Understanding the Financial Reform Bill

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by: FinancePM10b

The financial industry has been under serious scrutiny, politicians attacking the nature of investment banks and financial products. New regulation finally made its way through early Friday morning, but experts have yet to agree whether the bill will truly transform the industry significantly for the better. There are changes that will effect bank operations, the government, investors, as well as consumers, but not necessarily in ways we may have anticipated. I personally believe that although there are positive provisions, most of the legislation is insignificant, irrelevant, and will not prevent another crisis.

The next step is for President Obama to sign the bill. The new legislation will definitely control the amount of risk taking, but it will not go as far as preventing another downfall like 2008, or make significant transformations amongst the banks. All in all, Wall Street is pretty happy that the bill did not go as far as implementing extreme provisions.

At the end of it, banks can continue to run their derivatives operations (which represents trillions of dollars) used to hedge their risks. Credit default swaps, and other derivatives such as certain energy and metals, will have to go through a clearinghouse, which banks will have two years to move into a separate unit. However, banks will be allowed to continue to deal interest rate and FX swaps, which represent a significant portion of the derivatives business. I believe many institutions have already factored in the fact that derivatives will probably have to go through a clearinghouse, so not much shock here. In fact, trading through a clearinghouse should theoritically reduce the cost of derivatives, enabling corporate America to hedge risks at a cheaper price.

The Volcker rule proposed that banks altogether eliminate propriety trading, essentially baning banks from making “bets” with its own capital, and investing money into hedge funds/private equity. This proposal was immediately laughed at by Wall Street, but some did fear that such a drastic action would place a huge toll on banks’ profits, as well as the financial industry, and economy on a whole. About 10% of Goldman Sachs’ (NYSE:GS) revenue comes from prop trading. The new rule is a pretty insignificant compromise, restricting banks to allocating no more than 3% of Tier 1 capital into funds. In addition, banks cannot provide more than 3% of a fund’s equity. The effect? Honestly, the consensus is very minimal if any. For JP Morgan (NYSE:JPM), this represents a ceiling of about $4 billion, $2 billion for Goldman Sachs, and $3.5 billion for Citigroup (NYSE:C).

The government is given the power to break up failing financial institutions, which could in fact put the smaller banks at a competitive advantage. However, this could place American banks at a competitive disadvantage given the power and influence of international banking.The perceived problem of “too big to fail” is still not out of the question, but the bill still adds a positive tone to the industry. Although it is a winning battle for all, the financial reform bill will probably have a very minimal effect. Banks can continue to take huge profits in their businesses, and another financial meltdown will not be prevented with the new legislation in place.

The fact that the markets, especially financial stocks, rallied strongly to the legislation, was a sign that we are not going to see drastic signs in financial institutions. In fact, we may not see anything. Raj Date, a former Deutsche Bank executive, and currently executive director for Cambridge Winter Inc.’s center for financial institutions policy stated that banks “dodged a bullet” and “this has to be a net positive.” The bill may not change the fundamentals of Wall Street, but simply has added protections.

On the consumer level, Americans will have a sense of assurance from a newly created consumer protection agency, mortgage regulations, and rules on credit credit cards. The new regulator would essentially enforce rules to protect consumers on financial products by requiring lenders to provide more transparent disclosures. However, banks are starting to cut down on free banking (we saw several banks eliminate free checking) but consumers will at least be aware of the fine print.

Not even psychologists and psychiatrists can decipher the ultimate thinking process of politicians. The disconnect between politics and finance creates an everlasting problem that will like arise again in the near future. But politicians aren’t finance professionals, and don’t necessarily have the knowledge to understand complex financial instruments. Many often fail by criticizing something they don’t understand, before making an attempt to comprehend the importance to the health of the economy, or at least the reasoning/effect of certain products. Even though there were former financial figures involved in the legislation, we are not going to see the sweeping changes of preventing another meltdown, and banks will continue to make unrestricted profits (and they deserve to).

There are many factors that contributed to the financial crisis from 2007 to current, and I believe the bill fails to address these problems. The sub prime mortgage weakness had a huge ripple effect. Americans were buying homes they couldn’t afford, while banks and lenders were granting loans while practicing loose credit policies. Ultimately the housing bubble burst, and the collapse spread across the nation to every industry, and eventually spread globally. With leverage in play, banks were borrowing more money to lend out- eventually bad loans were rising and problems were inevitable. Finally, lending slowed down, but assets plummeted and the economy faced a drastic toll. When capital reserves ran out, the government bailed out financial institutions. How will this bill prevent this “credit crunch” from happening? Perhaps we need to pay more attention to credit and lending policies, rather than trying to bash banks for making profits.