To keep taxpayers from having to bail out giant banks again, lawmakers faced two choices: design rules to try to prevent them from failing, or shrink them so that if they do fail, they won't threaten the financial system.
Our political leaders chose the rules.
At more than 2,000 pages, the new financial regulatory bill takes aim at everything from megabanks straddling the globe to street-corner payday lenders. And with a bit of luck, the overhaul — the most sweeping since the Great Depression — will help make big bank failures less likely and less damaging if one does occur.
The House and Senate hope to pass the bill this week in time for President Barack Obama to sign it before July 4. Its backers say it is needed to avoid the kind of cascading fear that brought the financial world to a near standstill after Lehman Brothers collapsed in September 2008.
Whether it succeeds rides on how dozens of regulators, including the Securities and Exchange Commission and the Federal Reserve, fill in the details, because a lot was left up to them. The bill calls for banks to hold more money as a cushion against risks, but it doesn't say how much. It also was mum on the amount of cash that firms dealing in complex derivatives need to set aside in case those bets sour. Lobbying by industry and advocacy groups is expected to be fierce in the months ahead and take place mostly behind closed doors. It will take years for many of the rules to take effect.
But one thing is clear: For the nation's biggest banks, it could have been a lot worse.
In the Senate's version of the bill, banks such as Goldman Sachs Group Inc., Citigroup Inc. and JPMorgan Chase & Co. would have been barred from trading derivatives. In the final one, banks lose only a sliver of that business.
Another near-miss for Wall Street involved a ban on banks investing in hedge funds and private equity firms. The bill limits those investments, but not enough to hurt most big banks, says Dean Baker, co-director of the left-leaning Center for Economic and Policy Research.
"Those guys walked away pretty happy," he says.
Shares of big financial companies rose Friday after the bill was approved in the wee hours of the morning by a House and Senate conference committee.
Perhaps the biggest victory for giant banks: They get to stay big. A proposed amendment to cut them down to size was killed after receiving scant support.
"There's no magic bullet, so they need to be small enough to fail," says former International Monetary Fund chief economist Simon Johnson. Dallas Federal Reserve chief Richard Fisher agrees, stating in a recent speech that the "only" way to end bank bailouts is to "shrink 'em." Henry Kaufman, an elder statesmen among economists, puts it succinctly: "Break them up."
The stakes are high because banks are bigger than ever.
Thanks in part to acquisitions of Countrywide Financial Corp. and Merrill Lynch & Co., the assets of Bank of America Corp. have jumped 36 percent from before the financial crisis to $2.34 trillion. JPMorgan bought Bear Stearns Cos. and Washington Mutual Inc. and has assets of $2.14 trillion, up 37 percent.
The top four banks now have 40 percent of the nation's deposits.
The legislation increases government oversight of these and other big, interconnected financial firms. The goal is to identify problems early and address them — not allow them to grow until a giant bank is in trouble and a threat to the financial system. If the problems do mushroom and a big bank is failing, the new rules include a plan to seize and liquidate the bank. The enormous cost of doing that would be paid by other giant banks, not taxpayers. At least, that's the theory.
When Lehman got in trouble two years ago, the government lacked the authority to take it over. Lehman filed for bankruptcy, and other banks feared that firms with money tied up at Lehman might fail, too. Trust evaporated. Credit markets froze, and the stock market crashed. Under the new plan, the thinking goes, everyone linked to a failing bank would know that money was on its way and so they would be less likely to panic. Think of the orderly closings of smaller banks by the Federal Deposit Insurance Corp. every week — writ large.
To keep financial firms from collapsing in the first place, the bill calls for a new Financial Stability Oversight Council headed by the Treasury secretary to crack down on risk that threatens the financial system.
But a big question remains: Will these top cops even be able to spot problems early? The record isn't encouraging.
As late as May 2007, Fed Chairman Ben Bernanke predicted damage from reckless lending to homeowners with bad credit would "likely be limited." Treasury Secretary Henry Paulson also failed to finger these risky loans as a systemic risk. "I don't see (it) imposing a serious problem," he said in April of the same year.
Before the crisis, there was a patchwork of regulators overseeing the financial industry. But each was too focused on firms under its watch to see dangerous practices across the industry. For instance, few regulators among the many overseeing mortgages questioned lenders who stopped requiring borrowers to prove they could pay back their loans. Defaults mounted. When regulators woke up to the danger, it was too late.
The bill's key change aimed at fixing that problem eliminates the Office of Thrift Supervision. The OTS oversaw many of the riskiest players during the housing boom: Washington Mutual, IndyMac Bank and Countrywide. All were either sold in a fire sale, bailed out by taxpayers or seized by the government before they collapsed.
But critics are skeptical about whether the new council will be able to coordinate the various regulatory agencies and fulfill its mission.
"People are worried about the next bubble, and whether regulators will miss it and refuse to act upon it," says Robert Litan, an economist at the Ewing Marion Kauffman Foundation, which supports entrepreneurship programs.
The legislation gives regulators power to break up the biggest financial firms if they threaten the entire system. But some proposed crackdowns were cut from the bill. And the fate of many of those that remain are in the hands of regulators who must write the rules and then implement them in the years ahead. The record of regulators — like the OTS — is spotty.
The big banks could also claim a victory, of sorts, when it comes to the regulation of derivatives.
Derivatives are bets between two parties on how the value of an asset will change. They are often used by companies to hedge risks. A bank that fears its borrowers will default on their loans might use a derivative that pays off if that happens, thus minimizing its losses.
But derivatives can be used to speculate, too. A bank might use derivatives to bet that the value of an asset it doesn't own will go up or down. Derivatives were used just this way to bet on the housing market. Often, banks borrowed huge sums of money to make these bets. That magnified losses when home prices crashed. It was as if the market was several times bigger than its actual size, and that made the meltdown worse.
Thanks to such gambles, American International Group Inc. nearly collapsed and required a $182 billion bailout by the government. Regulators were scarcely aware of the massive bets made by AIG and other financial firms because they were struck in private deals.
The new bill requires federal oversight of lucrative derivatives for the first time. It requires many types of derivatives to trade on exchanges so regulators can better watch them. Banks using them must put aside money in case they lead to losses, something AIG was not required to do.
An original version proposed by Sen. Blanche Lincoln, D-Ark., would have forced federally insured banks to spin off their derivatives trading businesses. Under the bill approved early Friday and now heading to the full House and Senate for votes, banks would only have to spin off their riskiest derivatives trades. They would be able to keep trading derivatives related to things such as interest rates, foreign currencies, gold and silver. They could even arrange credit default swaps, the notorious instruments involving mortgages that were blamed for the meltdown, as long as they were traded through the exchanges.
Hedge fund manager Michael Lewitt, who lashes out at derivatives in his book "The Death of Capital," says that AIG-like bets with derivatives should have been banned, not just moved to exchanges so they will be visible.
"We can have an AIG again because everyone is interconnected and for what? So people can speculate?" Lewitt says. The bill "will prove completely inadequate to prevent future crises."
Under a provision known as the Volcker rule, named for former Fed Chairman Paul Volcker, banks also won't be allowed to buy and sell securities for their own profit, as opposed to doing that for clients. But the distinction is sometimes vague. For instance, banks often buy shares of companies for "inventory" in their role as middlemen helping clients in their own share purchases. If the bank buys more than needed to help others, it can generate profits. Analysts who have studied the bill say it isn't clear that this would violate the rules.
Likewise, the legislation will impose a cap of 3 percent on the amount of its capital that a bank can invest in risky hedge funds, private equity funds and real estate funds. Typically, though, such investments already fall below the 3 percent threshold. And banks will still be able to manage such funds and collect fees and a percentage of trading profits.
Richard Bove, an analyst at Rochdale Securities, thinks gray areas like that will leave banks such as Goldman Sachs relatively unscathed from the new rules. "I don't see how (the bill) is going to hurt Goldman much at all," he says.
His prediction: Goldman shares rising nearly a third to $182 in a year.
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