This week, the House of Representatives will consider The Wall Street Reform and Consumer Protection Act (press release), the first major piece of financial regulatory reform legislation in a decade.  The bill includes provisions to address a number of critical issues, such as the stability of the U.S. financial system, ending “too big to fail” by establishing resolution authority for complex financial institutions, the regulation of over-the-counter derivatives, and enhanced consumer protections.

As this bill moves towards the House floor, and as the Senate Banking Committee members continue to work through their concerns with Senator Dodd’s draft bill, ForumBlog sees four critical elements that are necessary to make these reform efforts effective (full letter to Members of Congress here - PDF).

1.   End “Too-Big-to-Fail”: The shareholders and management of financial institutions – regardless of size – should never be insulated from the consequences of their own mistakes.  The discipline of potential failure is necessary to ensure truly fair and competitive markets.

The remedy to the problem of “too-big-to-fail” is more effective supervision coupled with resolution authority – the legal authority and procedural protocol for seizing and winding down even the largest, most interconnected and complex entities. No federal or state agency currently enjoys such authority.  The preemptive dismantling of large, healthy, well-managed institutions is not the appropriate response.

2.   Enhance Consumer Protections: The United States cannot be a world-class financial marketplace unless consumers have full confidence in the safety and soundness of financial institutions, the integrity of the markets, the quality and suitability of financial products, and the basic fairness of the broader financial system.

One option to enhance consumer protections would be to create an Office of Consumer Protection and Education within each Federal functional regulator charged with policing consumer protection issues within that agency’s purview.  The efforts of these entities would be further strengthened by the creation of a Council of the Directors of the various Offices of Consumer Protection and Education to share information and observations, promote cooperation, harmonize standards, and develop best practices.

Strong national standards should be the principle that guides consumer protection efforts.  Allowing states to adopt different rules, and enforce both federal and state standards, will result in a patchwork of inconsistency and generate uncertainty about which set of rules apply to institutions conducting a national business and how those rules will be interpreted and enforced by 51 different authorities.  Such a regime would lead to confusion, structural distortions, unnecessary costs, reduced credit availability, slower growth, and job losses – none of which is in consumers’ interest.

3.   Regulate Over-the-Counter Derivatives: Derivatives are financial tools that enable corporations and other businesses to hedge the risks to which they are exposed – thereby lowering the cost of capital and contributing to economic growth and job creation.  Effective oversight of OTC derivatives markets is necessary to ensure that those markets do not threaten the stability of the broader financial system, promote market transparency and efficiency, prevent market manipulation, fraud, and other abuses, and ensure that derivatives are not used or marketed inappropriately.

4.   Designate a “Systemic Supervisor”: Our current supervisory framework is highly balkanized, with agencies focused on particular institutions within specific industry sectors.  Gaps in oversight naturally develop between the silos of sector-specific regulation, and no agency is currently charged with assessing risks to the financial system as a whole – the big picture.

To ensure a more coherent, consistent, and comprehensive approach to supervision, some entity should be charged with monitoring, assessing, and addressing emerging risks that might threaten the stability of the financial system.  The systemic supervisor could be a single agency – such as the Federal Reserve – or a council of agencies, provided the council is chaired by one agency that would be held accountable.

Change is difficult – even change that everyone agrees is necessary and overdue.  But reform and modernization of financial supervision is both possible and desirable.  For decades the U.S. financial system remained the world’s leader despite the costs and deficiencies of an antiquated supervisory framework.  The recent financial crisis and the damage it has inflicted on the broader economy and millions of people vividly demonstrate that America can no longer avoid difficult reforms.