isn't possible, regulations will require that parties to the contracts put up more collateral and disclose more about the terms of the contracts.

For Uncle Sam's watchdogs, there'll be some new powers and the merging of old rivals, such as the Office of the Comptroller of the Currency and the Office of Thrift Supervision. To manage systemic risks and to prevent future AIG-like debacles, the Federal Reserve and the FDIC will be given expanded authority over financial activities of firms, regardless of the firms' core business. And there'll be more collaboration between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission, though those agencies won't merge anytime soon.

"I see a broader role for the Federal Reserve and more authority for the FDIC to act preemptively," says Walter J. Mix III, a managing director in LECG's Los Angeles office and former commissioner of the California Department of Financial Institutions.

Pensions will likely be limited to the kinds of high risk investments they can make. And hedge funds and private equity players of a certain size will be required to register with the SEC. The agency will also ask the riskier players to disclose more about their strategies, making it easier for the feds to detect big movements and potential trouble spots developing on Wall Street. "My sense of Congress and policymakers is that they will make meaningful attempts to curb the kinds of issues that came up this time around," says Isaac. "There will be more sound regulation in place for new firms, but they won't kill the goose that lays the golden egg."

Credit rating agencies will be required to be much more open about their decisionmaking processes. But their business models won't drastically change. They'll still be getting their revenues from the firms whose debt they are rating. And on executive compensation, there won't be outright caps, but companies will be required to more clearly report to the SEC the details of pay and bonuses at financial companies. Plus, there'll be closer scrutiny of directors' compensation.

All financial players will be required to have higher capital and liquidity standards. Firms that offer securitized assets will have to hold a bigger percentage on their books so they have skin in the game. And insurance companies will be offered federal charters, despite longstanding resistance from the states.

Together, the changes will bring more market stability but at a steep price: Lending will be costlier with some high risk borrowers cut out, even after recovery begins. And there'll be added operating costs for financial firms to meet new paperwork requirements. Plus, taxpayers will have to foot the bill for paying more regulators to track more financial activities. Robert Litan, a senior fellow at the Brookings Institution think tank and vice president for research and policy at the Kauffman Foundation in Kansas City, Mo., says, "New regulation will make credit more expensive. But leverage was part of the problem."

The whole economy will feel the impact of less profit potential, consonant with fewer risks and less leverage. New regulation will "make things simpler and standardized, more predictable, transparent, stable," says Peter Fisher, a managing director at BlackRock Inc., an asset-management firm, and a former Treasury Department official. "Part of the price of that is that innovation will be slower and the financial sector will shrink."

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