President Obama and the Financial Reform - Research Paper Example

President Obama and the Financial Reform Contents Contents 1 Introduction 2 Aims & Objectives of the Paper 2 Literature Review 3 Global Financial Crisis 2007-2010 4 President Barack Obama’s Financial Reform Plan 5 Research Methodology 7 Discussion & Findings 7 Future Implications of the Proposed Reforms 9 Conclusion 10 References 11 Introduction The Financial Crisis 2007-10 brought the world economy to its knees and those considered ‘too big to fail’ corporations either collapsed or seek bailouts from the regulators. But this crisis brought forward the weaknesses in the US financial system and called for major financial reforms so as to end the severe recession. The President signed the Dodd-Frank Wall Street Reform & Consumer Protection Act into law in July 2010 and creation of two major bodies for oversight and consumer protection. It has also enacted the Volcker Rule based on the advice of Paul Volcker a former Federal Bank’s Chairman and headed Obama’s Economic Recovery Advisory Board. Although many are skeptical of the features and progress of the new Act, but the law is understood to be more stringent on the unregulated trading and risk-taking by the financial corporations. This paper attempts to present the need of financial reforms, the analysis of the new reforms and what implications they are going to have in the future. Aims & Objectives of the Paper In order to conduct research through discussion and analysis, a set of objectives have been determined considering the topic of research: To understand the causes of financial crisis and need of financial reforms To review the highlights of Dodd-Frank Wall Street Reform & Consumer Protection Act To discuss and analyze the implications of financial reforms and how US President Obama and his administration going to implement the legislative reforms to pull back the economy from recession. Literature Review There have 3 major financial reforms in US history preceded by the recessionary phases and accounting scandals. First, the US economy faced the worst financial crisis since the Great Depression in 1929 as a result of which the Glass Steagall Act came into existence in 1933 which legislated the separation of commercial banks from investment banks. Senator Carter Glass was responsible in bringing the Act who believed that the commercial bank’s direct involvement with dealing in corporate securities was a threat to the financial system stability. Since then it has been the topic of research for many economists (Clark, p.205). Second, in 2002 the Sarbanes Oxley Act was signed in the wake of global corporate and accounting scandals such as Enron, WorldCom and Tyco International (Slander, p.1). The Act contains provisions of corporate governance and auditor’s independence and led to the creation of quasi-public agency Public Company Accounting Oversight Board which was responsible for regulating and overseeing the accounting firms as external auditors. Third the most important reforms, the Dodd-Frank Wall Street Reform & Consumer Protection Act has been enacted in 2010 by President Barack Obama and his administration. The law has led to the creation of two important oversight bodies- Financial Stability Oversight Council and Consumer Financial Protection Bureau. The new Act is considered by many to be based on the Glass Steagall Act. Global Financial Crisis 2007-2010 The Global financial crisis started with the bankruptcy of investment bank Bearn Stearns Inc in 2007 due to heavy exposure to mortgage-backed securities, central to subprime mortgage crisis. The bank was sold to JP Morgan Chase. Then the collapse of Lehman Brothers, the fourth largest bank in America was followed, which unfolded the global financial crisis. All those financial institutions which had exposures to the collapsed bank’s short-term assets faced the liquidity crunch. The largest insurance firm AIG faced liquidity crisis in 2008 because its credit ratings were downgraded. The company had sold the Credit Default Swaps on CDOs (Collateralized Debt Obligations) which later declined in value. As a result AIG was nationalized. This led to the setup of TARP (Troubled Asset Relief Program) authorizing the $700 billion bailout aimed to buy back the troubled assets in the financial system. Even this could not stop the economy to get trapped into recession. Another pertinent question was raised about the large compensation packages of top managers of financial institutions. The efforts made by regulators and government could not stop the rise of short-term interest rates which led to liquidity crunch. Since then have been many troubled spots such as small European banks, credit swaps, money market funds, bond insurers, consumer lenders, state government investment funds, where many of these had no direct link to the US subprime market (Jickling, “Introduction”). The regulators realized the importance of basic payments system i.e. basic operations of a bank which are integral to a sound financial system. These banks provide the intermediation of matching the safety needs and readily available liquid funds with the need for credit by individuals, businesses and government. As a result the improved capital requirements and restrictions on leverage became key elements of reform (Volcker, p.2). President Barack Obama’s Financial Reform Plan US President Barack Obama signed the Dodd-Frank Wall Street Reform & Consumer Protection Act into a law in July 2010 in response to the economic crisis leading to the loss of millions of jobs, plummeted housing prices, washed out savings, lost production and failing businesses. The reform’s significant areas were: 1. Regulation and stability of financial institutions 2. Regulation of OTC derivatives market 3. Regulation of corporate governance and executive compensation 4. Set-up of Financial Stability Oversight Council 5. Regulation of hedge funds and private equity funds 6. Proper liquidation procedures for troubled institutions 7. Set-up of Consumer Financial Protection Bureau 8. Volcker Rule imposition on restrictions on investments and proprietary trading in hedge funds and PE funds by banks (Lowenstein Sandler, p.3). The Legislation has provided for the advanced warning system before the stability of financial system is threatened. By setting up proper liquidation procedures for troubled institutions, tough capital and leverage requirements it has been made sure that the taxpayer’s money will possibly never be used to bailout the financial firms. The main features of Consumer Financial Protection Bureau (CFPB) are independent head, budget & rule-writing, creation of office of financial literacy, clearly defined oversight, examination and enforcement of regulations for banks, credit unions and mortgage related businesses, working with bank regulators, creation of consumer hotline and clearly defined oversight which excludes those small businesses that meet the standards. The main features of Financial Stability Oversight Council are expert members’ panel, stringent requirements on companies making difficult for them to become big, regulation of non-banking financial companies, setup of financial research office within treasury, periodic disclosure of risk assessments by Office of Financial Research, Federal Reserve supervision on banks that received TARP, capital structure standards and requirement to divest some holdings by firms deemed to pose threat to financial stability of the country. To prevent any future bailouts of troubled companies, legislation has provided guidelines such as no taxpayer funded bailing of the financial company, monitoring of systemic risks, Volcker Rule prohibiting proprietary trading, sponsorship of hedge funds and PE funds, payment, clearing & settlement regulation, proper liquidation procedures, limited Federal Reserve emergency lending, and limits on debt guarantees by Federal Deposit Insurance Corporation (FDIC). Other provisions of legislations included the Federal Reserve reforms, transparency and accountability to derivatives market, mortgage reforms, raised standards and regulation of hedge funds, oversight of credit rating agencies, corporate governance and executives’ compensation giving the shareholders right to object, and improvements on banking and thrift regulations (U.S. Senate Committee on Banking, Housing, and Urban Affairs, “Highlights of the Legislation”). Simply put, the legislation has tried to simultaneously reform various regulatory and supervisory models which historically have been associated with different financial institutions and products. This might be due to the complex mix of causes for financial crisis. Research Methodology The research methodology is an important section of a research paper. The validity of the research is determined by appropriate selection of research methods. Generally research can be conducted using primary data or secondary data. The aim of this paper is to research and analyze the Dodd-Frank Wall Street Reform & Consumer Protection Act, 2010 and the commitment of President Obama and his administration towards bringing the necessary changes through the Act. This paper does not provide an empirical analysis of the reforms but mainly discusses the provisions of the law and the effectiveness of Obama’s administration in economic recovery and any future implications of the reforms. Therefore the secondary data has been found to be useful. The research is basically a qualitative research. Discussion & Findings The new law Dodd-Frank Wall Street Reform & Consumer Protection Act has addressed all the issues raised in the wake of recent financial crisis providing greater governmental oversight. It is a very simple legislation, but due its wide horizon, the impact needs a substantial amount of time to uncover. In order to better understand the impact and future implications one has to take two phases: First phase is about the progress made by agencies in implementing the law in the last one year after the introduction of the legislation and second phase is about what can be expected from the future ahead. The second phase is discussed in the ‘Future Implications of the Proposed Reforms’ section. During the last one year the regulatory agencies have proposed and drafted rules and guidelines with the goal of transparency in mind as required by the reforms. For the Federal Bank, the new duties involved writing a lot of Dodd-Frank rules as well as monitoring the systemic risks of the institutions. Realizing this Financial Institutions Supervision Group is formed to take care of the Fed’s expanding role (Fest, “The Dodd-Frank Effect”). The congressional oversight required by the Dodd-Frank reform began in January 2011 (PWC, p.3). Although they covered every area of reform the derivatives reform and CFPB were the main focus throughout the year. The financial reforms law requires the risky derivatives trading activity to be separate entity from the banks, and the interest rate and currency derivatives can be traded in-house thus will not affect the derivatives industry except the requirement of transparency. The Dodd-Frank reform required the Systemically Important Financial Institutions (SIFI) subject to increased prudential requirements because of their likely impact on the stability of financial markets. This requirement is to limit the market impact from too much risk concentration. As the troubled banks’ list has grown to more than 25% since 2009, the FDIC has sent examiners to check on the every possible area of banks operations. There have been many changes in compliance procedures and risk management methodologies. The banks are asked to a further fair lending compliance and prudently classify the salvageable loans by these examiners. The FDIC’s acting chairman has identified the economic inclusion and mainstream banking services as their major priorities. There has been more than one year since passing of the bill but still a lot of time is needed for all the 11 banking regulators to finish their restructuring or start their operations. The launch of CFPB and merger of OTS and OCC two federal agencies were not official till July 2011. All the agencies have steadily filed their reports to Congress such as a joint study by SEC and Commodities and Futures Trading Commission, and clearinghouse trading regulations in Europe, US and Asia (Fest, “The Dodd-Frank Effect”). Due to the lagging rules-drafting, possible deadline extensions and downgrading of US debt ratings have left many bankers have to question if ever the Obama administration will be able to put proposed reforms in line. Future Implications of the Proposed Reforms The reform measures are very direct and simple but challenges theoretical foundations of the US financial system. The progress of last one year shows that the changes have just been started and a lot of time is left to see the effects. The banking regulators have just issued rules on Living Wills, the Volcker Rule, and systemic regulation. The derivatives regulators have adopted the derivatives and clearing rules. A new consumer finance federal regulator has become operational but the Basel III implementation is yet to be finalized. The Fed has created offices for policy and research, financial market analytics and infrastructure oversight. It is also helping to create the new requirements under Basel III. The difference with Fed’s approach in dealing with big firms is ‘macroprudential’ judgments which require deeper knowledge of the strategies behind portfolios (Fest, “The Dodd-Frank Effect”). There has been emphasis on risk-based modeling, a quantifiable analytics, in assessing banks’ credit risk measurements which didn’t prove to be effective during the crisis. It seems too much reliance on quantitative approach may leave examiners with narrow viewpoint. The future of the present reforms lies in the ability of the regulators to effectively implement rules with transparency and strict supervision of institutions’ systemic risks. The reforms provided by Dodd-Frank were primitive and it will take many reviews and meeting of regulators to arrive at the optimal solutions to all economic problems. Conclusion The paper has discussed various past recessions the US economy faced and the policy reactions from regulators and Congress. It has also analyzed the recent Financial Crisis and the need for financial reforms. The Dodd-Frank Wall Street Reform & Consumer Protection Act has been summarized and the major initiatives taken by the regulatory agencies are discussed. The reforms have resulted in formation of two major bodies -Financial Stability Oversight Council and Consumer Financial Protection Bureau. The reforms are prioritized on stringent supervision of financial institutions, the Volcker Rule which prohibits proprietary trading and speculative trading by private equity and hedge funds and derivatives regulation. The progress of agencies in implementing the new reforms has only been limited to drafting rules and launching the new regulatory bodies within the prescribed deadlines. The effects of the implemented reforms need more time to be seen. The reason can be the complexity of the US financial system and the long inherent business practices. References Clark, C.L. The American Economy: A Historical Encyclopedia, Volume 1. ABC-CLIO. 2011. Fest, G. The Dodd-Frank Effect. 2011. The Dodd-Frank Effect: Supervision and Compliance American Banker Magazine Article. November 08, 2011 http://www.americanbanker.com/magazine/121_11/dodd-frank-1043336-1.html. Jickling, M. Introduction. 2008. Averting Financial Crisis. November 08, 2011 http://fpc.state.gov/documents/organization/103688.pdf. Lowenstein Sandler. General Overview: Dodd-Frank Act. 2010. Dodd-Frank Wall Street Reform and Consumer Protection Act. November 07, 2011 http://www.lowenstein.com/files/Uploads/Documents/DoddFrank%20July%202010.pdf. Slander. What is Sarbanes-Oxley? Tata McGraw-Hill Education. 2005. U.S. Senate Committee on Banking, Housing, and Urban Affairs. Highlights of the Legislation. 2010. Brief Summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act. November 08, 2011 http://banking.senate.gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_comprehensive_summary_Final.pdf. Volcker, P. 2010. How to Reform our Financial System. November 08, 2011 http://www.econ.puc-rio.br/Mgarcia/Seminario/textos_preliminares/How%20To%20Reform%20Our%20Financial%20System%20(The%20New%20York%20Times).pdf. Read More