Historic legislation to restructure the financial regulatory system moved toward full House debate this week. Rep. Barney Frank (D-Mass.) has been a key proponent of the reforms, pressing an agenda that addresses how financial institutions deal with consumers, how credit rating companies grade financial products, and how privately-traded derivatives are regulated. The Senate Banking Committee, led by Sen. Christopher Dodd (D-Conn.) will begin fine-tuning its own broad reform package next month.
In the meantime, here's a guide to how the current bills in the House and Senate approach three major problem areas in the financial system.
|To establish a new agency that will protect consumers and reduce confusion about financial products. The Consumer Financial Protection Agency (CFPA) would oversee banks and other financial institutions offering such products as mortgages and credit cards. The independent agency would consolidate consumer protection powers held by current regulators, including the Federal Deposit Insurance Corporation and the Federal Reserve. The CFPA, which would have subpoena power, would also enforce new credit card regulations that go into effect in February.|
|House Bill||Senate Draft Bill|
|POTENTIAL POWERS||The House is still debating who will be in charge of the CFPA. The Financial Services Committee wants a single director. The Energy and Commerce Committee wants a five-member board to make rules and establish general operations for the agency.||The Senate draft bill wants a five-member board of four presidential appointees and the director of the newly-created Financial Institutions Regulatory Administration (FIRA). The CFPA would develop policies to ensure that low-income communities have access to loans.|
|POTENTIAL LOOPHOLES||» The CFPA would not have authority over auto dealers and private student loans.|
» Banks with less than $10 billion in assets and credit unions with less than $1.5 billion in assets would be exempt from direct CFPA examination, but still subject to CFPA rules. Current bank regulators would continue to oversee these banks.
» If federal and state consumer protection laws conflict, federal regulators could override state regulations, even if the federal rules are weaker. (UPDATE: The bill now clarifies that the Comptroller of the Currency and other banking regulators have the power to override state regulations.)
|None of the loopholes identified in the House bill are currently in the Senate draft.|
|ISSUE||CREDIT RATING AGENCIES|
|PROPOSAL||New regulations are intended to make the rating process more transparent. Specifically, the bills require the credit raters to disclose the methods and information they use to determine a rating. Rating agencies also will have to explain the reliability and shortcomings of each rating.|
|House Bill||Senate Draft Bill|
|POTENTIAL CHANGES||» Bond issuers would be barred from advertising a rating without the credit rating company’s approval. |
» No more than one-third of a rating company’s board members can be employed by, or receive money from, the rater.
» Raters have to be more sensitive to conflicts of interest; if an analyst leaves a rating company to work for a bond issuer, the rating company must review the analyst's work for any suspect ratings.
» A new Credit Ratings Agency Advisory Board would be formed within the Securities and Exchange Commission (SEC) and must report annually to Congress. (UPDATE: The following two provisions were late inclusions to the bill).
» Provide investors an explicit right to sue the rating companies, while also changing the standard for suing them. Instead of proving a rating company “knowingly or recklessly” issued a bogus rating, investors would only have to show the raters were “grossly negligent.”
» Remove references to credit ratings in many existing federal rules, including one that mandates mutual funds and other investment companies buy only top-rated products. This measure has the potential to squeeze the raters out of their special status in the financial system.
|» Investors would be able to sue credit raters for not fully investigating, or having a third-party investigate, an investment before rating it. |
» Raters would have to report to the SEC any bond issuers suspected of misconduct.
» Rating analysts would be tested on their knowledge of the ratings process. A rating company that has a history of inaccurate ratings could lose its status as an SEC-approved rater.
» A new Office of Credit Ratings within the SEC would oversee and regulate the rating companies.
|POTENTIAL LOOPHOLES||» The bill stops short of preventing the conflict of interest between rating companies and the products they grade--credit raters are paid by bond insurers, not investors, for their work.|
» The bill clarifies what investors must prove to successfully sue the raters, but it doesn't enable investors to bring additional suits. (UPDATE: This Loophole Has Been Closed)
|The Senate draft fails to address raters' conflicts of interest other than to call for increasing compliance staff at the rating companies.|
|PROPOSAL||To reduce risks posed by the unsupervised trading of derivatives. Buyers and sellers of these contracts are gambling in a $600 trillion market, often over the phone or online. Regulation of this so-called over-the-counter market will prevent the buyers and sellers from betting more than they have to cover their bets. By requiring more trades to be reported to regulators, the market also will become more transparent.|
|A comparison of the two derivatives proposals finds them to be essentially the same. Here are the key provisions:|
|POWERS||The Commodity Futures Trading Commission and the Securities and Exchange Commission will jointly write rules to crack down on risky and opaque trades. The rules focus on two areas:|
» Clearinghouses and Exchanges: More derivatives trading would be moved onto regulated clearinghouses, which guarantee contracts in case one party defaults. The CFTC and SEC would decide which derivatives are standardized enough to be cleared. When they are too customized to be cleared, details of trades will still be reported to regulators. Those derivatives that are cleared would then be traded on regulated exchanges, such as the New York Stock Exchange, or a “swap execution facility,” a new alternative derivatives marketplace.
» Capital and Margin Requirements: Companies that use derivatives, and the banks that arrange the deals, will have to keep greater amounts of capital on their books to ensure they can make good on their contracts. They also will have to post margin--cash down payments, or collateral--that show a party has sufficient assets to trade. To incentivize clearing, there will be higher capital and margin requirements for non-cleared derivatives.
|POTENTIAL LOOPHOLES||Derivatives traded on a foreign exchange, as well as those based on foreign currency, are exempt from U.S. regulation. Major industries that use derivatives to hedge their risk, for example airlines hedging against a spike in oil prices, are exempt from capital and margin requirements. Trades involving these so-called end users also do not have to be cleared or traded on an exchange.|