Will House-passed financial reform bill leave big risks?

The US House of Representatives on Friday passed a bill aimed at preventing a repeat of the financial crisis that shook the global economy in the fall of 2008. The sweeping measure would transform the regulatory landscape for banks and other financial firms.

Although it drew immediate praise from the Obama administration and consumer groups, some financial experts warn that the economy will remain exposed to the risk of bubbles, busts, and firms that are “too big to fail.”

The bill spans many markets and regulatory activities:

• Creates a financial stability council of regulators to identify financial firms that are so large or interconnected that their collapse would put the entire financial system at risk. These systematically risky firms will be subject to increased oversight, standards, and regulation.

• Gives the government new powers to dismantle large financial firms that fail. Investors in those firms would be exposed to losses during such a wind-down process. But, as regulators will also be trying to protect the economy from spillover effects, some critics of the plan say large firms might receive government assistance rather than bankruptcy-style restructuring.

• Creates a new consumer financial protection agency, aimed at preventing abusive or risky lending practices such as those seen during the subprime mortgage boom.

• Gives shareholders a “say on pay” for executives, an advisory vote including executive salaries and golden parachutes. It also enables regulators to ban inappropriate or imprudently risky compensation practices, and it requires financial firms to disclose incentive-based compensation structures.

• Regulates complex “derivative” investments, so that standardized transactions are traded on an exchange or electronic platform. Critics worry that this market, including “customized” derivatives that won’t be traded on exchanges, will have too little oversight.

• Requires hedge funds to register with the SEC and to be subject to systemic risk regulation by the financial stability regulator.

• Exposes the Federal Reserve to so-called “audits” by Congress, a move that finance experts say opens the door to limits on the Fed’s independence from politics.

To reach President Obama’s desk, the bill must be matched by one in the Senate, which has not yet moved its legislation toward a vote.

The bill comes at a time when Americans are deeply concerned about the economy and jobs – a situation that intertwines closely with banking policy. If lawmakers fail to improve regulation of the financial system, many experts say it could allow other big crises to occur – or restrain the economy’s growth during good times.

The concern was captured in a question Obama was asked during a town hall meeting last week.

“Are you confident that there have been enough safeguards put in place so that we don’t run over that cliff again with these irresponsible risky investments?” an audience member in Allentown, Pa., asked.

Obama used the opportunity to make the case for financial reforms, and said “if we get this package passed then we will have the safeguard in place to make sure this stuff doesn’t happen again.”

Economists are wary of saying that even a well-designed bill will prevent financial crises, which have occurred periodically before and after the modern era of central banking.

Simon Johnson, a finance expert at the Massachusetts Institute of Technology, recently praised Obama for pushing the idea of a new consumer protection agency for financial products. But, in recent testimony to the Congressional Oversight Panel on bank bailouts, he said Washington policymakers aren’t doing enough to rein in the economic and political power of large financial firms.

“The power of the financial sector [is based] on an ideology according to which the interests of big finance and the interests of the American people are naturally aligned,” he said. “This ideology is increasingly … dangerous to the economy.”

The huge bill has been a battleground for lawmakers and industry lobbyists, but supporters say it offers important new safeguards.

The measure “will guarantee we have new, tough rules for Wall Street to play by and will fully protect consumers, investors, and US taxpayers,” Rep. Dennis Moore (D) of Kansas said in a statement Friday.