Michael Johnston's  Instablog

President Barack Obama is expected this week to announce sweeping changes to the way the much-maligned U.S. financial industry is regulated. The changes, which are to be unveiled Wednesday, are expected to include the development of a more centralized regulation system and enhanced consumer-protection capabilities. Speaking on the new developments, Treasury Secretary Timothy Geithner commented that the current regulatory system "was fundamentally too fragile and unstable and it did a bad job of protecting consumers and investors." Following the release of plan details, financial sector ETFs are sure to be in focus this week as investors digest and dissect what may be the most important piece of legislature in Obama's presidency to date.

Although the details of the administration's proposed regulatory changes won't be officially released until mid-week, a piece by Geithner and Lawrence Summers in Monday's Washington Post has already shed some light on what can be expected:

• Centralized Responsibility: According to Geithner, the U.S. financial system is less centralized than most other developed economies. With more than 8,000 financial institutions, maintaining consistent accountability is a daunting task. The proposed regulations are expected to include the establishment of a more centralized system.
• Increased Fed Authority: Geithner and Summers hint that while all financial firms will be subject to more stringent liquidity requirements, the "largest and most interconnected firms" will be subject to even more strict requirements and will be subject to consolidated supervision by the Federal Reserve.
• Asset-Backed Security Changes: The proposals will impose "robust reporting requirements" on issuers of asset-backed securities, designed to reduce investor reliance on third-party ratings agencies (which is obviously bad news for S&P and Moody's). Also, sponsors of asset-backed securities will now be required to maintain a financial interest in products they issue, thereby incentivizing stability.
• Consumer Protection: Geithner and Summers are extremely vague on this point, noting only that the administration will build upon recent efforts taken to prevent predatory lending to develop a "stronger framework" for investor protection.
• Orderly Failures: While defending the government's refusal to allow the failure of several financial firms in the current crisis, Geithner and Summers also admit that such actions are neither desirable nor appropriate in the long term. The new regulations will establish a mechanism to support the orderly winding down of large financial institutions deemed "too large to fail." Only to be available in extraordinary situations (the definition of which is subject to interpretation), such a tool, if successfully implemented, would save the government from choosing between bailouts and financial collapse.

While the Post piece is certainly interesting and provides a few insights into what is on tap Wednesday, it discusses potential changes only at a very high level. As with most legislation, especially legislation with potential for such wide-reaching influence, the devil is in the details. Given the central role the U.S. financial sector has played in starting and exacerbating the current financial crisis, few will argue with the need for drastic reform to the regulatory system. But debate will rage on exactly how to implement such reforms and just how stringent new regulations should be. The Obama administration faces the undesirable task of walking a very fine line with its proposals. The proposed reforms must be meaningful and effective changes in order to instill confidence that a financial meltdown will not occur again. But any proposals must also be conscious of the still delicate financial condition of U.S. financial institutions. Reeling from loss of consumer confidence and erosion of demand for many of their most popular and profitable products and services, banks must be allowed to be profitable. Again, one would be hard pressed to find support for allowing banks to run unchecked, but becoming too aggressive with restrictions could be equally as damaging.

Despite being down in line with the broader market Monday morning, bank ETFs have staged remarkable rallies over the last three months, with many rising more than 100% since bottoming out in March. A few funds to keep an eye on during the week ahead:

• Vanguard Financials ETF (VFH): Invests in companies of all sizes engaged in activities such as mortgage and consumer finance, asset management, insurance, and financial investment. VFH is down 5.5% year-to-date, but up more than 80% since March.

• iShares S&P Global Financials (IXG): Although the financial overhaul plans will impact U.S. banks most directly, the effects will no doubt affect the regulatory structures imposed across the world. IXG tracks the S&P Global Financials Sector Index, which includes financial institutions in 25 countries. More than 65% of IXG's holdings are based outside the U.S.
• Direxion Daily Financial 3x Bull Shares (FAS): While not for buy-and-hold investors, leveraged ETFs provide a way for investors to amplify daily returns. FAS may be a good option for investors who believe the market will react positively to the proposed overhaul, while Direxion's 3x bear financials fund (FAZ) allows investors to bet heavily on a poor reception.  

Disclosure: No positions