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What Investors Should Know About Financial Reform

The measure is a mixed bag. But new regulations aim to assist investors by adding transparency and preventing sudden panics on Wall Street.

Investors won’t gain much relief from the sweeping financial reform measure signed into law July 21. They will still suffer nasty stock-market selloffs, such as the one that clipped 2.6% off the Dow industrials on June 29. They’ll continue to have to worry about gut-churning accidents, such as the May 6 “flash crash.” And the legislation won’t restrict automated, rapid-fire traders, who often do not know (or care) much about the specific securities they play with.

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The frequency of market cataclysms suggests that the investor-protection system needs more architects and engineers. Instead, the Dodd-Frank Wall Street Reform and Consumer Protection Act mostly adds more cops, lawyers and accountants -- primarily the Treasury Department, Federal Reserve and Securities and Exchange Commission, all of which have far from perfect records. It will take years to judge the new law’s success or failure.

It will also take some time to determine the legislation’s impact on the profitability of banks and other financial-services companies. The bill doesn’t go nearly as far as banks feared it might. Some parts of the reform package are likely to pressure banks’ revenues, but companies will be able to make up for lost income by hiking fees on many financial products. As financial firms release second-quarter earnings reports, investors will be paying close attention to what managements have to say about the impact of reform on their businesses.

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Looking at the big picture, the grandest goal of Dodd-Frank is to prevent panics sparked by the unscripted bankruptcy of big financial firms. The law gives the Treasury and banking regulators power to order the breakup and liquidation (“death panels,” after a fashion) of any troubled bank or bank-like financial outfit whose bankruptcy would ripple through the economy and possibly ignite another credit crisis and stock-market crash. Large, complex firms, such as Citigroup, Bank of America and Goldman Sachs, will be required to submit “funeral plans” for their orderly shutdown. The thought is that by killing sick firms in advance, the government will prevent a repeat of the contagion (or fear of contagion) that exacerbated the 2008 financial crisis and contributed to its spread around the world.

The second investor-protection theme in Dodd-Frank is expanded openness and disclosure. Hedge funds may or may not be vile villains of volatility, but the new law will require them to register with regulators and disclose the assets. Investment firms can still trade derivatives, but the creation of exchanges and clearinghouses will supposedly make these markets more transparent, making it easier to see who’s taking what risks. The Volcker Rule, named after former Fed chairman Paul Volcker, will limit banks’ investments in hedge funds and other private, off-the-books investment ventures. It should be easier to tell a sound bank from one that’s been able to boost its earnings and capital strength (not to mention executives’ pay) with such outside dealings.

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Dodd-Frank also reorganizes the regulatory authorities. Because no existing regulators prevented Bernard Madoff’s multi-billion-dollar swindle or the Bear Stearns and Lehman Brothers meltdowns, you may wonder how the same agencies will do any better in the future. Congress obviously wondered about that as well. So, on the theory that more is better and that regulation is more effective when the regulators talk to one another, Dodd-Frank establishes a Financial Stability Oversight Council. The council will include the Secretary of the Treasury as its leader and 15 other regulators, including the head of the new Consumer Financial Protection Bureau. (For more on the CFPB, see 6 Ways Financial Reform Will Change Your Finances.) The council’s missions include building a warning system to monitor financial companies for possible intervention. The law also lays the groundwork for federal supervision of credit-ratings agencies, insurance companies and, to a lesser degree, municipal-bond issuers.

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Dodd-Frank is 2,300 pages thick, and much of it -- perhaps its most critical parts -- pertains to mortgages and credit. Owners of individual stocks, though, get some rights over corrupt executives and more information about what’s going on at companies. Publicly traded companies will be able to “claw back” bonuses paid to executives if it later turns out that they cooked the books or engaged in other acts of malfeasance. And shareholders will get to vote on executives’ incentive pay and golden parachutes.

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Beyond all this, it’s hard to say what the new law will mean for stock prices. Obviously, you don’t want to invest now or during some future crisis in banks with ultra-low share prices (typically a sign that the company is under stress). And if a large bank gets into trouble, the government will not use taxpayer money to keep the institution afloat. Uncle Sam will let it fail, and shareholders -- perhaps bondholders as well -- are likely to get wiped out.

One piece of unfinished business buried deep in Dodd-Frank is whether the fiduciary standard that applies to investment advisers will also apply to brokers. Under the existing scheme of things, brokers owe their formal allegiance to their employers, while advisers have a fiduciary -- that is, legal -- responsibility to their clients. In a dispute, this distinction can be crucial. The brokerage industry has fought the fiduciary standard bitterly, but the days of brokers acting primarily as salespeople may be numbered. The reform legislation gives the SEC six months to study the situation and authorizes the agency to declare brokers as fiduciaries if it so desires. SEC chairwoman Mary Schapiro is a career regulator who favors the fiduciary system, so there’s good reason to think that by 2011 brokers will be held to a higher standard of behavior.

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