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Base text on financial reform released

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Late Thursday afternoon the base text the conferees on financial "reform" will use as the starting point for the debate was made public. Here are some of the highlights of the base text:

1. Too-Big-To-Fail: The base text from which the conferees will work includes the Senate bill language which does not have a pre-funded liquidation fund. The process is somewhat akin to provisions in the Bankruptcy Code and the FDIC is responsible for liquidation of TBTF institutions. There are provisions, however, that give the FDIC broad authority to pick and choose which debt holders will be given priority, and the Federal Reserve still has authority to make cash advances as may be necessary. Reasonable people disagree about whether these provisions actually end too-big-to-fail as a matter of national policy.
2. Minimum Capital Requirements: The language of the Senate bill is included in the base text, at least to begin the debate. This means that trust-preferred securities (and Treasury TARP investments) may not be included as Tier 1 capital for bank holding companies. Regulators will establish minimum leverage and risk-based capital requirements for all banks, bank holding companies and other financial firms.
3. Consumer Financial Protection Bureau: The base text includes language from the Senate bill that creates a new consumer protection bureau within the Federal Reserve. It is not answerable to the Fed; it's just housed there. The director is appointed by the president and the new agency will have extremely broad powers to write the rules to which all traditional banks will be subjected in dealings with their customers. Interestingly, Wall Street firms and mortgage brokers are exempt from its provisions.
   • Definition of "Abusive" Acts or Practices: The language includes a new and undefined legal term, "abusive," and adds it to the prohibition on unfair and deceptive acts or practices. There's not much legal definition of this term and mostly it will be determined by a look in the rear-view mirror.
   • Enforcement of Contracts: The base text includes a modified version of the Senate bill's provision on contract enforcement, but drops the language that would have made it unlawful to enforce or seek to enforce any contract for a consumer financial product or service that is not in conformity with any consumer protection law transferred to the new CFPB or any new rule issued by the agency. Thankfully.
4. Interchange: The Senate language is included which directs the Federal Reserve to set "reasonable rates" for "interchange charges" for debit and gift card transactions. The fee can only be based on the "cost" of the transaction, and permits retailers to discriminate between various debit and gift cards that may have a higher interchange rate.
5. Risk Retention Requirements for Mortgage Originators: The Senate language regarding mortgage originators and securitizers is adopted. That means there's a "safe harbor" provision for well-underwritten residential mortgages, presumably those underwritten by traditional banks.
   • The originator would not be required to retain up to 5 percent of the credit risk on such loans.
   • The Senate language would also minimize the risk retention requirements for commercial mortgage backed securities.
   • Provisions from the House bill banning yield spread premiums and imposing an "ability to repay" standard on all loans and a "net tangible benefit" for refinanced loans are included.
   • It would also establish a safe harbor for determining ability to repay and net tangible benefit, based on the same standards established for ability to repay included in the Senate bill (fully documented income; no negative amortization loans; no interest only loans, for example).
   • It would restrict (but does not ban) balloon loans and would impose new restrictions on "high cost" loans.
6. Preemption: The conference text includes the Senate version on preemption which preserves the Barnett Bank standard. It's not the greatest result, but it's better than the House version.
7. Derivatives: This is where there is likely to be a major disagreement. The initial text from which the conferees will work adopts the Senate language. That language requires most derivatives to be cleared through clearinghouses and also traded on an exchange. As a practical matter it severely limits the ability of banks regardless of size to engage in swap transactions. It also imposes a fiduciary duty on swaps entities when engaging in transactions with municipalities, state or federal agencies, endowments or pension plans.
8. Volcker Rule: The Senate language is in the base text and basically prohibits banks, holding companies and affiliates from engaging in "proprietary trading" in financial instruments, as well as investment in, and sponsorship of hedge funds and private equity funds. It also limits relationships with those funds.
9. State Bank Lending Limits: The base text retains language from the Senate bill that applies national bank lending limits to state banks.
10. FHLB Concentration Limits: The base text adopts House language that excludes the FHLBs from concentration limits.