Why financial reform doesn't go far enough to be truly effective © Brandx Pictures/photolibrary

Extra7/1/2010 6:00 PM ET

10 ways financial reform falls short

Good things survived the weakened legislation providing oversight and regulation of the US financial system. But the measure needs to be stronger.

By David Weidner, MarketWatch

Washington has shuffled the deck Wall Street plays with, hoping to create a new and safer game, but anyone who's gone back to the table after a big loss knows the score: same cards, same risks, and, if you stick around long enough, the house always wins.

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There are a lot of good intentions built into the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was approved by the House on June 30 but needs a final vote in the Senate, which won't take up the measure until after Independence Day.

Lawmakers have sought to create standards for mortgage underwriting, to preserve and strengthen bank capital requirements and move risky derivative exposure off balance sheets and into the open.

The banks with the most to lose include Bank of America (BAC, news, msgs), Citigroup (C, news, msgs), JPMorgan Chase (JPM, news, msgs), Goldman Sachs Group (GS, news, msgs) and Morgan Stanley (MS, news, msgs).

If you boiled down the complex bill's main flaw, it's that it puts too much emphasis on regulators who have failed in their charged tasks. The Securities and Exchange Commission and Federal Reserve -- at least based on their track records -- are short on the manpower and brain power required to successfully oversee Wall Street risks.

Without trained and well-paid regulators, and without closing the revolving door between Washington and Wall Street, it's hard to feel hopeful about financial reform, well-intentioned as it may be.

And despite the best intentions, the bill leaves plenty of loopholes to exploit. Here are 10 obvious ones:

1. The "Volcker Rule." Intended to reduce bank risk, the Volcker Rule would curtail bank participation in proprietary trading as well as private-equity and hedge fund investments -- businesses that arguably were tangential to the financial crisis. Don't believe it? Name one depository institution that teetered due to investments in these businesses.

2. Derivatives. Banks would be forced to spin off some derivatives and add more capital to those they kept. Exchanges would provide transparency. This would probably dampen bank profits. But really, looking back, it's unclear how this rule would have prevented the earlier crisis. The biggest credit-default-swap provider that ran into trouble was American International Group (AIG, news, msgs), an insurer, not a bank.

3. An oversight council. The legislation would create the Financial Stability Oversight Council, a regulator that would monitor Wall Street's largest firms and other market participants to spot emerging systemic risks. Creating a committee is what you do when you don't know what to do or are too scared to do anything.

Does anyone really think regulators who fed or at least missed the housing bubble would spot the next one? Even if they did get it right, any council decision would require a two-thirds majority. And even that could be challenged in court.

Moreover, without clear restrictions on bank size -- four banks control 56% of assets in relation to gross domestic product -- what are regulators supposed to look for? Matches and gasoline?

4. The Federal Reserve. The central bank would get a one-time audit of emergency loans and other actions taken to combat the financial crisis since 2007, but what would happen after that? Could any good news come out of a review?

Also, the body with a laissez-faire approach to derivatives (the Fed shouted down regulation in the late 1990s) would retains it authority over smaller banks and become a last line of defense, since the bill would eliminate the Office of Thrift Supervision.

5. State pre-emption. Inclusion of a provision setting a high bar on federal regulators before they could pre-empt state law is a big defeat for banks, which don't want to tangle with 50 new sets of rules. But the benefits would be short-lived in states that wanted to entice the banking industries to their state through "finance friendly" regulation. Consumers in those states would lose.

6. Consumer protection agency. A needed body to police banks and financial-services businesses for credit card and mortgage lending abuses, but unfortunately it would be run by the Fed, which would have to tackle payday lenders, check cashers and other nonbank finance companies.

Also, lobbyists scored a victory in that auto dealers would be exempted. "No money down, no credit check" still lives for what's usually the second-biggest financial decision for a household.

7. Fiduciary duty. The act would wipe away incentives to brokers who steered clients to expensive loans. That probably means all loans would become expensive.

For financial advisers, the move to a "fiduciary" standard from a "suitability" standard would increase costs without obvious benefits.

8. No Fannie, no Freddie. Exclusion of Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs), the quasi-independent agencies that buy and sell a majority of the nation's home mortgages, from financial reform is a travesty.

9. Credit rating firms. The legislation would add some liability on companies such as Moody's (MCO, news, msgs) and Standard & Poor's, a unit of McGraw-Hill (MHP, news, msgs), and give the SEC oversight of the industry.Does the name Bernie Madoff mean anything to those who think the SEC is up to the task?

10. Glass-Steagall. The bid to reimpose the Depression-era banking reforms that separated investment banking from depositary banks was excluded from the bill. For more than 50 years it basically kept the casino out of the bank branch. The industry says finance is too complex to bring it back. Proponents say that's precisely the reason it should have been brought back.

There's more, too. Where are protections against off-balance-sheet entities? Other than a benign say-on-pay provision, where's any kind of executive pay provision? Does a bank owning 5% of a mortgage-backed security make anyone feel safer?

Don't get me wrong. The Dodd-Frank bill has some good things in it. Compared with business as usual, it would stop the wide-open environment the financial industry has operated in for a decade.

But really, the bill could have been so much more.

Even if regulators make all the right moves, there's still a lot of potential for trouble. Switching the game from Texas hold 'em to gin rummy must have sounded safe in committee. Too bad the game is going on in the back of the bank.

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