Tape for Balloons

Financial reforms in the United States aim to prevent grave financial crises in the future.

If the scale of the economic crisis since 2008 determined the magnitude of reforms needed in the financial sector, American legislators have proved themselves worthy of the task before them. The new law signed by President Obama this week, which is supposed to prevent the causes behind the collapse of 2008, is 2,319 pages long; even so, there are 243 to 350 more rules that have yet to be written. In the end, the page count may have increased to anywhere from 15 to 20 thousand, a figure worthy of the Brussels bureaucracy. This bureaucracy is keeping up to date on these changes, since what happens on Wall Street will eventually trickle over to Paris, London and Sofia.

The Dodd-Frank Act (named after its two main authors, Senators Chris Dodd and Barney Frank) is based on two major principles — reducing the risk borne by banks and ensuring the security of consumers. Deterred by the lack of sufficient votes in the Senate, the Democrats gave up on bolder plans, such as a five-year additional tax on big banks and hedge funds that would have served to collect $20 billion towards covering the costs of the reform. As a result, the decided-upon compromise is highly controversial for both the left and the right. Some Democrats criticize the reached resolution, arguing that taxpayers will still have to foot the bill and that the law does little to prevent another crisis. Republicans believe that the law will create more bureaucracy and limit the dynamics of the market.

The banks most affected by the new act, however, have responded more moderately than expected. The anticipated avalanche of negative advertising campaigns opposing the reform did not inundate U.S. media as expected. Some, such as Vikram Pandit, executive director of Citigroup Inc., even attended the signing ceremony. This is because the new law tightens control over the financial sector, but does not return to the Glass-Steagall Act, which was passed during the Great Depression and which separated commercial from investment banking. Since the 1980s, Glass-Steagall was gradually liberalized and was finally repealed in 1999. Now Dodd-Frank, which has not overly constricted the rules, will nevertheless bring a return to the retention of control in the financial sector.

Outlines of the New Financial Landscape

Large banks have already started adapting to the new rules. “If you’re a restaurant and you can’t charge for the soda, you’re going to charge more for the burger,” Jamie Dimon, chief executive at JP Morgan Chase, explained to The New York Times. Eliminating the fees that merchants pay on each debit or credit card transaction at their sites will lead to the introduction of Visa and Mastercard fees on the credit and checking accounts of their customers. Once banks can no longer sell direct derivatives (financial products based on other financial instruments, the rapid expansion of which used to explain the depth of the financial crisis), they prepare proxy firms to sell them in future clearing houses.

The new rules will lead to major changes in the financial landscape, although it is unlikely that the nature of financial institutions’ work will change much. The so-called Volcker rule (named after former Federal Reserve Chairman Paul Volcker), is quite ambiguous. Banks that take deposits will be allowed to deal on their own accounts, but will retain the right to invest up to 3 percent of their share capital into hedge funds. They will be limited to transactions on the derivatives market, but will easily overcome this barrier, as they can create companies that are formally independent. Other measures are consistent with the severe economic situation; for instance, banks will be required to increase their capital reserve against bad loans. This will be enforced after five years, however, so that our already contracted credit doesn’t shrink further.

For their part, derivatives markets will be regulated, and transactions will go through clearing houses, where they will be registered to enhance transparency and competition.

The Great Never Die

One of the objectives of the reforms was to ensure that they would not repeatedly lead to a situation where large financial institutions could not afford to fail because their collapse would shake the whole system. This used to spur risky behavior, as businessmen thought that there was no way they could drown if things became rough.

According to James Surowiecki, even if the law does not do much against the “great” banks, then it will at least ensure that they won’t go bankrupt. By implementing the Dodd-Frank act, the administration has assured that they will not be caught unprepared again. A new line of agencies will be established to secure the stability of the financial sector in case it begins to once again inflate like a balloon. The problem, as many observers commented, is that the institutions will be filled with people from the Department of Finance and from the Federal Reserve; these are the same people who “overslept” for the beginning of the current crisis.

As former Treasury Secretary Henry Paulson claimed in a Wall Street Journal interview, the new legislation is unlikely to prevent another crisis, but it can ensure a milder and more manageable one. Besides the fact that the big banks should be prepared with a plan for liquidation as a last resort, crisis administration will be able to immediately take over their management, rather than make a purchase at the expense of taxpayers’ bad assets. Barack Obama himself, when signing the law, emphasized this was one of his favorite aspects of the law: “There will be no more taxpayer-funded bailouts. Period.”

Be Careful What You Sign

The branch will be heavily influenced by the creation of a financial consumer protection agency with broad powers and a director appointed by the president. When it starts operating next year, the agency will assess the safety of consumer products and investment contracts for credit cards, in the same way that traditional consumer committees used to check toasters and televisions for flaws.

Its creation is necessary because, after the collapse of the real estate market, it seemed that many Americans do not understand increasingly complex financial instruments, such as contracts, mortgages or credit cards. The problem in the system so far has been that the federal banking supervision, the main function of which is to ensure the prosperity of the sector, was also put in charge of consumer protection (two interests which do not always coincide). Thus, this made it possible for the existence of profitable contracts on credit cards for the financial industry, which charged non-usage fees, and allowed banks to increase their annual interest without explanation (from the end of August, the two practices are prohibited).

Quite expectedly, the first major task of the Agency for Financial Protection is to create new, clear rules on mortgage contracts. The change will have its price because widely available credit led to a large number of people having access to funding (some could not actually afford it). “Passage of financial reform will make us safer, at a reasonable cost,” said Brookings Institute economist Douglas Elliott to the Wall Street Journal. Given that the current global crisis was triggered by the collapse of U.S. mortgages, this might not be a bad change.

From Washington to Basel

As part of financial reform, Washington is insisting on security on a more global level. Barack Obama’s administration is trying actively to push forward international rules that will increase reserves and reduce risks for large banks in front of the G-20 (a group of the world’s largest economies). As U.S. Treasury Secretary Timothy Geithner said at the last G-20 meeting in Toronto, in today’s global world, risky operations flee to countries with lower standards, so even if a country were to create a perfect set of regulations, problems would not be eliminated.

International rules, called Basel III on behalf of the Basel Committee on Banking Supervision, are to be presented at the next G-20 meeting in Seoul in November. The countries have thus far been unable to reach a consensus. Some fear that increased security will cost too much for their economies. The Institute of International Finance’s research, for instance, claims that the stringent rules will reduce the annual growth of value, with decreases of 0.9 percent in the European Union, 0.5 percent in the United States and 0.38 percent in Japan.

In general, large banks seemed to quietly welcome the reforms. The reason for this being that the reforms do not suggest anything too extreme, resembling instead a piece of tape on a balloon — they will not allow the balloon to pop (which almost happened in 2008), but will instead allow a slow and steady release of air. From now on, the most interesting thing to keep our sights on will be the methods that ambitious financial players will use to circumvent the newly-established rules.