Reed Smith Client Alerts


Regulation of Financial Institutions Moving Quickly

The next few weeks are make-or-break for the Obama administration and Congressional Democrats as they consider separate and often competing proposals on the regulation of financial institutions. The House of Representatives last year passed its own version of legislation, H.R. 4173, the "Wall Street Reform and Consumer Protection Act of 2009," sponsored by the Chairman of the House Financial Services Committee, Rep. Barney Frank (D-Mass.-4) ("H.R. 4173"). This legislation would create a "Financial Stability Council" to identify those at-risk financial institutions whose failure would most likely hurt the nation's financial system; and it also establishes a process for dismantling those institutions without the need for taxpayer funds. In addition, it would create a Consumer Financial Protection Agency to protect consumers against unfair financial practices.

Over in the Senate, Sen. Christopher Dodd (D-Conn.), the Chairman of the Banking, Housing and Urban Affairs Committee, is working on his second proposal (the first effort last year having been withdrawn) and has held talks on this with both the Ranking Member of the Committee, Sen. Richard Shelby (R-Ala.), and another member of the committee, Sen. Bob Corker (R-Tenn.). While a full draft of Sen. Dodd's bill has not yet been made public, elements are being released for Senate comment, as Sen. Dodd attempts to produce a bipartisan bill. Finally, the Obama administration has upped the ante by recently proposing restrictions on (1) bank size and (2) the ability of banks to buy and sell financial instruments with their own funds, not their customers', customarily referred to as "proprietary trading."

Timing for Possible Action

The window for getting a bill passed by both Houses of Congress and to the president's desk is quickly closing. Congress has only a few months to consider the huge issues pending before it on health care, the economy, and financial regulation before it adjourns for the summer. We do not see any significant legislative activity occurring in the fall as members head home to campaign in the midterm congressional elections. So what happens next is pivotal to the success of the proposed reforms. This Client Alert provides (1) a discussion of some of the key issues in the regulatory reform proposals being debated between Congress and the Executive Branch and within Congress itself, and (2) suggested possible affirmative steps that might be taken to influence that process.

Key Questions Being Considered in Financial Regulation Proposals Before Congress and from the Obama Administration

What's the best way to protect the public from risky financial products and services?

Both the Obama administration and the House bill drafted by Financial Services Chairman Frank support the creation of a stand-alone consumer agency, called the "Consumer Financial Protection Agency," to regulate all consumer loan products as a way to protect against some of the most notable problems in the financial system, including, for example, the sale of "subprime" mortgages and the marketing of credit cards to those who could not afford them. Those who criticize this proposal, including the United States Chamber of Commerce and many congressional Republicans, cite this approach as creating needless additional government bureaucracy that will only add to the burdens that small businesses and community banks face when they decide to extend credit or offer a loan.

Senate Banking Chairman Dodd's proposal will play a large role in determining what is included in a final version of the legislation, as he must write a bill that can gain the support of 60 senators. We note that last week, Sen. Dodd released a proposal to rename the Consumer Financial Protection Agency as the "Bureau of Financial Protection" and to place it within the Federal Reserve. The head of the Bureau would be appointed by the president. Other elements currently being considered for inclusion are: (1) giving the Bureau regulatory authority over banks and the power to examine and enforce rules on large banks and mortgage companies, and (2) allowing it to raise its own funds through assessments on financial institutions. However, Dodd's legislation appears to be a compromise aimed at addressing Republican concerns about giving the government too much power over banks, and also addressing their safety and soundness concerns. He tries to address their issues by placing the new regulatory authority under the Federal Reserve but not as its own separate agency. He also gives banks the opportunity to appeal any rule issued by the Bureau to a "Council of Regulators." The Council could override any decision of the Bureau if it hurts the stability of the nation's financial system. Reports in the press indicate that Republicans in the Senate, including Sen. Shelby, are working with Sen. Dodd on this compromise, and we note that the elements of this measure can and likely will change over the next few days.

What's the best way to address "systemic risk," i.e., when the collapse of a financial institution impacts the entire financial system?

The failure of a number of and major investment banks in 2008 and the impact this had on the nation's economy has caused members of Congress and the Obama administration to support measures to address systemic risk. However, as with everything, the devil is in the detail. The House-passed bill, H.R. 4173, includes, as previously noted, language creating a "Financial Stability Council" to identify those at-risk financial institutions whose failure would most likely damage the nation's financial system; it also establishes a process for dismantling those institutions without requiring taxpayer funds. A number of agencies involved in financial regulations, including the Federal Reserve, Federal Deposit Insurance Corporation, and the Securities and Exchange Commission ("SEC"), would be represented on the Council. The Treasury Department would head the Council and the Federal Reserve would have enforcement powers. The Obama administration, on the other hand, would give the Federal Reserve more power as the systemic risk regulator, something that is strongly opposed by many members of Congress who view it as a root cause of the systemic problems that have developed. Both the Obama administration and the House-passed bill would also institute higher capital requirements and an obligation to contribute to a bailout fund.

Again, the Dodd proposal will go a long way in determining what measures will reach the president. No elements of Sen. Dodd's approach, however, have yet been released.

Separately, the Obama administration has recently proposed efforts to regulate banks directly, by (1) limiting their size, (2) limiting their ability to engage in proprietary trading of financial securities, including subprime mortgages, and (3) severing their ties to hedge funds and private equity funds. These proposals are clearly in response to the public's anger at the financial industry and go beyond the act of creating a regulatory agency to oversee lending. Whether they are ultimately included in the Dodd bill or are simply a bargaining ploy to get banks to agree to a compromise remains to be seen.

How should trading in derivatives be regulated?

The trading of over-the-counter derivatives would, under H.R. 4173, be regulated for the first time. Derivatives are financial contracts promising a payment based on the performance of an asset such as a security, the change in an interest rate index, or the default of a company. Under H.R. 4173, all standardized transactions between dealers and other larger market participants would have to be cleared and traded on an exchange or electronic platform. Clearing organizations would have to seek approval from either the Commodity Futures Trading Commission ("CFTC") or the SEC before a derivative or class of derivatives can be accepted for clearing. H.R. 4173 divides jurisdiction over derivatives between the SEC and the CFTC. The SEC oversees activity in derivatives that are based on securities like equity and credit-default swaps. The CFTC is responsible for all other derivatives—including those based on interest rates and currencies.

This approach is supported by the Obama administration but has not yet been addressed in the Senate.

Some Actions to be Considered

While much has been written about the level of partisan gridlock in Washington, the continuing anger coming from the public and directed at Wall Street still gives financial reform legislation one of the best chances of reaching the president's desk before the 111th Congress adjourns at the end of 2010. Reed Smith The Public Policy & Infrastructure Practice Group, co-chaired by Christopher L. Rissetto, has experience working successfully with congressional staff members on financial regulatory and other legislative issues. Potentially adversely affected parties should be aware that a number of steps remain available to develop an effective lobbying strategy. Such steps include meetings with key Republican and Democratic staff members in both the legislative and executive branches, and possible participation in providing comments and testimony, among other key steps. Bringing to bear client viewpoints can affect the outcome of legislative direction, so development of a legislative strategy should be a necessary step for financial institutions to consider. Please feel free to conatct any of the following Reed Smith attorneys for additional information.