"The Two Issues to Watch on Financial Reform"

As financial reform progresses through the legislative process, how can you tell if it is being watered down by "lobbyists and their politician allies"?:

The Two Issues to Watch on Financial Reform, by Alan Blinder, Commentary, WSJ: We may now be approaching the final act of the lengthy legislative drama of financial regulatory reform. ...

That said, it is way too early to declare victory. Armies of lobbyists and their politician allies are still fighting to weaken the bill in a variety of ways. ... So here are two bellwether issues to watch.

The first is the fate of the proposed Consumer Financial Protection Agency (CFPA). ... On the consumer protection front, there are the three key things to watch:

First, how much independence will the new agency have, especially for writing and enforcing rules? ... People who come to bury the CFPA, not to praise it, want to subordinate it to some more powerful agency.

Second, and related, to what extent does the legislation create an agency focused on a single mission: protecting consumers? Opponents of the CFPA concept would rather hand the responsibilities over to, say, the Fed, where consumer protection would be its fourth most important priority—after monetary policy, financial stability, and safety-and-soundness regulation.

Last, but certainly not least, watch how many institutions and financial products get exempted from consumer protection regulations. The more, the merrier for the industry—but not for the public.

The second bellwether issue is the regulation of derivatives. ... Creative derivatives such as the notorious CDOs ... and CDSs ... made it too easy for financial gamblers to synthesize dangerous amounts of leverage. One way or another, regulators must restrain the wild-and-wooly derivative markets.

Alas, there is no perfect way. But my favorite approach has long been to push derivative trading onto organized exchanges... But before derivative contracts can be traded on exchanges, they must be standardized—which is now the exception, not the rule.

Both the House and Senate bills embody this idea—except for the exceptions. ... As the debate progresses, watch those exceptions like a hawk. How many derivatives will be allowed to remain customized...? ...

Yes, there are unusual cases in which customization is important. But let's not deceive ourselves: The primary beneficiaries of customization are the ... five big Wall Street firms... If they can stave off standardization and exchange trading, comparison shopping will remain very difficult and profit margins will remain sky high. But if reform makes standardized, exchange-traded products dominant, competition will squeeze profit margins to the bone. ...

Under heavy pressure, the House bill allowed too many exceptions. But the bill passed yesterday ... suggests the Senate may take a much tougher stand. Let's hope so. ...

While much else will be going on, watch the exceptions for derivatives and the strength of consumer protections. And keep your fingers crossed. This just might work

There seems to be a lot of optimism building over financial reform, but in key areas such as limiting leverage, bank size, the CFPA, and derivatives, the reforms do not go far enough. The worst outcome of all is a bill that makes people believe they system is safer when in fact the risks are still present.

We will be safe so long as the present crisis is fresh in our minds and caution is the order of the day in the financial marketplace, but it won't be too long until we forget and that's when the danger begins. Once the appetite for risk returns, if the financial system -- including regulatory oversight -- operates under the false presumption that the system has adequate protection built into it, another meltdown is all too possible.