Thursday, May 20, 2010

Market reacts when financial reform bill clears Senate

It was a terrible day in the market, with European and general capital markets uncertainty and some disappointing economic statistics for the U.S. economy. At approximately 2:50pm it was announced that the Senate had passed the financial reform bill for all practical purposes. The market then dropped another 200 points in the last hour. Is this a coincidence, not likely, and where is this reported as a reason for half of the day's swoon.

The bill passed by the Senate still contains the Blanche Lincoln led complete break of the derivatives business from all banking institutions. This remains insane. Derivatives should definitely be regulated and traded transparently to the extent possible but to divorce this financial tool from all banks makes no sense, as detailed here several weeks ago. That a Senator with no knowledge of finance or apparently current day business, from a state where the Democratic primary attracts only 220,000 voters in total, can force this through the Senate is a joke, but unfortunately all too real. The bill also still contains the most onerous limits on proprietary trading. Prop trading should have oversight but separating simple balance sheet management from what is actually prop trading is difficult at best, and applied by regulators in a rigid way could create far more risks for banks if their balance sheets cannot be hedged due to interference by bureaucrats with a limited understanding of risk management.

These two aspects of the bill are why the market reacted. For those who say, "get over it, the financial industry needs to be regulated harshly, this will pass", the answer is "not so fast". Large corporate America depends on its banks for financing and myriad services. When their banks lose earnings power they lose their ability to build capital, thus losing their marginal ability to finance. When their banks lose their risk management capabilities, financing cannot be appropriately hedged. The point is that this regulation is not limited to an impact on banks. It will have a meaningful impact on corporate America and eventually on capital investment and job creation broadly. That's why it was a broad market reaction to the Senate bill, not just a sell-off in banks.

There remains the House and Senate conference to reconcile the two bills. If the Congress keeps avoiding the issue and passing the buck to avoid any political risk, these misguided provisions could improbably become law. If so, historians looking back will mark this bill as the point at which the Great Recession took hold again and led to the unknown. That may be too dramatic, but it's true in my head and my gut today.


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