House and Senate negotiators on Friday approved a bill aimed at increasing oversight and regulation of the U.S. financial system. They brokered last-minute deals on a ban on proprietary trading by banks and oversight of the derivatives market.
Parts of the legislation that could have the biggest impact include derivatives reform, limits on proprietary trading and a potentially potent, new consumer-finance watchdog.
This giant conglomeration of restrictions will be loaded onto an industry that's still struggling to adjust to losses from the financial crisis.
The new rules represent the biggest regulatory changes for banks and brokers since the Glass-Steagall Act was introduced after the Great Depression in 1999.
Congress still needs to vote on the final version of the legislation, but President Barack Obama is expected to sign it into law by July 4.
Banks will be allowed to invest in private-equity and hedge funds, though they will be limited to providing no more than 3 percent of the fund’s capital. Banks also can’t invest more than 3 percent of their Tier 1 capital.
The change alters language in a bill the Senate approved in May, which would have barred banks from sponsoring or investing in private-equity and hedge funds.
The legislation defines proprietary trading as engaging as a principal for a trading account of a bank or non-bank financial company supervised by the Fed “in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative or contract, or any other security or financial instrument” that regulators designate through rule-writing.
The ban on propriety trading, in which a company bets its own money, may reduce profits. Goldman Sachs Group Inc., the most profitable firm in Wall Street history, has said proprietary trading generates about 10 percent of its annual revenue. The firm made $1.17 billion in 2009 from “principal investments,” which include stakes in companies and real estate, according to a company filing.
Derivatives:
The new legislation forces institutions to take some of their derivatives operations out of their commercial-banking operations and put them into a new subsidiary or company. These entities will need lots of capital, because customers won't trade with derivatives dealers that are considered financially weak.
The largest banks, such as J.P. Morgan and Citi, will try to keep as much of the derivatives business as they can within their commercial-banking operations. But they will likely have to send the rest into separate subsidiaries.
The new law will likely force standardized derivatives to be traded on exchanges and cleared through clearinghouses. Big derivatives dealers also will have to set aside more collateral to support positions in the market. This may reduce counterparty risk and increase transparency, which is good for customers. But it will likely lower the derivative-trading profits of the big banks.
The banks will be able to maintain their trading operations so long as they are used to hedge risk or trade interest rate or foreign exchange swaps, a victory for banks that were on the verge of losing the desks entirely. The proposal will force a fundamental shift in the industry, giving federally insured banks up to two years to send instruments such as un-cleared credit default swaps off to a separately capitalized subsidiary.
Regulators also will be required to impose heightened capital requirements on companies with large swaps positions, and would be given the authority to limit the number of contracts a single trader can hold.
Selling over-the-counter derivatives is among the most lucrative businesses for the largest financial companies. U.S. commercial banks held derivatives with a notional value of $212.8 trillion in the fourth quarter, according to the Office of the Comptroller of the Currency.JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp., Goldman Sachs Group Inc. and Morgan Stanley hold 97 percent of that total.
While JPMorgan and Citigroup might have to spend billions to re-capitalize their trading desks, the three others might have much smaller costs. Morgan Stanley and Goldman Sachs, which each entered the commercial banking business in 2008 in the midst of the financial crisis, will be less affected. Morgan Stanley kept just over 1 percent of its $86 billion in derivatives holdings in its bank in the first quarter, and Goldman Sachs held 32 percent of its $104 billion. Bank of America, which absorbed broker-dealer Merrill Lynch in 2009, had 33 percent of its $115 billion in its bank.
Consumer Bureau:
A consumer financial-protection bureau will be created at the Federal Reserve to police banks and financial-services businesses for credit-card and mortgage-lending abuses.
The bureau could require credit-card lenders, including JPMorgan Chase & Co. and Citigroup Inc., to reduce interest rates and fees. Mortgage lenders, including Bank of America Corp., may be subject to tougher rules including more upfront disclosures to borrowers about loan terms.
The idea for a new agency grew out of criticism from lawmakers and consumer groups that bank regulators, including the Fed, failed to properly exercise their consumer-protection authority during the housing boom.
Credit, Debit Cards:
The Federal Reserve will get authority to limit interchange, or “swipe” fees, that merchants pay for each debit-card transaction.
Visa Inc. and MasterCard Inc., the world’s biggest payments networks, set interchange rates and pass that money to card- issuers including Bank of America and JPMorgan. Interchange is the largest component of the fees U.S. merchants pay to accept Visa and MasterCard debit cards. The fees totaled $19.7 billion and averaged 1.63 percent of each sale last year.
The amendment directs the Fed to ensure that debit-swipe fees are “reasonable and proportional” to the cost of processing transactions. The provision will take effect a year after enactment.
Oversight Council:
The bill will establish the Financial Stability Oversight Council, a super-regulator that will monitor Wall Street’s largest firms and other market participants to spot and respond to emerging systemic risks. The Treasury Department will lead the panel, which includes regulators from other agencies.
The council can impose higher capital requirements on lenders or place broker-dealers and hedge funds under the authority of the Fed. The council also will have authority to force companies to divest holdings if their structure poses a “grave threat” to U.S. financial stability.
Private Equity:
Large hedge and private equity funds will be forced to register with the SEC, subjecting them to mandatory federal oversight for the first time. Venture capital funds were exempted from the registration rule.
Registration subjects funds to periodic inspections by SEC examiners. Any firm with $150 million or more in assets, such as ESL Investments Inc. and Soros Fund Management, will be covered by the law.
Hedge and private-equity funds will be required to report information to the SEC about their trades and portfolios that is “necessary for the purpose of assessing systemic risk posed by a private fund.”
Unwinding Failed Firms:
The bill gives the FDIC, which already has authority to liquidate failed commercial banks, power to unwind large failing financial firms whose collapse would roil the economy.
Risk Retention:
The legislation will force lenders, with the exception of some mortgage providers, to hold at least a 5 percent stake in debt they package or sell.
The rule will affect credit-card debt, auto loans, mortgages and other securitized debt. Issuers of asset-backed debt and the originators, who supply them with pools of loans, including credit-card companies, will be forced to retain some of the credit risk. The goal is to align the issuers’ interests with those of the investors who buy their financial products.
The legislation could have been worse: The outright ban of some capital-markets businesses, the breakup of systemically important companies and specific, strict capital requirements were avoided. However, the new law casts doubt on the financial industry's growth prospects and its ability to restore profits to more normal levels.
“Financial supermarkets" like Bank of America Corp., Citigroup Inc., J.P. Morgan Chase & Co. and Wells Fargo & Co. will be hit the hardest. Big banks and brokers may be hit hardest by limits on their derivatives business.
Some of the largest banks may shift their focus overseas in search of growth. The commitments of more capital -- even if margins and commissions on trades stay the same -- mean that this capital can't be used elsewhere to make money.
Both industry and economic growth will likely be suppressed for an extended period as banks continue to deleverage and develop a more thorough understanding of the broad-based structural changes likely to affect the industry in the coming years.
