My Take on Financial Reform

The new rules for our financial system are a mixed bag for individual investors.

The Dodd-Frank financial-reform law is designed to stabilize the economy and the financial system. But it's likely to impact individual investors for decades in ways both good and bad.

I approve of the rules that limit and tighten capital ratios for all major financial firms (not just banks), and require the firms to draw up "living wills" that clearly establish the order of claims if they fail. Furthermore, I like the idea of bringing most of the $600-trillion derivatives industry out into the open, where contracts can be traded, priced and monitored by all parties. The lack of clear pricing, for example, allowed American International Group to get by for far too long because regulators didn't recognize how much the insurer was underwater on its credit-default swaps.

The law also establishes a Financial Stability Oversight Council headed by the Treasury secretary. Financial stability should be the Federal Reserve's responsibility, but both Alan Greenspan and the Fed were asleep at the switch while the housing bubble was inflating. They did not think that the housing market qualified as a bubble or that the buildup of poor-quality credit in the banking system was cause for concern.

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The council's task of warning about financial excesses will not be easy. There's a danger that the council could squelch a booming sector of the economy that isn't a bubble at all but instead heralds a breakthrough in technology. Nevertheless, given the Fed's failure to warn of dangers in the last cycle, a second opinion may be useful. Some economists are dismayed that the new law doesn't address the critical issue of "too big to fail." But here I think the law is right. Like it or not, most large international borrowers and lenders are attracted to big-name financial firms. Arbitrary limits on the size of companies would greatly hinder the ability of the U.S. banking industry to establish strong and dominant positions in global markets.

A Mixed Bag

Of lesser importance to financial stability is the creation of the much-ballyhooed Consumer Financial Protection Bureau. Consumer protection was really not an issue in the last crisis and, to be truthful, existing agencies had the power to issue most of the regulations assigned to this new bureau.

Increased regulation of the credit-rating agencies is another mixed blessing. There's no question that Standard & Poor's, Moody's and other rating agencies failed big-time to rate housing-related securities properly, and their overly optimistic ratings clearly contributed to the financial crisis. It's also true that the government had given these firms special status to be arbiters of the quality of debt instruments.

So I welcome the new rules that will strip away the privileges of the agencies and give individuals power to sue the rating firms. But the government could easily go overboard and make it too risky for those firms to assess the quality of assets because of potential litigation.

In a similar vein, the bill gives regulators the power to deem which investments are "appropriate" for individual investors. That could open the door to massive litigation by investors who suffer losses.

Another provision that I'm concerned about is "say on pay" regulations that require extensive shareholder input on executive compensation. Conflicts of interest between management and shareholders have been a fact of corporate existence for centuries. This issue is best resolved not by government regulators but by investors denying fat paychecks to profligate managers.

The vast majority of regulations required by the law are yet to be written. If they become burdensome, they will make our financial sector less competitive. If not, they can contribute to growth and stability. The devil of this law is not only in the details, but also in the regulators who enforce them.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and the author of Stocks for the Long Run and The Future for Investors.

Jeremy J. Siegel
Contributing Columnist, Kiplinger's Personal Finance
Siegel is a professor at the University of Pennsylvania's Wharton School and the author of "Stocks For The Long Run" and "The Future For Investors."