Wall Street 2 Years Later: How Much Has Changed?

Saturday marks the second anniversary of the Wall Street reform law known as Dodd-Frank. Passed in the wake of the financial crisis that nearly destroyed the world economy, the law reforms Wall Street and the financial regulatory system to prevent or soften future crises.

Due to the colossal complexity of the industry and the law, as well as agency budget cuts and opposition from Wall Street, we still don't know what exactly the final form will be; regulators and Wall Street are still hashing out many of its details.

My take, from what we do know, is that the law will make the financial system safer, though -- as the series of scandals in just the past few months has shown, from MF Global's astonishing collapse, to JPMorgan's (NYS: JPM) massive sudden trading loss, to the LIBOR interest rate rigging -- there's still plenty of work to be done.

Here's a handy summary of some of the major parts of the law and their progress.

Too big to fail
Four banks in the U.S. control some 40% of the country's deposits. Five banks hold almost all of the financial industry's derivatives exposure. Wall Street's size and concentration was a big reason why the failure of a major bank would wreak havoc on everyone and why banks were bailed out instead of being allowed to fail.

The law requires the biggest banks to set aside more money, take regular stress tests, and submit a plan for how they'd be wound down in case things go wrong. It also clarifies that instead of bailouts, the FDIC should manage the bankruptcy, cleanup, and sale or liquidation of failing megabanks just as it does for smaller, simpler banks.

Although the FDIC has been doing a good job of thinking through all the logistical problems of how this would work, it remains to be seen whether it's even possible for the relatively small agency to handle the failure of a large, international behemoth or two during a financial crisis.

So, in addition to figuring out what to do with large banks when they fail, it would have also made sense to shrink unjustifiably large institutions (say, over half a trillion in assets). Citigroup (NYS: C) , Bank of America (NYS: BAC) , and Morgan Stanley are roughly the same size as they were when the law passed, and Wells Fargo (NYS: WFC) , JPMorgan, and Goldman Sachs have actually gotten a little bigger.

Consumer protection
One of the many reasons for the prevalence of risky mortgage products that blew up during the financial crisis was the sketchiness of many fly-by-night lenders. Financial regulators failed to ensure honesty and transparency in financial products in part because none of them really cared; protection responsibilities had been scattered across a half-dozen financial regulators as a minor priority.

So Dodd-Frank set up the Consumer Financial Protection Bureau to consolidate consumer protection into a dedicated agency that's supposed to be for the financial industry what the FDA is for the pharmaceutical industry, although the goal is arguably much more modest than that. Instead of inspecting products before they go out to the market, the CFPB claims it will mostly try to ensure clarity in contracts and honest marketing to prevent a race-to-the-bottom in fine-print legalese.

The main financial industry lobbyist group has complained that the agency has meant fewer creative financial products, though they acknowledge that it hasn't reduced the availability of credit.

So far, the agency has mostly been busy with the logistics of getting set up, but it's done a few substantive things.

  • It's proposed simpler loan estimate and closing disclosure forms for mortgages and has created a non-mandatory two-page credit card contract prototype.

  • The agency is looking into monitoring credit reporting agencies.

  • It's also been collecting consumer complaints and has levied its first enforcement action -- a $210 million fine to Capital One for allegedly misleading credit card customers, the majority of which will be refunded to customers. (A few other companies, including Discover Financial, have said they're under investigation.)

Shareholder bill of rights
Some parts of the so-called "Shareholder Bill of Rights" that many Fools supported were incorporated into the bill.

  • Shareholders have a stronger ability to voice their displeasure at overpaid and underperforming management teams. The law requires clearer disclosure of executive compensation and "say on pay," an annual, nonbinding shareholder vote on executive compensation.

  • The law also clarified that the SEC has the ability to give shareholders the right to nominate directors to boards of directors to ensure that boards are representing shareholders rather than kowtowing to CEOs. A few months later the SEC wrote a rule giving shareholders that right, but for now it's been blocked in court by the Business Roundtable and Chamber of Commerce.

By the end of 2007, Lehman Brothers had borrowed $30 for every $1 of its own money. That means a little more than a 3% decline in the value of its investments would bankrupt it.

Higher capital requirements in Dodd-Frank and international negotiations have pushed banks to use less leverage and hold bigger capital cushions to protect themselves for the next time things go wrong:

It's arguable that capital levels should have been set even higher than they were to further smooth out Wall Street's profits and losses and make the financial system more stable, but higher capital requirements are gradually making banks safer than they would otherwise be.

Until now, derivatives -- financial instruments used to hedge risk and speculate -- had been the wild west of Wall Street. Since they weren't usually traded on exchanges like stocks or sent through clearinghouses for collateral, no one knew which banks were safe and which were in danger of collapse when the crisis hit in 2008-2009. That left the financial system vulnerable to panic and the possibility of a domino-like collapse where the failure of one company like AIG (NYS: AIG) with too much derivatives exposure could easily take down many others.

Among other things, the law requires derivatives that are able to run through exchanges and clearinghouses to do so. It's an insanely complicated market, and the CFTC has written about two-thirds of the 60 rules assigned to it despite a crimped budget.

Besides the sheer complexity of the task, one challenge will be the fact that the heavy concentration of derivatives trading in a small handful of banks gives them enough market power over clearinghouses.

Volcker Rule
In 1999, Congress repealed the portion of the Great Depression-era law known as Glass-Steagall that separated boring, safe, federally insured depository commercial banking from exciting, risky investment banking. The following decade saw huge mergers between enormous commercial and investment banks and an explosion of proprietary trading and risky leverage at the new megabanks.

Dodd-Frank partially fixed the problem with the so-called "Volcker Rule" that tries to prevent banks with deposits from trading for their own account and clears up some conflicts of interest where banks like Goldman Sachs were allegedly betting against the same products they were selling their own customers.

Although the Volcker Rule may work, the rule is still being finalized. It's complicated to legally define which kinds of activities are allowed and which aren't, and the rule has ballooned to massive complex proportions as regulators and a few congressmen try to accommodate all the exemptions that Wall Street is arguing for.

In May, JPMorgan CEO Jamie Dimon announced his bank had lost $2 billion -- now up to $6 billion -- on a "flawed, complex, poorly reviewed, poorly executed and poorly monitored" trade using bank deposits that he claimed wouldn't have violated the Volcker Rule. But it should clearly have been covered by the spirit of the rule.

If the Volcker Rule, once implemented, doesn't prove up to the task, hopefully next time we'll just reinstate the full, clear Glass-Steagall separation between commercial and investment banking.

A step in the right direction
On the whole, the Dodd-Frank Act goes a long way toward making the financial system safer. But fixing Wall Street and our financial industry regulators is also a massive undertaking. Because the incentive to take huge risks and rip off customers appears so far to be largely unchanged, it still remains to be seen whether the law, once fully implemented, will be able to prevent the next crisis, or whether a more fundamental reform of Wall Street will be needed.

What do you think? Let your fellow Fools know in the comments box below.

Ilan Moscovitzdoesn't own shares of any company mentioned. The Motley Fool owns shares of JPMorgan Chase, Bank of America, and Citigroup.Motley Fool newsletter serviceshave recommended buying shares of Wells Fargo, Goldman Sachs Group, and American International Group. The Motley Fool has adisclosure policy.

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