Q&A: US bank regulation

Lehman Brothers employee clears his desk during the financial crisis The bill is a belated reaction to the global financial crisis of 2008

The US Congress has agreed a bill containing the biggest overhaul of banking regulation since the 1930s.

The bill is the culmination of efforts led by President Barack Obama to ensure that the financial crisis of 2008-09 can never be repeated.

What will the bill do about financial regulation?

A new Consumer Protection Agency will be created with a mandate to clamp down on abusive practices by credit card companies and mortgage lenders. A big chunk of the enormous losses in the sub-prime mortgage market was due to fraudulent lending to US home buyers who had no hope of repaying their loans.

Regulatory oversight of the financial markets will be ramped up, with the creation of a new Council of Regulators that will bring together the heads of the various financial watchdogs. The Federal Reserve (the US central bank) is likely to have a leading role.

What about the big banks?

Regulatory authorities will be given new powers to seize and conduct an orderly liquidation of large financial firms like Citibank. It is hoped that this will address the so-called "too big to fail" problem, whereby pushing huge firms into a full-blown and complex bankruptcy process during the height of the financial crisis - as happened with Lehman Brothers - could destroy the entire financial system.

Large banks will be required to increase the amount of capital - money raised from shareholders - that they hold in reserve against possible loan losses. However, this requirement will only come into effect after five years, as a faster timetable might have forced poorly capitalised banks to cut their lending back.

What is the Volcker Rule?

Banks will be banned from proprietary trading activities (that is, the ability of traders to make large speculative bets on financial markets using their bank's money). This was a key plank of the so-called Volcker Rule, named after Paul Volcker, chairman of the Economic Recovery Advisory Board, who proposed it.

A second leg of the Volcker rule also survived negotiations, though in a limited form. Mr Volcker wanted to ban banks from making risky investments in hedge funds and private equity funds. Hedge funds make money via clever - but often high-risk - trading strategies, while private equity firms buy up and then shake up underperforming companies. Instead, the bill will limit banks investments in these funds to 3% of their capital.

And derivatives?

Derivatives are contracts that allow companies to hedge their exposure to (and hedge funds and banks to speculate on) the financial markets.

Under the reforms approved, most of the $600bn derivatives market will need to be cleared through third-party exchanges. This will reduce the risk that institutions that wrote these derivative contracts fail to pay out the amount they owe if they go bust.

Banks will also be required to hive off some of their swaps businesses into affiliated companies, in order to reduce their exposure to potential losses. Swaps are among the most profitable types of financial derivatives carried out by the banks.

Are the reforms popular?

The bill is surprisingly draconian, considering the initial opposition of Senate Republicans to reform.

However, clamping down on Wall Street plays well with voters from across the political spectrum, and it is likely that many senators had November mid-term elections in mind when they decided to vote in favour.

Public anger is likely to have been further inflamed by the return of big bonuses for bankers this year, as well as the accusations of fraud levelled at Wall Street firm Goldman Sachs by US regulators.

What do the banks think?

Unsurprisingly, the banks lobbied heavily against the new reforms.

President Obama criticised the financial services industry for unleashing "hordes of lobbyists and millions of dollars in ads" against the bill.

As financial markets have recovered over the past 12-18 months, banks have begun to turn in big profits again.

But most of those profits have been derived from the banks' trading activities, precisely the business area that will be worst affected by the new reforms.

The plan to hive off banks' proprietary trading and swaps businesses roused their particular ire.

And the requirement to shift derivatives contracts on to third-party clearing houses is likely to make them much less profitable, as the contracts will need to be simpler and their pricing more transparent.

What about Europe?

Brussels has revealed proposals for a national network of "resolution funds" partly paid for by the banks, which would be used to help dissolve failing banks rather than bailing them out.

There are also new rules on hedge funds and private equity funds which have been approved by EU finance ministers, despite opposition from London's financial hub, the City.

There is also a growing international consensus on the need to tax banks more heavily and to clamp down on banks' usage of tax havens.

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