The financial reform bill passed.  Do you feel any differently?  Probably not.  But this bill took over a year to come together, and theoretically would protect our economy from the sort of implosion that happened in the summer of 2008, so it’s kind of a big deal.  So what exactly changed?  Read on to find out.

Slaying the Giants

The last two years seemed to be dominated by the phrase “too big to fail”. Several financial institutions (Fannie Mae, Freddie Mac, Bank of America, etc.) were deemed too large and crucial to the economy to be allowed to go bankrupt. And they were going bankrupt, threatening to cause a biblical amount of wailing and gnashing of teeth, and leading to the multi-trillion dollar series of bailouts. Congress sought to prevent institutions from once again becoming “too big to fail” in an effort to prevent a recurrence of this crisis.
So how does the bill solve this? Basically by expanding the power of the federal government to regulate these institutions. A 10-member oversight committee will be created to exclusively look out for problems in the financial sector and specifically in large financial firms. The Federal Deposit Insurance Corporation (FDIC) will be given the power to take apart large financial firms that are in trouble and pose a risk to the economy as a whole.

Reining in the Gambling

Another large problem that came to the forefront at the start of this crisis was the high-risk trading that permeated the financial industry. Annual bonuses at financial firms tended to be based on the returns the trader generated that year, giving an incentive for them to invest in high-risk, high-reward (or high-loss) securities over steady low-risk investments. These “risky bets” earned the traders high bonuses, but contributed to the collapse of the financial system. Also, many fancy new derivatives were created and sold that were confusing at best, and impossible to assess at worst.
The bill attempts to curb these two practices in a variety of ways. To make the riskiness of firms and securities more apparent, credit-rating institutions will be forced to show publicly how they calculate credit ratings, and (almost) all derivatives will be required to be traded through a clearinghouse or equivalent institutions. A clearinghouse is essentially an independent institution that acts as the overseer of a trade. The two firms participating in the trade, or member firms, must trade through the clearinghouse, which requires additional security such as the disclosure of credit ratings of the member firms, the posting of collateral for the trade, or providing a fund that covers the losses if one member firm fails. All of this forces derivative trading to happen in a more-open and more-secure environment, preventing complex financial instruments from being traded behind closed doors. In addition, the bill gives shareholders some oversight (in the form of non-binding votes) over the compensation paid to top executives.

Protecting Consumers

Dishonest loaning practices were behind much of the trouble caused by the sub-prime mortgage crisis that helped set off the crisis as a whole. Mortgage-lenders were often willfully-ignorant of the borrowers’ inability to pay back the loans. Borrowers were able to just write in on the mortgage application what their annual income was, without documentation.
To fix this problem, the bill requires mortgage-lenders to receive documentation proving how much the borrower earns to determine whether he or she has the means to pay the loan back. In addition, a new regulatory agency will be created, dubbed the Consumer Financial Protection Bureau, to oversee the consumer loan and credit card industry’s to curb any unfair practices. Also, the Federal Reserve will be given the authority to regulate the fees banks charge businesses when a consumer uses a debit card at their place of business, also known as the debit card swipe fee.
How will all these measures be paid for? The estimated $19 billion legislation will be paid by a tax on banks and financial institutions. Let’s hope these changes, weaker than the bill that was originally proposed, can get the job done and prevent further fraud and economic crises.

(Image via xinhuanet)