Will Banks Find Wiggle Room Post-Reform?

NEW YORK ( TheStreet) -- The financial reform bill that is headed toward President Obama's desk covers nearly every element of finance from Wall Street to the local community bank.

"Unless your business model depends on cutting corners or bilking your customers, you have nothing to fear," the president said in a speech on Thursday afternoon.

Still, the Dodd-Frank Act that finally passed through the House and Senate overlooked one important item: Simplicity.

In fact, despite assurances that the financial-reform bill would streamline the financial regulatory system, the Dodd-Frank Act may have actually made it more complex and added new arbitrage opportunities. Now it's a question of whether regulators can effectively implement the array of new rules among an array of new and existing agencies.

"No one with a clean sheet of paper would come up with the current structure," Michael Helfer secretary and general counsel at Citigroup ( C) said Thursday, just hours before the reform bill had passed. Helfer called the lack of streamlining of the system "the lost opportunity" of financial reform.

When a top bank executive says the financial reform bill didn't do a good enough job of closing loopholes, that says a lot about how much the bill accomplished in that regard. It's an important factor because, even if finreg represents the best, most effective laws that could be placed on the books, they're made moot if implemented poorly.

Right now, banks answer to up to seven regulators, depending on how they are chartered and what businesses they operate in. There's the Federal Deposit Insurance Corp., Federal Reserve, Securities and Exchange Commission, Commodity Futures Trading Commission, Treasury Department -- as well as the Office of Thrift Supervision and Office of the Comptroller of the Currency within it -- and state regulators as well.

The system has long been criticized as being rife with opportunities for so-called "loophole lawyers" who figure out ways for banks to take advantage of conflicting regulatory agendas: A state-chartered bank answers to someone other than the federally chartered bank, and banks with an array of different business lines had no one regulator manning the ship.

Furthermore, while the Fed has always had the highest perch upon which to look down at the financial system, it could only enforce action on holding companies, not the entities within them. The Fed also has been criticized for failing to pop the housing bubble as it was inflating. The OTS allowed banks like IndyMac to get away with practices that were embarrassingly irresponsible when disclosed. The SEC doesn't have the greatest track record of enforcement, either, as Judge Rakoff made plain when handing down his judgments on a Bank of America ( BAC) lawsuit last year.

Effectively, if a bank asked its mom to stay out late on Friday night and she said no, it would try to ask dad, who was less strict. If all else failed, the bank would sneak out of the house, and neither parent seemed to have been much of a disciplinarian anyway.

"I think being streamlined definitely makes it more effective," says Heath Tarbert, former special counsel at the Senate Banking Committee who heads Weil, Gotshal & Manges' regulatory reform group. "I think fragmentation is one of the reasons that the system has been largely ineffective."

Large banks like B of A, Citigroup ( C), JPMorgan Chase ( JPM) and Wells Fargo ( WFC) answer to an array of regulators. Those that oversee one-time investment banks like Goldman Sachs ( GS) and Morgan Stanley ( MS), which mainly operate in the capital markets, have been panned as ineffective. Meanwhile, other huge firms like American International Group ( AIG), Fannie Mae ( FNM) and Freddie Mac ( FRE) got into hot water partially because they faced relatively little regulatory scrutiny, and big hedge funds didn't really have to answer to anyone at all.

The Obama administration pledged to change that when it first unveiled its sweeping reform proposal roughly a year ago. It promised to "address an important source of regulatory arbitrage" by getting rid of the OTS and creating a broad oversight council. Both of those objectives were accomplished by the reform bill.

Yet, the bill also creates a new consumer-protection agency, delegates additional powers to existing regulators and requires them to coordinate with one another before taking action. Instead of seven or eight regulators with conflicting opinions butting heads, there will now be nine or 10.

"At the end of the day, they're only getting rid of one agency and adding a bunch of other agencies," says Tarbert.

Furthermore, the oversight council will be composed of 10 key regulators, charged with handling issues that affect systemic risk.

"There will be 10 different institutional imperatives and 10 different egos," says C. F. Muckenfuss III, a former regulator at the Treasury and FDIC, said on Thursday at a regulatory-reform panel discussion sponsored by SIFMA, the securities industry's main trade group.

Tarbert also points out that "the people that comprise the membership are incredibly busy people. Not only do they bring different viewpoints, but their main job is to run their agency, which is probably three jobs in one as it is."

Still, Tarbert believes that the reform measure did a pretty good job at closing some of the loopholes. He says the fact that agencies will have to coordinate when taking action will disallow the arbitrage that flourished during the Gramm-Leach-Bliley days. Additionally, if regulators are too busy butting heads to be effective, the Fed will have enough power to overstep them and crack down on practices that could harm consumers or the financial system.

"If the Fed looks at the whole structure and sees a subsidiary that's overseen by another regulator, let's say the SEC, it'll go to that regulator and say, 'What's going on here?' " he says. "And if that regulator doesn't act, the Fed can go in and take action."

Perhaps the better question to ask is whether any industry with such complex operations, whose actors are interconnected not just with each other but with businesses and consumers across the globe, can possibly be handled in a simple format.

Mahesh Swaminathan, who heads strategy for residential-mortgage backed securities at Credit Suisse ( CS), said recently that the financial system has modernized along with technology to suit people's demands.

"I don't necessarily think complexity is bad," said Swaminathan, referring to complexities of the housing financing system. "Horse and carriages were simple, but I don't necessarily think we're going to give up our automobile for that."

Perhaps the same idea can be applied to financial regulation.

A single regulator wouldn't be able to handle the task of managing thousands of banks and nonbank institutions all on its own. And while having competition among regulators with conflicting opinions may present loopholes, it will also result in the kind of dialogue and competition that is necessary for the most effective regulation.

At the conference on Thursday, Neal Wolin, deputy to Treasury Secretary Tim Geithner -- both of whom played a key part in structuring the new reform bill -- acknowledged the criticisms but said the Obama administration was satisfied with the bill that was then poised to pass through Congress.

"To legislate every detail of financial regulation -- every issue of practical application -- would be to create a fixed and brittle system," said Wolin. He called the bill "thorough and specific" and pledged that the new regulatory hierarchy "will replace a regulatory system that was deeply, fundamentally flawed."

-- Written by Lauren Tara LaCapra in New York.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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