Will the Financial Reform Bill Really Rein In Wall Street?

The Senate on Thursday approved an extensive financial reform bill that would give Washington broad new powers over Wall Street. However, there's still a question over whether the bill will really be able to rein in Wall Street, or if it will simply become another broken barrier tripping up the free market.

The legislation is the most drastic since post-Great Depression bank reform and was approved by a 59-39 vote. It's also being seen as a victory for the Obama administration, which has vowed to toughen up on Wall Street practices since the collapse of the housing market sent the financial sector into a tailspin.

The bill will be reconciled with legislation that was passed by the House of Representatives in December 2009 before it can be signed into law by President Barack Obama - something that could happen by July 4. 

The Senate bill's key points include stricter regulation of the derivatives market, prevention of costly bailouts, and more responsibility for the U.S. Federal Reserve in consumer protection and firm supervision.

"When this bill becomes law, the joyride on Wall Street will come to a screeching halt," said Senate Majority Leader Harry Reid, D-NV. "It's a choice between learning from the mistakes of the past or letting it happen again. For those who wanted to protect Wall Street, it didn't work."

The new derivatives policies are the most hotly contested by Wall Street lobbyists. A provision by Sen. Blanche L. Lincoln, D-AR, forces big banks to spin off their derivative trading arms into separate subsidiaries - but the likelihood of that provision being approved in the final version has been questioned by analysts.

The bill attempts to increase transparency in the controversial $450 trillion derivatives market, which includes credit default swaps that are largely blamed for 2008's large bank losses. It establishes a "financial stability oversight council" to create rules on derivatives trading. Derivatives would be traded on a public exchange and cleared through a third party.

The new oversight council would also monitor financial system risk factors to prevent the formation of asset bubbles and "too big to fail" institutions.

To prevent future billion-dollar bailouts that have generated taxpayer criticism since the housing market collapse, the bill outlines procedures for the government to seize and liquidate a failing institution.

The Federal Reserve will get a significant increase in power with the responsibility of a consumer protection division to create and enforce rules that curb abusive lending practices. The Fed also will be allowed to impose restrictions on companies taking on too much risk. 

Notable Differences to Reconcile

The reconciliation process should start within a few days and will have to settle over a dozen differences, although both the Senate and House versions provide for a significant increase in government regulation.

One of the biggest differences is a $150 billion fund created under the House bill to handle failing institutions instead of using taxpayer money to do so. Financing for the fund would come from mandatory fees charged to large banks. Opponents see the fund as too tempting for regulators to use to "prop up" troubled banks. The Senate instead wants to wait until after a firm is liquidated and then impose a levy on large financial companies to pay for the other company's collapse. 

The House bill would give less power to the Federal Reserve by charging the oversight council with placing restrictions on "risky" institutions and creating an independent consumer protection agency. 

The House bill also is easier on big banks with trading desks. It wouldn't require them to create subsidiaries to manage their derivatives business.

Large financial firms like JPMorgan Chase & Co. (NYSE: JPM), Goldman Sachs Group, Inc. (NYSE: GS), and Bank of America Corp. (NYSE: BAC) are very concerned about their future profitability with their trading desks up in the air.

Some analysts predict the big firms could take up to a 20% hit in profits with the proposed reform. Derivatives-related revenue could be cut by 30%-50%.

President Obama asserts the new policies will increase company accountability and consumer protection without choking the free market. The bill is largely in tune with an outline for reform he proposed last year.

"Over the last year, the financial industry has repeatedly tried to end this reform with hordes of lobbyists and millions of dollars in ads, and when they couldn't kill it they tried to water it down. ... Today, I think it's fair to say these efforts have failed," said Obama.

But some opponents fear the bill will result in over-regulation.

"It will inevitably contract credit," Sen. Judd Gregg, R-NH, told The Wall Street Journal. The bill "is probably undermining the system...probably making for a weaker system."

Other critics say the bill doesn't do enough to control the actual causes of the financial crisis - and may not be able to so long as interest rates are low.

"If money is very cheap, if the returns on low-risk investments are low, it's in the nature of investors, whether they are pension funds of individuals, to seek out yield," Giles Keating, head of Credit Suisse Global Economics and Strategy Group, told CNBC.

Analysts also say the bill does not address the banks' habit of lending to people who can't afford certain loans.

"It's hard to legislate culture," said Keating.  

The proposals fall short of enforcing new regulation for Fannie Mae and Freddie Mac, the government mortgage arms that extended high-risk loans that are continuing to default.

But proponents like Sen. Reid think the law will not only be effective, but send the right message.

"To Wall Street, it says: No longer can you recklessly gamble away other people's money," said Reid. "It says the days of too big to fail are behind us. It says to those who game the system: The game is over."

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