By Dan Alamariu
Despite rising concerns over a Republican Senate filibuster, over the next month or so, the U.S. Congress will probably pass the most comprehensive financial regulatory reform overhaul since the aftermath of the Great Depression. Yet the proposed overhaul has drawn strong criticism-from the left and the right-for not doing enough to prevent the next crisis, whether in dealing with too-big-to-fail banks, oversight of "shadow banking" or by not providing solutions for dealing with Government Sponsored Entities like Fannie Mae and Freddie Mac. Market reaction to each step in the congressional process has only added to the skepticism. Bank stocks gained both when the reform bill cleared the Senate and when it was reported out of the House-Senate conference. That indicates that investors see reforms as "manageable" for the financial sector.
In the very short term, the markets and the bill's critics have a point: it could have been tougher. It won't be a replay of the Glass-Steagall Act that separated investment from commercial banking in 1933.
But these reactions miss a crucial point: The reforms currently debated in Congress represent only the opening salvo of a larger reform process that will take years to complete and whose outcome will be both unexpected and more stringent on financials than the currently debated legislation.
Despite its critics, the Dodd-Frank bill (assuming it clears the Senate) will limit some of the activities that helped trigger the crisis. Large systemically important banks will need to hold more capital. Consumer protections will go a long way toward addressing issues like mortgage lending. Derivatives rules will move a significant number of these products into clearinghouses, allowing for increased transparency. Add enhanced investor protections, reforms of credit rating agencies, and changes to corporate governance, and you have something more substantive than its critics appear to realize. These may not be the radical solutions that some prefer, but they will have a large long-term cumulative impact on the U.S. financial sector.
It's impossible to say, of course, whether these measures can head off the next meltdown. The new rules will also create new risks and new loopholes that will be exploited. That's always the case with regulatory reform. But the current package will nonetheless limit the scope of financial activities that banks undertake today, and there are just too many changes in the Dodd-Frank bill to conclude that the proposed reforms are a wash. Their impact will be staggered, as rules based on the legislation will come online over a two-year period, if not longer. But they will impose significant hurdles on large financial institutions, which may become less competitive relative to smaller institutions. It may not be the sudden change that critics prefer, but it could still lead to a welcome and gradual diminution of the too-big-to-fail risks over time.
Second, the current legislation is far from the last word. Congress will take up regulatory reform again next year, following the Financial Crisis Inquiry Commission (FCIC)'s report in December. Mandated by Congress last year, the FCIC is based on the Pecora Commission that investigated the causes of the Great Depression and provided the rationale for the landmark pieces of legislation of the Great Depression Era (the Glass Steagall Act, the Securities Act of 1933, and the Securities Exchange Act of 1934). The FCIC has kept a relatively low profile until now, but its findings will bring another round of legislation. It remains unclear what we can expect on the 2011 agenda; that will depend on the post-election balance of power within Congress, on the perceived impact of the current regulations, and, obviously, on the findings of the FCIC. But there will be another debate and more legislation.
Then there's the bigger picture. Regulatory reform following a crisis is often a matter of trial and error. New rules are written, and sometimes rewritten. More regulations are introduced as the economic picture changes and as new risks land on the policymakers' agenda. Congress was still passing new pieces of Depression-era reform as late as 1940.
Congress may no longer have an 11-year attention span, but the current round of reform marks the beginning of a process that will last several years. And Washington won't be the only source of change. The Basel capital accords, which set the thresholds for capital reserve requirements, liquidity, and leverage that financial institutions must hold, are also being negotiated. This complex multilateral process involving all the developed economies, will take years to implement, once the changes are agreed on, likely later this year or early next. Finally, the United States will need to harmonize its extensive regulatory reforms with other large jurisdictions, most notably the European Union, and further changes to the regulatory environment will be needed.
The complexity and time-span of this process guarantees that nobody can predict exactly how the United States and global architecture will look in three or four years. A surge of economic growth -- or another financial crisis -- might radically change the list of available options. One thing we can say for certain: The current debate is merely the "end of the beginning" for reform of the U.S. financial sector.
Dan Alamariu is an analyst in Eurasia Group's Comparative Analytics practice.