Proposed Reforms (Part 1)

With sweeping financial industry reform again on Washington’s agenda what should investors be watching? Last week, the House Financial Services Committee took up debating the major proposals. The big issues to be debated in the coming months include:

Too-big-too-fail institutions – A proposal would create a designation for financial institutions that are systemically important and subject them to special regulation. The outcome of this legislation is likely to have a market impact. At first glance, this designation would give an institution a competitive advantage because it would have what amounts to Government Sponsored Enterprise status with an implied government guarantee. This competitive advantage for Tier 1 institutions to access capital cheaply may result in consolidation of the industry among a few systemically important institutions rather than a larger number of competitors that would pose less individual risk to the financial system – which would be counter to the intention of the legislation. However, the additional cost to these firms in the form of higher capital requirements, contributions to pre-fund a bailout fund, and the threat of a break-up may have negative consequences. Last week, the UK regulators forced Royal Bank of Scotland to sell some business lines to reduce the size of the institution and the stock reacted poorly falling over 10% in a couple of days. Clearly, how this issue is dealt with is very important to the financial services industry. This is the most contentious issue and is unlikely to be resolved before the end of the year resulting in lingering uncertainty for the sector.

Consumer Financial Protection Agency – The Obama administration has proposed the creation of a new agency intended to protect consumers purchasing financial products. The focus has shifted from regulating the types of products that can be sold, (which would eliminate complex financial products and ensure only plain vanilla products are marketed) to making sure the disclosure is appropriate on products that are more complex. The reach of this agency to regulate what products are sold, how they are marketed, and perhaps even how they are priced is critical to the size and profitability of the financial industry. This could be a positive for the sector if it lessens the risk of default or litigation risk for lenders, but presents challenges if it forces consolidation as the products become commoditized.

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