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Banking Reform and You: Will the System Be Safer? (Part 1 of 3)

July 19, 2010

| MoneyRates.com Senior Financial Analyst, CFA

The long-awaited financial reform bill overhauling the nation's banking system in the wake of the housing bust and credit crisis is now reality. The legislation is wide-ranging and took many twists and turns in the legislative process.

How will this new law affect banking customers, particularly depositors with a money market account, savings account, or CD? MoneyRates.com breaks it down in a three-part series. Part 1 here examines whether the new law will make the financial system safer. Part 2 looks at the costs of the new law, and Part 3 examines how the financial reform legislation should affect shopping for a bank.

How Financial Reforms Help Deposit Safety

The new financial reform legislation does attempt to stabilize the financial structure of banks and provide consumer protections. In particular, the law provides for:

  • Curbs on proprietary trading. Elements of what has become known as the "Volcker Rule" (after proponent and former Federal Reserve chairman Paul Volcker) made it into the new law. These elements will limit proprietary trading, or bank investments in hedge funds and derivatives, especially when insured deposits are used for those investments. These limits should rein in some of the most egregiously high-risk behavior that put certain financial institutions--and thus their depositors--in sudden jeopardy during the banking crisis. However, the curbs on proprietary trading are far from a total protection. Banks are being given seven years to cut back on their hedge fund investments, and there is some wiggle room in the definition of a derivative investment.
  • Extension of deposit limit. The new law permanently raises the Federal Deposit Insurance Corporation (FDIC) deposit insurance limit to $250,000 per individual per institution, a measure that is already in effect but had previously been scheduled to expire at the end of 2013. This is a clear win for consumers with deposits in CDs, savings, or money market accounts.
  • New government authority for banking oversight. The financial reform law gives the government new powers to step in and liquidate troubled firms that are large enough to cause broad damage to the financial system, and also creates a council to monitor systematic financial risks. This means that major triggers to financial calamity should be caught and diffused earlier.
  • The Consumer Financial Protection Bureau. This bureau, housed within the Federal Reserve, will be charged with monitoring the retail practices of financial institutions and with enforcing consumer protections. However, banks with less than $10 billion in assets will be outside its jurisdiction--and the vast majority of banks offering savings accounts, money market accounts, and other deposit accounts have less than $10 billion in assets.
  • Tougher mortgage standards. Mortgage lenders will be given new responsibilities for determining a borrower's ability to repay the loan. This should not only protect individual borrowers but might have prevented (or at least slowed) the flood of bad debts that jeopardized the banking system two years ago.

In terms of making the US financial system safer, the most significant provisions are the Volcker Rule restrictions and the mortgage lending guidelines. Features such as higher deposit protection and the government's resolution authority for large, troubled banks are more like safety nets--they don't prevent trouble, they merely try to catch a problem after it has happened. However, extending a safety net doesn't always encourage safer behavior--sometimes just the opposite is true.

Ultimately, a great deal depends on how the new regulations are enforced. After all, there were a variety of regulatory agencies, not to mention House and Senate banking committees, in place as the last crisis developed, but nobody took action until it was too late.

Perhaps that lesson, along with the new regulations, will be what makes things different next time around.

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