Related links: http://www.richmondfed.org/publications/research/region_focus/2010/q3/policy_update_weblinks.cfmFinancial markets

Renee Courtois Haltom

English

Research Papers in Economics

6 Region Focus | Third Quarter | 2010 
B
y most accounts the nation’s financial regulatory
framework has some catching up to do. Regulation
did not effectively keep pace with the profound
changes in the financial system over the last several decades
and was a contributing factor to the financial crisis, Fed
Chairman Ben Bernanke stated in testimony to the Senate
Committee on Banking, Housing, and Urban Affairs in
September 2010. 
The Dodd-Frank Wall Street Reform and Consumer
Protection Act, signed into law by President Obama in July
2010, is intended to bring regulation up to speed. At 848
pages and 16 separate titles, the Act is the heftiest reform
package to greet the financial system in decades. With the
legislation lawmakers attempt to address an array of poten-
tial gaps in financial regulation and policy. 
Akey example is the notion of systemic risk. Many regu-
lators now argue that supervision and regulation before the
crisis was much too focused on the health of single institu-
tions (microprudential supervision) at the cost of awareness
concerning the financial system as a whole (macroprudential
supervision). The latter would require greater focus on the
linkages between firms that lend to and borrow from each
other.
The Dodd-Frank Act aims to fix this problem by creating
the Financial Stability Oversight Council (FSOC). The
group is responsible for identifying systemically important
financial institutions, which the Fed will then be required to
supervise. The FSOC is comprised of staff from each of the
financial regulatory agencies, including the Fed.
The mortgage boom brought attention to occasionally
unsound practices in consumer finance. The Act creates an
independent Bureau of Consumer Protection housed within
the Fed, charged with writing consumer financial protection
laws and examining financial institutions for compliance.
The legislation addresses the so-called Volcker Rule
(named after former Fed Chairman Paul Volcker), which
prohibits banks from certain speculative investments unless
they are being made on behalf of a customer, limiting the
extent to which banks can engage in risky behavior using
their own money. Credit rating agencies will be more tightly
regulated and less relied upon by regulators. In the area of
executive compensation, shareholders of large corporations
will now have a voting say in how much executives are paid.
One of the Act’s stated goals is to put a credible end to
government bailouts of financial institutions that fall into
trouble. Several Fed policymakers have argued that actions
taken by the Fed and other agencies during the crisis, though
necessary given conditions, were “distasteful” (in the words
of Chairman Bernanke) and “excruciating” (according to
Richmond Fed President Jeff Lacker) because of the moral
hazard problems they would almost certainly exacerbate.
The concern is that institutions would now be more likely to
expect assistance in a crisis, which may encourage them to
take undue risks and make such crises more likely.
The Act attempts to mitigate moral hazard by curbing
the government’s discretion to intervene. The Act limits the
Fed’s ability to extend some types of emergency loans under
Section 13(3) of the Federal Reserve Act, the provision heav-
ily invoked during the financial crisis for the first time since
the Great Depression. The Fed is no longer allowed to lend
to specific individuals, institutions, or corporations. Instead,
emergency loans from the Fed are now allowed only if made
available to a broad array of firms, and require Treasury
approval.
The Act also sketches out a process — known as resolu-
tion authority — by which the government will step in to
dismantle large, systemically significant bank holding com-
panies or nonbank financial firms in the event of failure.
(Failing banks, on the other hand, are dealt with by the
Federal Deposit Insurance Corporation.) Supporters of this
provision of the Act claim that without such plans, the rapid,
disorderly failure of a single large firm can harm many cred-
itors that have extended that institution loans. Others,
however, have argued that by effectively shielding creditors
this process could dampen market discipline.
Implementing the Act will be a significant undertaking for
all regulatory agencies. It requires the Federal Reserve alone
to complete more than 50 rulemakings and guidelines, many
studies and reports under a short timeframe, and more than
250 separate projects and initiatives to implement the law. 
It’s not just the scale of the Act that poses a challenge.
Many new tasks — such as judging the degree of systemic
risk that an institution poses, or deciding when a firm is too
imperiled that it must be dismantled — are difficult calls to
make. Perhaps more important, firms will likely innovate in
ways that allow them to work around new regulatory barri-
ers they find excessively burdensome. Regulators will have
to remain flexible and vigilant to maintain a regulatory
framework appropriate for a dynamic financial system.
Charles Plosser, the president of the Philadelphia Fed,
summed up the thoughts of many financial industry
observers in a September speech: “Dodd-Frank is a massive-
ly complex piece of legislation, and many details remain to
be worked out in the rule-writing underway to implement
the act. It is also highly likely there will be many unintended
consequences. It is too early to assess all of its ramifications
or whether it can achieve all of the lofty goals that people
assigned to it. Only time will tell.”  RF
POLICYUPDATE
BY RENEE COURTOIS HALTOM
Financial Reform Moves Forward, Challenges Remain

Policy update : Financial reform moves forward, challenges remain

http://www.richmondfed.org/publications/research/region_focus/2010/q3/pdf/policy_update.pdf

Policy update : Financial reform moves forward, challenges remain

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