Financial Sector Reform--Or is it?

The United States Congress has finally decided to govern. More than likely action on financial regulatory reform is a little too late for this body of incumbent politicians but, possibly in time to do some good for the American people.

This past Thursday, lawmakers made two key changes to financial sector reform legislation making its way through the U.S. Senate. In a 64-35 vote, the Senate voted to create a ratings board overseen by the Securities and Exchange Commission (SEC) designed to decide which credit rating agencies will rate mortgage-backed and other “structured” securities. It is necessary to do this because currently Standard & Poor’s and the Moody’s Investment Service have historically inflated the value of the very same mortgage bonds that they are paid to assess.

Public pension funds blame S&P and Moody’s for helping to cause the global financial crisis by assigning top rankings to mortgage-linked securities that blew up when the housing market collapsed in 2007 and 2008. Lawmakers and regulators have debated since then on how reduce this “staggering conflict of interest”

Senator Franken, not only a freshman Senator but one who arrived months late to begin his term because of endless recounts and lawsuits challenging his victory in Minnesota, seemed to grasp the conflict and its resolution rather quickly. Moving to halt such practices is as Senator Franken said in a statement, a no-brainer. During floor debate on his amendment, he stated that “There is a staggering conflict of interest affecting the credit-rating industry. Issuers of securities are paying for the credit ratings. They shop around for their ratings.”

Before we break out the Franken for President banners however, let’s keep in mind that the new ratings board proposed in his amendment would oversee only structured securities, leaving Wall Street salespeople free to carry on the rigging of ratings for other instruments.

In the second key change to the financial regulatory reform package, merchants may finally get relief from the onerously high “interchange” or swipe. These are fees card-issuers charge to process debit-card transactions. Similar to Senator Franken’s amendment in terms of its reform power, this second change, as far as reforms go, is also pretty low-hanging. Even those same Wall Street honchos who decry any kind of financial reform have expressed support for ending the high fees merchants pay for the ‘privilege’ of processing debit-card transactions.

What makes this interchange limit sponsored by Senator Richard Durbin, (D-Ill.) so weak is that it applies only to debit cards—leaving credit-card fees alone. That is a major concession to financial firms because the swipe income they derive from credit card transactions dwarfs what they receive from debit card purchases. Senator Durbin’s original proposal had targeted both.

So, despite all the fiery rhetoric in Washington lately, the reform bill in its current form remains fairly tame, at least relative to the crisis that plunged the country into its current state of economic recession. It will put a dent in bank profits, but it won’t drastically alter the paradigm of the way they do business. Wall Street is relatively unscathed.

That could all change next week however as the US Senate is scheduled to vote on three major provisions that, if passed, could significantly alter the financial landscape. One amendment, backed by Senator Blanche Lincoln, (D-ARK.), would force banks finally to unload their derivatives businesses.

Another would also forbid banks from engaging in proprietary trading. This practice occurs when banks actively trade stocks, bonds, currencies, commodities and their derivatives or other financial instruments with its own money as opposed to its customer’s money, so as to make a profit for itself. They act like a hedge fund and many critics of this practice insist that large banks purposely leave ambiguous the amount of non-proprietary trading they do versus the amount of proprietary trading they do because it is felt that proprietary trading is riskier and results in more volatile profits.

For example, if a company sold stock with a bank, whoever first purchased shares would possibly have a difficult time selling them to buyers if those buyers were not familiar with the company. Consequently, the investment bank then agrees to buy the shares sold in order to identify another buyer. This, by the way, provides liquidity to the marketplace. The bank normally does not care about the fundamental or intrinsic value of the shares, only that it can sell them at a slightly higher price than what it paid for them. To accomplish this, the investment bank employs traders who over time begin to devise different strategies within this system designed to earn even more profit independent of providing client liquidity, and this is how proprietary trading was created.

Proprietary traders have the highest value at risk among other activities at the bank and this is why investment banks such as Goldman Sachs, Deutsche Bank and the late Merrill Lynch are known to have earned a significant portion of their profits through proprietary trading.

Finally, a third provision would inhibit U.S. states in protecting consumers from predatory lending and related abuses while providing more power to the federal government to protect consumers. Most Senate Democrats however, along with the White House and even many state attorneys general are pushing for a version that would have federal regulators set a minimum standard while allowing states to push for tougher rules as they feel appropriate.

As one would imagine, the financial industry strongly opposes the bans on derivative and proprietary trading while supporting the federal government’s right to “preempt” state-level financial enforcers. I suppose we are all about to find out if Congress really means business. As George Washington so eloquently phrased it, “Guard against postures of pretended patriotism.”