Obama lays down the law to Wall Street

Federal Reserve to police large firms judged a potential risk to the financial system
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The Independent Online

The sweeping overhaul of the way the US regulates its financial markets will hand new powers to the Treasury department and to the Federal Reserve and put major restrictions on the Wall Street firms deemed responsible for the credit crisis.

President Barack Obama unveiled his long-awaited blueprint for reforming financial regulation yesterday, calling it the most significant overhaul since the 1930s and saying it would allow government to properly monitor the global firms whose activities could put the financial system in jeopardy.

There will also be efforts to reshape the way the finance industry conducts business, bringing the credit derivatives market under control and making lenders responsible for the quality of loans they write, instead of palming off all the risk on to others.

For years, the President said, "regulators were charged with seeing the trees, not the forest... a culture of irresponsibility took root from Wall Street to Washington to Main Street."

The most important change is that a top tier of systemically important firms will fall under the regulatory control of the Federal Reserve. They will be forced to hold much higher levels of capital, reducing the likelihood of them failing and pulling interconnected firms with them. If they do teeter, there will be an orderly process for winding them down, based out of the Treasury.

The aim is to avoid a Hobson's choice between risking letting a firm go bust, as the previous administration did with Lehman Brothers last September, and bailing it out, as it did three days later with AIG.

"When this crisis began, crucial decisions about what would happen to some of the world's biggest companies – companies employing tens of thousands of people and holding trillions of dollars in assets – took place in emergency meetings in the middle of the night," said Mr Obama. "We should not be forced to choose between allowing a company to fall into a rapid and chaotic dissolution or to support the company with taxpayer money. That is unacceptable."

Legislation will give the Fed wide discretion to decide what counts as "systemically important", taking into account a firm's size, its links with other institutions and the economic significance of its lending to businesses and consumers. The administration is fearful that if it sets specific measures to define "systemically important", firms will find ways to get round them.

The administration has shied away from some of the more radical structural changes to the regulatory framework that it had once considered, even though officials had often publicly blamed the patchwork of overlapping agencies for contributing to the credit crisis. In fact, there will be more regulatory agencies as a result of the changes, not fewer, since a new consumer protection agency – which will mandate plain English documentation for financial products and regulate product sales – will also be created under the new proposals.

Where once the Federal Reserve had expected to take on responsibility as a systemic regulator, charged with maintaining the stability of the financial system as a whole, that role will be carried out instead by an "oversight council" of all the regulators, chaired by the Treasury secretary.

Even despite the reduced scale of the President's ambitions, he still faces a potentially difficult battle to get his proposals through Congress. Immediately, some lobby groups raised their voices against key planks of the plan.

The US Chamber of Commerce said the proposals on regulating systemically important firms would disadvantage smaller financial companies. "The bigger firms are getting an implicit or explicit guarantee from the government," said David Hirschmann, president of the Chamber's centre for capital markets. "It is premised on the belief that these firms cannot or should not fail. We don't buy the premise."

The rules that will most affect the way Wall Street does business grow directly out of lessons learned from the credit crisis. All banks will be forced to hold more capital and to build up cushions above the regulatory minimum at the top of the business cycle.

There will be big changes to the credit derivatives markets, where loans are parcelled together by the original lenders, sliced and diced by brokers, and then sold on to investors. This process meant the original lenders had little interest in the quality of the loans and contributed to the collapse in lending standards, the subsequent spike in defaults, and the contagion that caused chaos across the credit markets.

When loans are securitised, the originator of the securities should be forced to keep some 5 per cent of them on its own books, under the new rules.

There is also to be reform of money market mutual funds, which are supposed to be among the safest investments available to the public after bank deposits, and which millions of Americans use as if they were bank accounts. It was a crisis of confidence in these funds which threatened to turn the financial crisis into a full-on public panic last September, after larger investors began pulling their money out. The government had to step in to guarantee all the money in all the funds, and now the Obama administration says there must be new rules to make them less susceptible to runs.

Crunching the crisis: How radical are Obama's plans?

Does President Barack Obama's plan live up to its billing?

In terms of the scale of the legislation that will be needed if the President is to enact all his reforms, it is certainly the biggest revamp since the 1930s, but it doesn't do anything nearly as radical to the structure of the country's regulatory agencies as was originally envisaged by the administration.

Why the scaled-down ambitions?

Officials have had to contend with growing concern on Capitol Hill that the Federal Reserve may be becoming too powerful or too close to the Treasury. They have also had to give way in the face of fierce lobbying from competing regulators, who sought to win more power and influence. The mooted merger of the Securities and Exchange Commission, which oversees securities markets, and the Commodity Futures Trading Commission, which oversees derivatives, has been scrapped, for example.

Who are the big winners?

The Fed does become the primary regulator of those "too-big-to-fail" institutions, which can now include firms that aren't even banks. It loses its consumer protection role, however, having spectacularly failed to use it to moderate the excesses in the sub-prime mortgage market. The main winner is the Treasury, which will run the oversight council of regulators charged with identifying systemic risks. It will also have to sign-off on any emergency lending the Fed decides to do in future. And it is making a grab to more closely regulate insurance companies, which currently fall under state laws.

Will Wall Street wear it?

There will be varying degrees of opposition to all the main parts, not least to the creation of the new consumer protection agency, which is already being described by critics as an unnecessary layer of red tape. More importantly, there will be almighty fights to come over the details.

Will it really change Wall Street?

Those details are arguably more important than the framework outlined yesterday. Exactly what requirements will be set on bankers' bonuses, for example, is still vague. The operation of the credit derivatives market, which the administration wants to force on to regulated exchanges, is still to be hashed out. And bankers are already saying the requirement that loan originators hold 5 per cent of the risk of their loans might be unworkable.

In the end, bankers see regulations as rules to be got round with clever new products. Even President Obama is not proposing mandatory personality transplants.