Ever since the credit markets began seizing up in the late summer of 2007, the federal government has worked franticly to prevent a full-scale financial meltdown. The Fed has slashed its benchmark interest rate to as low as zero percent and has welcomed dodgy assets onto its balance sheet. The Treasury Department, meanwhile, has taken the once-unthinkable step of buying large ownership stakes in some of the nation's biggest banks. But now, as the financial system begins to stabilize, President Barack Obama faces a second—but equally imposing—task: preventing the next banking crisis from ever occurring. To that end, the administration has pledged to overhaul the nation's outdated financial regulatory structure, which has been blamed for failing to prevent the reckless risk-taking that helped trigger the whole mess.
"It is an indisputable fact that one of the most significant contributors to our economic downturn was a unraveling of major financial institutions and the lack of adequate regulatory structures to prevent abuse and excess," Obama said Wednesday, as he unveiled his much-anticipated blueprint for regulatory reform. "A regulatory regime basically crafted in the wake of a 20th century economic crisis—the Great Depression—was overwhelmed by the speed, scope, and sophistication of a 21st century global economy."
Here are seven things you need to know about the administration's plan to reform financial regulation:
1. Policing financial giants: In recent years, our regulatory structure has failed to adequately supervise the huge, interconnected financial institutions (think AIG) that operate in our banking system. As we have learned, problems at such firms can send ripples through the financial ecosystem and hammer the entire economy. Obama's regulatory plan would give the Federal Reserve expanded powers to regulate these systemically-important companies, subjecting them to higher capital levels and tougher risk management mandates. The plan would also create a process to safely unwind these firms during periods of financial crisis.
2. Filling the gaps: Instead of a single, consolidated system, the current financial regulatory structure is made of up a handful of distinct agencies. Critics say this structure is vulnerable because it allows firms to slip through the regulatory gaps that exist between different agencies. To address this, the plan calls for the creation of a Financial Services Oversight Council—made up of top regulators from key agencies—to identify emerging risks, point out regulatory gaps, and facilitate better communication within different parts of the government. The administration's plan would also eliminate the federal thrift charter—and therefore the agency that regulates thrifts—while requiring advisors to hedge funds and private equity firms to register with the Securities and Exchange Commission. In addition, the administration will conduct a thorough review of the current capital requirements for all banks.
3. Consumer protection: Inadequate consumer protections regarding exotic mortgage products, such as subprime loans, also contributed to the financial crisis, the administration contends. To protect consumers using financial products and services going forward, the plan calls for the creation of a new agency. The agency, which could use fines and penalties to enforce compliance, is designed to help consumers better understand the consequences of their financial choices, ensure that they have access to less-risky loan products, and put alternative financial products under closer scrutiny.
4. Secure securitization: A number of the problems that triggered the financial collapse occurred outside of the traditional banking system, in the less-regulated securitization market—where assets are bundled into securities and sold off to investors. Obama's plan would bring this market into to government's reach by requiring that complex financial instruments, such as credit default swaps and other "over the counter" derivatives, be traded on transparent exchanges. In addition, firms that originate securitized loans will be required to keep some skin in the game by retaining 5 percent of the credit risk after it is sold.
5. Political considerations: While Obama's plan is sweeping, it's not the "overhaul" some had hoped for. Although it gives regulators new powers, it preserves the patchwork of federal regulators that some blame for getting us into this mess in the first place. But scrapping the entire regulatory system and starting from scratch would have faced furious opposition from lawmakers and industry trade groups. By choosing the more modest approach of updating the existing framework, the administration is hoping to get its most essential ideas enacted into law—even if that means compromising in other areas.
6. Potential Snags: That's not to say passage will be easy, as opposition to portions of the plan is already mounting. The U.S. Chamber of Commerce issued a statement Wednesday saying it was "disappointed" with the plan. "While the Administration has made several positive recommendations, we're concerned that overall, the proposal simply adds to the layering of the system without addressing the underlying and fundamental problems," David Hirschmann, president and chief executive of the Chamber's Center for Capital Markets. "We can't simply insert new regulatory agencies and hope that we've covered our bases." Specifically, the trade group says it doesn't support the consumer protection agency "that cannibalizes regulatory expertise and ads yet another regulatory layer." It also doesn't back a systemic risk regulator "that duplicates existing regulation or permanently designates specific financial institutions as systemically significant, thereby designating them too big to fail."
Expanding the powers of the Federal Reserve could also stir stiff opposition as well. In a statement Tuesday, John Taylor, the president and CEO of the National Community Reinvestment Coalition, said broadening the Fed's authority needs to be done cautiously. "The regulatory failure of the Federal Reserve was the most significant of all the agencies," he said. "They had the power to regulate unfair and deceptive practices, and with that power wipe away much of the reckless and irresponsible lending that led to the subprime crisis, but they chose not to do so for years."
7. Congressional Outlook: A plan as sweeping as this is bound to be tweaked and altered as it makes its way through Congress. House Financial Services Committee Chairman Barney Frank, a Democrat from Massachusetts, said the legislation will be ready for the president's signature by year-end, Bloomberg reports. In light of the already-packed legislative calendar—the administration, after all, is trying to overhaul America's health care system as well—that's an ambitious time frame. But it's not impossible.
The House of Representatives is expected to pass the measure before the August recess, and the Senate—where the bill will face a tougher road—should take it up in the fall. Should the President emerge victorious from his battle over health care, he just might have enough juice to push regulatory reform through Congress by yearend too. "This is an enormous undertaking, and I am glad we have President Obama and his team to lead the effort," Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, said in a statement Wednesday.