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The US financial reform bill: Hit or flop?

Will the upcoming Financial Reform Bill in the US help prevent the next crisis or at least reduce its probability? This column argues that the answer is a firm “no”. It says this is not because the reform steps are damaging or wrong, but simply because they only provide the framework and do little to change incentives for banks and regulators.

A few weeks ago, the US Senate passed its version of the Financial Reform Bill. While it still has to be reconciled with the House version, the outline of the regulatory reform in the US is slowly becoming clear. A thorough assessment of the Bill, however, is made difficult by the sheer size of the Bill with over 1,000 pages, compared to 53 pages of the Glass-Steagall Act.

Do the important changes to US regulatory structure and oversight improve stability? I argue that this Reform Bill is neither the silver bullet to ensure a safer financial system nor a complete flop. It is but one small step in the long march of reforming the framework governing financial institutions and regulators. Critically, it does little in changing the incentives for banks and regulators.1

Financial sector regulation has different objectives that might imply a trade-off. While stability is at the top of policymakers’ agendas right now, policymakers also aim for regulation that fosters competitiveness and “useful” innovation.2 The reform efforts have been driven by the large amount of taxpayers’ resources that have been put at the financial system’s disposal to avoid a melt-down. But political considerations, including the re-election opportunities of individual senators have also had a major impact.

Changes in the institutional structure

While the balkanisation of the institutional structure of financial sector supervision has often been criticised, so has the lack of certain institutions. Both the House and the Senate versions foresee the creation of a new Bureau of Consumer Financial Protection, with the purpose of providing consumers with better information and protecting them from abusive and deceptive practices. While the House version sees an independent self-standing agency, the Senate version wants it independent but housed in the Federal Reserve. One wonders what priority consumer protection will have on the Federal Reserve’s Agenda, given its current focus on monetary policy and (more recently) financial stability. While this would speak for an independent self-standing institution, such an institution might simply not have sufficient standing power against the Fed and other regulators, especially in its early years. As often, however, the important question will not be where it is housed, but rather what authority it will have. Moreover it will be important to focus on financial services rather than simply financial institutions. This implies subjecting car dealers and therefore car loans as well as real estate brokers to the oversight of this consumer protection bureau.

Another institutional change is the merger of the Office of Thrift Supervision into the Office of the Comptroller of the Currency. This aims at reducing banks shopping around for the most lenient supervisor – supervisory arbitrage – and is certainly a step in the right direction. Similarly, the shifting of responsibility for supervising large financial institutions (including non-banks) to the Fed is aimed at avoiding the repeat of Lehman Brothers and AIG, where the authorities had the choice of either bailing out or liquidating. But the question remains whether this additional supervisory responsibility for the Fed raises potential conflicts of interest between regulatory and monetary policy tasks.

While one institution is being taken out of the regulatory framework, another is being added. The Financial Oversight Council was created as a compromise between those that wanted to take powers away from the Fed and those that saw an increase in the Fed’s powers as necessary. While this Council has the task of coordinating activities of different regulatory authorities, its strength will depend on its strongest member, which is still the Fed. This council can – in theory - have an important role in resolving coordination problems across different regulatory agencies. Coordination mechanisms, however, depend on the relative power of the institutions it coordinates and the willingness of cooperation by the underlying institutions. Indeed, one cannot avoid drawing parallels with the attempt of the US government to coordinate activities of its multiple intelligence agencies – an attempt that so far could only be called a success in a very limited sense. It is also interesting to note that the Council is headed by the Secretary of the Treasury and the staff supporting the Council are housed at the Treasury Department, which makes the Council effectively a political institution.

An interesting and potentially important change is to take away the freedom of security issuers to choose their credit rating agency – that is, effectively shopping around for the best rating (see Bolton, Freixas and Shapiro 2009 for a theoretical analysis). In addition, firewalls are to be erected between the rating departments of rating agencies and the sales and marketing of products, often rated by the same agency. Allowing the Securities and Exchange Commission to assign a credit rating agency is certainly a step towards reducing perverse incentives. But then again it might overload the agency and might simply shift the principal-agent problems away to a different level. Perhaps a better solution would have been to give these agencies the same status as auditors, i.e. force financial institutions to contract with one rating agencies for a limited time period for all their issues and then switch to another one. Indeed, it certainly does not go far enough for those who want to take credit rating agencies completely out of the process of determining capital requirements. Perhaps as important – or possibly even more important – is that issuers of asset-backed securities have to retain an economic interest in a material portion of the credit risk in the future, increasing their incentive to screen and monitor properly.

The risk of regulatory capture might be somewhat addressed by making the Fed more accountable to Congress, including subjecting the appointment of the New York to Senate approval. On the other hand, here also lies a huge risk – possible regulatory capture being replaced with political capture. As we have seen in the build-up of the last bubble, this is a real risk.

From Over-the-Counter to clearing houses

Another policy is that derivatives, some of which have up to now been traded over-the-counter, will be forced to be traded through central clearing houses. This can increase transparency, help reduce counterparty risk, and facilitate monitoring by regulatory authorities. While this will increase the costs of trading for financial institutions and other market participants, it is a cost that should be borne by these market participants given the external costs that a failure of one party can cause not just for the markets but for the economy at large, as we have seen in the case of the failure of Lehman Brothers. Moreover, forcing transactions on clearing houses is certainly a better option than a financial transaction tax along the lines of what is currently being discussed in Europe.

Activity restrictions – the Volcker rule

Following the crisis, there has been a fierce discussion on limiting banks’ activities. One suggestion has been to turn back the clock and return to the Glass-Steagall Act with its separation of investment and commercial banking. Such a suggestion, however, seems to be rather driven by nostalgia of the good old times of boring and supposedly safe finance, ignoring that this restriction was not only part of a much larger set of restrictions (including on international capital flows), but also that it carried with it high costs. A somewhat less severe restriction, also known as Volcker rule and which is included in the current Bill, is to prohibit banks from proprietary trading, thus risking deposits and capital. Banks’ ownership of hedge funds or private equity funds would also be prohibited. As so often, the devil is in the detail – are banks allowed to trade on their books, e.g. swaps, to hedge lending positions? And where is the borderline between proprietary trading and simply hedging positions.

Resolution authority and techniques

One of the critical components is the expansion of resolution authority, beyond commercial banks. It is widely agreed among economists that bank resolution needs a special framework and cannot be undertaken in the insolvency framework for non-financial corporations, given the need for speed. While the FDIC procedure for resolving failing banks has been seen as relatively successful, as it helps resolve banks over a weekend, thereby not affecting the payment system and depositors’ access to their savings, this regime was not able to be applied to Lehman Brothers or AIG, given their status as an investment bank and an insurance company. The externality from a failure of such a large institution, however, is as large as in the case of commercial banks. The new Bill gives the government the right to seize and wind up any large financial institution that is considered in risk of failing. In this context, living wills, i.e. ex-ante plans for resolving systemically important financial institutions, will be used. This is certainly an important step as it puts some burden of ex-ante planning on the institutions, effectively imposing a tax on them, but these living wills have to be updated regularly to fulfil its purpose of providing a blueprint for resolution. The Bill is, however, rather short on how such a resolution scheme would work.

The Senate and the House versions still differ in the financing of the resolution of a large financial institution, with the House version creating a resolution fund, thus ex-ante financing, while the Senate version provides for an ex-post financing solution. I remain hopeful that the Senate will prevail, as a pot of money created to “resolve” a financial institution creates moral hazard risk, which could be reduced by forcing an ex-post financing solution. This does not mean that a bank levy as suggested by the Obama administration is a bad solution, but it is better if it is included in the general budget, rather than being saved for rainy bank days (Beck and Losse-Müller 2010).


The reform bill addresses some issues, but also leaves out many others. The reformed framework adjusts rules and mechanisms for authorities to address the build-up of bubbles, to address fragility at an earlier stage, and to intervene more rapidly and effectively into weak and failing institutions.

Despite this, the bill focuses mostly on institutional aspects more than on changing incentives for banks and regulators. It increases the number of institutions under regulatory oversight and increases the power of regulators vis-à-vis financial institutions and markets. The Reform Bill does little to change incentives by banks in their risk-taking decisions, e.g. by making capital requirements a function of size and scope (Beck 2009) or focusing on the interaction of banks’ risk position when computing capital requirements (Adrian and Brunnermeier 2009). It does not address the issue of macroprudential capital regulation, i.e. the idea that capital requirements might have to vary over the business cycle.3 Similarly, the incentives and accountability of regulators are not being strengthened – maybe the suggestion by Ed Kane of deferred bonus and pension payments for regulators, well after they leave office, should be reconsidered.

Furthermore, the bill does not address the risk of political capture. The same politicians calling now for stricter lending standards called for extended home ownership only a few years ago. The future roles of Fannie Mae and Freddie Mac are notable absent from this Bill, and neither is the issue of mortgage subsidisation being addressed. And there seems to be rather more political oversight than less. While accountability of regulators is important, the line between accountability and capture is a thin one.

Will the new framework help prevent the next crisis or at least reduce its probability significantly? The answer is a firm no, not because the reform steps are damaging or wrong, but simply because they only provide the framework, within which the different actors and most importantly regulators, central bankers, and politicians will act. As shown clearly on this site by Ross Levine (2010), it was the violation or intentional ignoring of rules that led to the build-up of the bubble and the subsequent bust, not the lack of regulatory power or proprietary trading.

This Financial Reform Bill, even once enacted, will not necessarily be the last reform step. Current international regulatory reform discussions (Basel 3) will have major implications also for the US, as will the current debate on financial sector taxation. While a global financial transaction tax seems off the table, developments in Europe and other G20 countries concerning financial sector taxation might have an influence on future taxation in the US.


Adrian, Tobias and Markus Brunnermeier (2009), “CoVaR”, Princeton University mimeo.

Beck, Thorsten (2009), “Regulatory Reform after the Crisis: Opportunities and Pitfalls”, CEPR Discussion Paper 7733.

Beck, Thorsten and Thomas Losse-Müller (2010), “Financial sector taxation: Balancing fairness, efficiency, and stability”. VoxEU.org, 31 May.

Bolton, Patrick, Xavier Freixas, and Joel Shapiro (2008), “The Credit Rating Game”, NBER working paper 14712.

Levine, Ross (2010), “An autopsy of the US financial system: Accident, suicide or negligent homicide?”, VoxEU.org, 25 May.

1 For a video presentation on the US reform discussion and lessons to be learned from other countries, see Charles Calomiris here.

2 The idea of “useful” has been heavily discussed recently. As one example, see the recent Economist on-line debate between Ross Levine and Joe Stiglitz.

3 See here for a recent collection of papers on this issue.

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