In an effort to avoid a repeat of the recent U.S. financial crisis that hit the economy, on May 20, 2010, the Senate passed a comprehensive financial regulatory reform bill introduced by the U.S. Senate Banking, Housing, and Urban Affairs Committee Chairman Chris Dodd. As amended, the Restoring American Financial Stability Act (“S. 3217”) includes the most extensive overhaul of financial rules since the Great Depression by creating a new independent Consumer Financial Protection Bureau housed at the Federal Reserve. This ends the problem of firms being considered “too big to fail” by providing government authority to seize and dismantle unstable firms and creates a Financial Stability Oversight Council to identify and address systemic risks before they threaten the stability of the economy and imposing tough regulations on complex financial derivatives. S. 3217 also makes corporate governance changes including granting shareholders a non-binding vote on executive compensation. Finally, S. 3217 includes provisions providing new rules for transparency and accountability for credit rating agencies and makes changes aimed at streamlining bank supervision.
S. 3217 passed on a vote of 59-39 with two democrats opposing final passage and four republicans supporting final passage. Wisconsin Senator Feingold, who was one of the two Democrats to oppose S. 3217, said, “the bill does not eliminate risk to our economy by “too big to fail” financial firms, nor does it restore the proven safeguards established after the Great Depression, which separated Main Street banks from big Wall Street firms and are essential to preventing another economic meltdown.” Senate GOP leader Mitch McConnell and other Republicans were especially critical of S. 3217’s new consumer bureau, which they said was an unnecessary expansion of government power that will impose onerous new regulations on small businesses that had no role in the financial crisis. In addition, Republicans were upset that S. 3217 does not address the future of mortgage financing giants, Fannie Mae and Freddie Mac, which were seized by regulators during the financial crisis of 2008. Republicans worry the measures will crimp the free flow of capital in the U.S. economy resulting in unnecessary red tape. Financial and business groups call S. 3217 flawed and claim this bill will drive capital out of the U.S. and put the U.S. at a competitive disadvantage to the detriment of long-term economic growth.
As a result of the 60 amendments considered, the final text of S. 3217 as amended is not yet available in one comprehensive document. To view S. 3217 and its amendments, see http://thomas.loc.gov/cgi-bin/bdquery/z?d111:s.03217:. An overview of key provisions of S. 3217 follows:
Creating a Consumer Financial Protection Watchdog
New Consumer Financial Protection Bureau – S. 3217 creates the Consumer Financial Protection Bureau as an independent entity housed within the Federal Reserve. This Bureau will have the authority to write consumer protection rules governing all entities – banks and non-banks – offering consumer financial services or products. The Bureau would be led by an independent Director appointed by the President and confirmed by the Senate with a dedicated budget paid by the Federal Reserve Board. The Bureau also would have authority to examine and enforce regulations for banks and credit unions with assets of more than $10 billion, all mortgage-related businesses (such as lenders, servicers, mortgage brokers, and foreclosure scam operators) and large non-bank financial companies (such as large payday lenders, debt collectors and consumer reporting agencies). Banks with assets of $10 billion or less would be examined by their respective regulator.
Federal Preemption of State Law – The scope of federal preemption has been narrowed. The Office of the Comptroller of the Currency (“OCC”) and courts may preempt state law consistent with the Supreme Court decision in Barnett Bank v. Nelson, Florida Insurance Commissioner (i.e. to the extent state law would prevent or significantly interfere with a national bank’s exercise of its powers). Preemption no longer extends to national bank subsidiaries which are not themselves national banks. State attorney generals may sue to enforce consumer protection provisions of the new law, enforce regulations of the Consumer Bureau there under and may also bring enforcement actions for violations of non-preempted state laws.
Credit Score Disclosure – S. 3217 requires that any person who uses a credit score as a factor to deny credit to a consumer, require a consumer to pay a higher interest rate on a loan, or prevent an applicant from being hired for a job must provide the consumer’s or applicant’s credit score to the consumer or applicant.
Addressing Systemic Risks via Financial Stability Oversight Council
New Financial Stability Oversight Council – S. 3217 creates the Financial Stability Oversight Council to identify, monitor and address systemic risk posed by large, complex financial firms as well as products and activities that spread risk across firms. The nine member council will be chaired by the Treasury Secretary and will consist of regulatory representatives from the Federal Reserve Board, Securities and Exchange Commission (“SEC”), Commodity Futures Trading Commission (“CFTC”), OCC, Federal Deposit Insurance Corporation (“FDIC”), Federal Housing Finance Authority (“FHFA”), the new Consumer Financial Protection Bureau, and an independent member. Non-bank financial firms who pose a risk to the financial stability of the U.S. would be subject to regulation by the Federal Reserve upon a 2/3 vote by the council. By a 2/3 vote, the council would also have the authority, as a last resort, to require a large company to divest some of its holdings if it poses a threat to the financial stability of the U.S. large bank holding companies that have received Troubled Asset Relief Program (“TARP”) funds would remain subject to Federal Reserve supervision.
Leverage & Risk-Based Capital Requirements – The applicable agencies are to establish minimum leverage and risk-based capital requirements to apply to insured depository institutions, depository institution holding companies, and “systemically important” non-bank financial companies. The new requirements are to be not less than the levels in effect at the time of enactment of the law. As presently drafted, trust preferred and hybrid securities may be included only in Tier 2, not Tier 1, capital – although it has been suggested this is an oversight that will be addressed in Conference.
Ending “Too Big To Fail” Bailouts
Discourage Excessive Growth & Complexity – The Financial Stability Oversight Council will monitor systemic risk and make recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, and risk management standards as companies grow in size and complexity.
Volcker Rule – S. 3217 does not immediately impose new restrictions on proprietary trading and hedge fund ownership (“the Volcker Rule”), but mandates that regulations will be developed after a study by the Financial Stability Oversight Council and will be based upon their recommendations. S. 3217 requires regulators to implement regulations for banks, their affiliates and bank holding companies barring such proprietary trading based upon the Financial Stability Oversight Council's study and recommendations.
Funeral Plans / Liquidation Procedure – S. 3217 requires large, complex companies to periodically submit “funeral plans” for their rapid and orderly shutdown. Companies that fail to submit acceptable funeral plans would be subject to higher capital requirements and restrictions on growth and activity, as well as divestment. S. 3217 requires the Treasury Department, the FDIC, and the Federal Reserve to all agree to place a company into a liquidation process during which three bankruptcy judges must convene within 24 hours and agree that a company is insolvent for the process to move forward.
Improving Bank Regulation
OTS Merged into OCC – The Office of Thrift Supervision (“OTS”) would be merged into the OCC, with the OCC becoming the regulator for federally-chartered thrifts. The Federal Reserve would retain its supervision of bank holding companies and state-chartered banks and, with the elimination of the OTS, become the supervisor of savings and loan holding companies. No new thrift charters could be issued in the future.
Interchange Fees – S. 3217 requires that fees charged to businesses for accepting debit cards must be reasonable and proportional to the card network’s cost of processing the transaction. Issuers with less than $10 billion in assets are exempted. S. 3217 would also limit payment card networks from imposing anticompetitive network restrictions (such as (i) precluding or limiting discounts or incentives for the use of cash, check or another payment card, or (ii) preventing setting minimum or maximum dollar limits for card usage) on businesses.
Mortgage Lending Standards – S. 3217 amends the Truth In Lending Act by requiring lenders to determine, based on “verified and documented information,” that the borrower has a “reasonable ability” to repay the loan, together with taxes, insurance and assessments. It is unclear what is required to demonstrate an appropriate determination or whether they may be a potential for lender liability if the reasonableness of such a determination is challenged in the event of default.
Yield Spread Premiums – S. 3217 prohibits loan originators from receiving compensation that varies based on the terms of the loan rather than on the principal amount. This change applies to consumer credit transactions secured by real property or a dwelling and essentially prohibits yield spread premiums for mortgage brokers.
Fannie Mae and Freddie Mac – S. 3217 requires a study by the Treasury Department on the feasibility and desirability of ending the conservatorships of Fannie Mae and Freddie Mac.
Creating Transparency & Accountability for Derivatives
Closing Regulatory Gaps – S. 3217 provides the SEC and CFTC with the authority to regulate the over-the-counter derivatives markets, and prohibits banks from proprietary trading in derivatives. S. 3217 prohibits the Federal government from providing “Federal assistance” to any swaps entity – a provision which would effectively require most banks to move derivatives activities to a non-bank affiliate. “Federal assistance” includes Federal Reserve loans, FDIC insurance and federal loan guarantees. S. 3217 also includes language requiring derivatives trades to go through a central clearing and to be exchange-traded, unless an exemption applies. Lastly, S. 3217 would require the regulators to impose more stringent capital and margin requirements on those derivatives not required to be traded on an exchange.
Raising Standards & Regulating Hedge Funds
SEC Registration / Greater State Supervision – S. 3217 requires hedge funds that manage more than $100 million to register with the SEC as investment advisers and to disclose financial data needed to identify systemic risks and protect investors. S. 3217 also raises the assets threshold for federal regulation of investment advisers from $25 million to $100 million, a move expected to increase the number of advisors under state supervision by 28%, which will allow the SEC to focus its resources on newly registered hedge funds.
Creating New Office of National Insurance
New Office of National Insurance – S. 3217 creates the Office of National Insurance within the Treasury Department, which will monitor the insurance industry and coordinate international insurance issues. S. 3217 requires a study and report on recommendations of ways to modernize insurance regulation and also streamlines the regulation of surplus lines insurance and reinsurance through state-based reforms.
Creating New Office of Credit Ratings
New Office of Credit Ratings – S. 3217 creates an Office of Credit Ratings at the SEC with its own compliance staff and authority to fine agencies. S. 3217 requires Nationally Recognized Statistical Ratings Organizations to disclose their methodologies, their use of third parties for due diligence efforts and their ratings track record. S. 3217 prohibits compliance officers from working on ratings methodologies or sales. Investors could sue ratings agencies for a knowing or reckless failure to investigate the facts or obtain analysis from an independent source. The SEC would be authorized to deregister an agency for providing bad ratings over time.
Credit Rating Agency Board – S. 3217 creates a new self-regulatory organization that assigns qualified rating agencies to issuers for initial ratings of certain financial products.
Strengthening Shareholders Rights & Executive Compensation/Corporate Governance
Vote on Executive Pay/Compensation Committees/Nominating Directors – S. 3217 provides shareholders with a non-binding vote on executive compensation. Compensation committees would be required to include only independent directors and they would have the authority to hire compensation consultants to strengthen their independence from executives. S. 3217 also requires public companies to set policies to recover executive compensation if based upon inaccurate financial statements not in compliance with accounting standards. Lastly, S. 3217 gives the SEC authorization to grant shareholders proxy access to nominate directors and directors would be required to win a majority vote in an uncontested election.
Reducing Risks Posed By Securities
Securitization and Credit Risk Retention – S. 3217 requires companies that sell products like mortgage-backed securities to retain at least 5% of the credit risk, unless the underlying loans meet standards that reduce riskiness. S. 3217 also requires issuers to disclose more information about the underlying assets and to analyze the quality of the underlying assets.
Strengthening the Federal Reserve
Federal Reserve Transparency/Governance – S. 3217 creates transparency by authorizing the Government Accountability Office (“GAO”) to study the emergency lending that occurred during the financial crisis, but it would not be authorized to audit decisions made in the future. S. 3217 prohibits any company, subsidiary or affiliate of a company that is supervised by the Federal Reserve Board to vote for directors of Federal Reserve Banks; and their past or present officers, directors and employees cannot serve as directors. S. 3217 also increases accountability at the New York Federal Reserve Bank.
The House which passed its version of the financial regulatory reform bill (“HR 4173”) on a vote of 223-202 (27 Democrats joining unanimous Republican opposition) last December must now be reconciled with the Senate version. A formal House-Senate Conference Committee is expected to be appointed very quickly. Since both bills maintain the same broad framework for regulating Wall Street, insiders have predicted a relatively smooth process to merge the two bills. Leading the negotiations will be House Financial Services Chairman Barney Frank (D), who has said he would like to have a compromise package by the end of June. Senate Banking Committee Chairman Dodd (D) has said S. 3217 is hardly perfect and will be improved in the House-Senate negotiations. Both Democrats have predicated that the final bill will be written, passed and sent to the President to sign by the fourth of July.