US banks were surprised last week when the Senate voted for a financial reform package that was more draconian than many had expected. The Senate bill – which must now be reconciled with the House version before President Obama can sign it into law – would create a consumer protection agency, strengthen oversight of derivative trading and ban proprietary trading at banks. The bill would create a mechanism allowing the FDIC to liquidate large failing financial firms and a Financial Stability Oversight Council to monitor companies for threats to the economy. Among the strongest provisions is a plan to force banks to wall off their derivatives-trading operations. It would also force most over-the-counter derivatives to be cleared with a third party. The official summary of the bill is available here, but some key points include:

• A Financial Stability Oversight Council (FSOC) would be established with a remit to focus on identifying systemic risks posed by large, complex financial firms. It would be chaired by the Treasury Secretary. The FSOC would make recommendations to the Fed for increasingly strict rules for capital, leverage, liquidity and other requirements as financial institutions grow in size and complexity, with significant requirements on companies that pose risks to the financial system – in effect creating a sliding scale of regulatory requirements that are most stringent for the largest companies. The FSOC would, with a 2/3 majority vote, i) be authorised to require that a non-bank financial company be regulated by the Fed if its failure would pose a threat to financial stability (presumably this measure has AIG in mind); and ii) be able to approve a decision by the Fed to require a large bank to divest some holdings if it poses a threat to financial stability. Finally, there is a provision (presumably aimed at Goldman Sachs and Morgan Stanley) that specifically states that large bank holding companies that received TARP funds will not be able to avoid Fed supervision simply by relinquishing bank holding company status.

• A number of measures would be brought in to “prevent American taxpayers from being forced to bail out financial firms”. Key among these are the Volcker Rule prohibiting banks from engaging in prop trading, investment in and sponsorship of hedge funds and private equity, and limiting relationships with such organisations. Banks will also be required to submit “Funeral Plans” for their rapid and orderly shutdown in case of insolvency, and would be hit by higher capital requirements and restrictions on growth if they failed to submit acceptable plans.

• Derivatives would be more tightly regulated. “Derivatives that can be cleared” (as defined by regulators and clearing houses) would have to be centrally cleared and traded on exchanges. Greater margin would be required for un-cleared trades to offset risk and encourage more trading to take place in regulated markets.

• Limits on future bailouts: The Fed would be prohibited from making emergency loans to an individual entity. The Treasury Secretary would have to approve any future lending programme. Such programmes would have to be broad-based and could not be used to aid a failing financial company. The largest financial firms would be required to pay into a $50bn fund, to be built up over time, which will be used for any liquidation. This means that the FDIC would only need to borrow working capital while any such failing bank is being wound down. The FDIC would retain the power to guarantee the debt of solvent insured banks to prevent a bank run, but only if a 2/3 majority of the FOSC and the FDIC board determined that there was a threat to financial stability. The Treasury Secretary would approve the terms of any guarantee and set a cap on the overall guarantee amount.

The US administration hopes to complete the reconciliation process by Independence Day. Some measures are already losing momentum. Most strikingly, Ben Bernanke, Tim Geithner and Paul Volcker have all come out against the requirement that banks spin off their derivatives operations. Questions have been raised about what effect the banning of prop trading by large banks and the tighter regulation of derivatives will have on market liquidity at a time of continuing uncertainty. It is therefore not clear precisely what form the final package will take. But evidently the financial landscape will soon look very different – particularly when the new measures to be set out by the Basel Committee by December (which the US reforms partially anticipate) are taken into account.

The regulatory push in the US is another demonstration that politicians are seizing the initiative. It follows a commitment by the new British coalition government to introduce a bank levy (see previous blog) and the banning of naked shorts in Germany. What marks out the US initiative is its scope. It is an international game-changer. Most countries had intended to wait for the new Basel rules to come out before implementing any changes to their banking regimes – partly because it makes no sense to make changes without knowing the course of action likely to be taken by the US. Now that the US looks set to implement a tough new banking regime unilaterally, the door is open for other states to follow suit sooner than their banks might have expected or hoped.

Nick Smallwood - Credit Analyst

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