On March 22, the Senate Banking Committee passed the Restoring American Financial Stability Act on a party-line vote of 13 to 10.  Despite the partisan vote, Chairman Chris Dodd (D-CT) and Ranking Member Richard Shelby (R-AL) said they will continue to negotiate with the hope of achieving a truly bipartisan bill.

Notable aspects of the Committee-passed bill include the creation of a Financial Stability Oversight Council (FSOC), designation of the Federal Reserve as the supervisor of the nation’s largest financial institutions, creation of a Consumer Financial Protection Bureau within the Fed, creation of a $50 billion pre-funded resolution authority for failing financial firms, and the regulation of the over-the-counter derivatives market.

In creating the FSOC, the bill seeks to bring greater scope and coherence to financial supervision.  The FSOC would be comprised of the functional regulators, the Fed, and a Presidentially-appointed insurance industry expert, and would be chaired by the Treasury.  The FSOC will focus on identifying, monitoring, and addressing emerging risks to the financial system in totality, and will make recommendations to regulators based on its observations.

In an attempt to streamline regulation, the Senate bill would narrow the Fed’s principal supervisory purview from the more than 6,000 institutions it currently oversees (about 5,000 bank holding companies of all sizes and about 1,000 state-chartered, Federal Reserve system member banks) to the 55 bank and thrift holding companies with total assets greater than $50 billion.  The OTS would be merged into the OCC, which would also gain supervisory authority over all bank and thrift holding companies with assets of less than $50 billion whose lead banking subsidiary is a nationally chartered bank or thrift.  The FDIC would gain supervisory authority over state-chartered banks currently supervised by the Fed, as well as bank holding companies with assets of less than $50 billion whose lead banking subsidiary is a state-chartered bank.

While consolidation of federal banking agencies is to be commended, the dramatic reduction of the Federal Reserve’s supervisory purview is of great concern.  If enacted, the Senate bill would end the Fed’s supervisory dialogue with small and medium-sized institutions.  Such institutions – which make up the vast majority of the Fed’s current supervisory purview – are enormously important to the financial system and broader economy.  Moreover, information about such institutions’ condition and activities derived from Fed oversight informs the Fed’s monetary policy determinations in important ways.  Reduction of the Fed’s purview to only several dozen of the largest institutions would also presumably lead to the closure of several regional Reserve Banks, the presidents of which participate on the Federal Open Market Committee on a rotating basis, and would enhance the power of Washington and New York in the making of monetary policy.  As Thomas Hoenig, president of the Federal Reserve Bank of Kansas City recently said in remarks before a Chamber of Commerce event, the bill would “transform the central bank of the United States into the central bank of Wall Street.”  This provision is also at odds with the House bill, which would preserve the Fed’s current supervisory purview and add oversight of all non-bank financial institutions designated as systemically significant.

The bill would also create a Consumer Financial Protection Bureau within the Fed, consolidating the consumer protection duties of seven different federal regulators into one bureau.  The Bureau would enjoy both rule-writing and enforcement authorities, and would be headed by a Presidentially-appointed, Senate-confirmed Director.  While not free-standing like the Consumer Financial Protection Agency (CFPA) proposed in the House-passed bill, the Bureau resembles the CFPA in function and authority.

The bill seeks to end “too big to fail” by creating an “orderly liquidation” mechanism for large financial institutions whose failure could threaten the broader financial system.  The bill would establish a pre-assessed $50 billion resolution fund and would require the agreement of the Federal Reserve, Treasury, and FDIC to begin the liquidation process.

While ForumBlog applauds both bills for taking steps to end “too-big-to-fail,” the pre-assessed resolution fund is problematic, for a number of reasons.  First, it is impossible to properly fund a hypothetical resolution.  Second, a pre-assessed fund could perpetuate precisely the kind of moral hazard a resolution framework is intended to end.  Even more problematic, removing capital from the banking system would undermine efforts to increase lending and stimulate economic growth.  Indeed, because each dollar of bank capital can support 10 to 12 times that amount in new lending in our fractional banking system, removing $50 billion in capital removes as much as $600 billion in new lending.

Finally, the bill calls for greater oversight of the derivatives market.  It is unclear at this time whether Senator Dodd will include language prepared by Banking Committee members Jack Reed (D-RI) and Judd Gregg (R-NH), or Agriculture Committee Chairman Blanche Lincoln (D-AR).  The broad goals of either language will be to require greater transparency and standardization within the market, more stringent clearing and margin requirements, while allowing for well-reasoned exemptions for industrial end-users.  While not yet officially released, Politico has reported that Senator Lincoln’s bill will go much further in regulating the market than previously thought, including forcing banks to “spin off” their swap desks and regulating foreign currency swaps.  “My proposal will go further than any other congressional or administration proposal to prevent future bailouts,” said Lincoln, in a press statement.

Legislators from both parties, the Obama Administration, and regulators have all predicted that the President will sign a regulatory reform bill this year.  The precise timing of the legislation depends on continuing negotiations between Democrats and Republicans in the Senate.  Achieving sensible financial regulatory reform is integral to the strength and stability of the U.S. financial system and the growth and vitality of our economy.  The Financial Services Forum is committed to continuing to contribute to this public policy debate in a thoughtful and productive manner.