Financial Regulation: Not as Ugly as It Looks

I’ve been plowing through Senator Chris Dodd’s 1,300-page bill to overhaul financial regulation, and I’m surprised. At first glance, it is tougher and better than I had expected.

Readers beware: it’s not a pretty piece of work. Kids! Do not read this at home. It makes the prospectus for a subprime mortgage-backed security look like a model of clarity.

The bill is full of murky exclusions, exceptions and hair-splitting — usually a red flag that our elected representatives have capitulated to big-money interests and disguised the bombshells behind eye-glazing boilerplate.

But there are a lot of genuinely tough changes, and the bill is a lot less ugly than it first appears.

The big banks and Wall Street firms are already howling in protest. Front groups like the U.S. Chamber of Commerce, which claim to be looking out for mom-and-pop businesses, are throwing everything they have at it.

But here are a few key issues, and you judge for yourself.

» An independent consumer financial protection “bureau.’’ As expected, Dodd dropped the plan for a stand-alone consumer agency and replaced it with a “bureau’’ inside the Federal Reserve.

That could have been a huge sell-out, given how disgracefully the Fed and the other “prudential’’ bank regulators failed to crack down on catastrophic mortgage lending. And in Dodd’s original bid to GOP senators, it would have been.

But this isn’t. Having decided to go it alone, with or without Republicans, Dodd carefully protected the new consumer agency’s independence.

For starters, the director would be nominated by the president and wouldn’t be answerable to the Fed chairman. In fact, the Fed chairman “may not intervene in any issue or process before the director’’ of the consumer bureau. Nor can the Fed chairman block the consumer bureau from issuing an order or a regulation.

Indeed, the consumer bureau’s funding would be more independent than that of any other regulator. It would come from the Fed, which earns its money mainly from financial market operations. The Fed would have to allocate whatever the consumer director decides is “reasonable,’’ with the amount capped at 12 percent of the Fed’s other spending.

Bottom line: this agency could end up better funded and more independent than any other regulator in Washington. IT wouldn’t have to placate Congress, which runs hot and cold on regulation. Nor would it rely on fees from the institutions it regulates, as is the case with almost every other bank regulator and has turned them into captives of industry.

To be sure, the consumer bureau could still be overridden by the new systemic risk council, the so-called Financial Stability Oversight Council that will be made up of bank and securities regulators and headed by the Treasury secretary. But that would take a two-thirds vote, which wouldn’t be an easy hurdle.

» State pre-emption. The Dodd bill is confusing on this point, but it seems to give states the authority to write consumer regulations that are tougher than federal regulations.

This is a very big deal. During the housing bubble, federal bank regulators relentlessly blocked states from cracking down on predatory lending and discriminatory practices. But while states like North Carolina, New York and Iowa saw the trainwreck coming years in advance, the feds sat on their hands and did nothing.

The House-passed financial overhaul bill largely capitulated to the banks on this. Though Rep. Barney Frank, its author, had wanted federal rules to serve as a “floor’’ for state rules, conservative Dems on his committee essentially turned the floor back into a ceiling.

Dodd’s bill, to my surprise, declares that state consumer rules are not “inconsistent’’ with federal rules if thee state rules are stronger.

The Dodd bill goes one step further: it allows state attorney generals to participate in class-action lawsuits against lenders that violate federal consumer regs. This has financial lobbyists trembling, because they expect state prosecutors to simply farm out the job to private trial lawyers.

» Too Big To Fail. The Dodd bill puts the Federal Reserve in charge of banks with more than $50 billion in assets – about 40 of the top banks. It also gives the Fed regulatory power over big non-bank financial companies – an AIG, or a Lehman Brothers – if the Financial Stability council agrees that its failure would pose a risk to the whole financial system.

The bill also orders the Fed to come up with capital requirements that become progressively higher as the institution in question becomes bigger and more complex. It also orders the Fed to make sure that bondholders as well as equity shareholders take a hit if a failing institution needs to be liquidated or, God help us, bailed out.

And unlike Treasury Secretary Tim Geithner’s original proposal, in which the banks would only be charged for future bailouts after they occurred, the Dodd bill would require them to chip in upfront to a $50 billion fund.

» The Hotel California Provision. This is a sweet measure nicknamed after the Eagles song and its immortal line: you can check in anytime, but you can never leave. This provision blocks Wall Street firms from wiggling out of the tougher oversight they took on when they converted themselves into bank-holding companies during the financial crisis.

Recall that Goldman Sachs (GS), Morgan Stanley (MS) and others converted themselves into bank holding companies, mainly in order to tap the Fed’s discount window and other emergency credit facilities.

Under the Hotel California provision, any bank with more than $50 billion in assets, and that took money from the Treasury’s TARP program, is not allowed to drop its bank charter. Among other things, that now exposes them to Fed supervision of, ahem, executive pay.

(One financial lobbyist called this the “roach motel provision” – once you go in, you can’t get out – but he admitted that the image of bankers as cockroaches probably wasn’t ideal for their cause.)

There’s a lot more to the bill, and it will need a lot more scrubbing.

Clearly, there are many concessions. Among the industries that will remain free of the consumer protection bureau: insurance companies, real estate brokers, companies that sell manufactured housing, accountants and lawyers. Oh yes, and one other small group: about 8,000 banks with assets under $10 billion. Never, never underestimate the political power of the Independent Community Bankers of America, even though many community banks are reeling from brokered deposits and crummy commercial real estate loans.

There are also a huge number of incredibly important issues that would be left up to the judgment of regulators. No amount of tough-sounding language about capital requirements guarantees that the regulators will get the balance right.

But it’s not a bad start. My concern is not that the bill is too tame, but that Republicans and the financial industry will block anything at all from passing.

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