Real US financial reform out of lawmakers' hands

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As Senator Christopher Dodd attempts to seal his legacy by pushing through sweeping financial reform legislation this year, the real changes that threaten financial firms' bottom lines lie in the ever-shifting hands of regulators.

It is the regulators and examiners on the ground who have the ability to set capital standards, judge loan values and tell firms to knock off risky behaviors, all outside of the give-and-take game between lawmakers and lobbyists.

So while lawmakers spend the coming months putting the final touches on their broad-brush reforms, a cloud of uncertainty will loom over financial firms, especially because some chief watchdogs are soon due for an exit.

"Congress and the legislation sets the foundation and maybe designs the blueprint of the house, but the regulators finish the construction," said David Hirschmann, president of the US Chamber of Commerce's Center for Capital Markets Competitiveness. The chamber is the nation's largest business lobbying group and a vocal opponent of many of the proposed financial reforms.

"Ultimately the regulatory stage is just as important, if not more important," Hirschmann said.

One example is hedge fund registration. The industry has largely signed off on registering -- a key component of the reform bill that passed the House and has been proposed in the Senate.

But the real impact would be in what exact disclosures the U.S. Securities and Exchange Commission requires, how the agency does its examinations, and if the agency is any good at it. "Ultimately that matters much more to hedge funds," said Hirschmann.

Another big question mark will be the personalities who help shape the regulators' approach to stepped-up policing.

John Dugan, head of the Office of the Comptroller of the Currency and the key regulator of the nation's largest banks, will likely step aside when his term is up this summer.

Sheila Bair, the chairman of the Federal Deposit Insurance Corp and a highly influential voice on reform, has said she wants to move on to non-profit work or return to academia when her term is up next year.

And the Federal Reserve will get a shake-up of its board, which has two of its seven seats open and may get a third if Vice Chairman Donald Kohn leaves when his term expires in June.

Financial institutions will have to wait and see if new people take a fresh, hard-nosed approach like SEC Chairman Mary Schapiro took when she grabbed the reins from the more business-friendly Christopher Cox.

She has been in office less than a year but has already stepped up enforcement, pledged to crack down on lucrative high-frequency trading techniques and worked to give shareholders more power over boards of directors.

The administration and Congress will likely exploit pending vacancies to name leaders less friendly to financial firms, said John Dearie, executive vice president at the Financial Services Forum, a group of financial services firm chief executives.

"We're going to be in for a period of rather adversarial and intrusive relationships," Dearie said.

Regulatory question mark

One of the scariest fill-in-the-blanks could be an amendment from Democratic Representative Paul Kanjorski that would give regulators the ability to force big financial firms to break up, said Brian Gardner, policy analyst at investment firm Keefe Bruyette & Woods.

Kanjorski's amendment at first seemed like a radical idea but gained so much steam that it made it into the final version of the House bill. A similar measure has been introduced in the Senate.

Gardner said the wording of the proposal is so vague that it gives regulators wide latitude to determine which lines of business must be sold off.

"We don't know exactly how regulators will interpret and act on that authority," he said. "I think that does create uncertainty for the largest institutions."

Further, Congress's reforms might not do much to prevent another financial crisis unless regulators themselves step up to get rid of the pro-cyclicality in the system, said Bill Isaac, former FDIC chairman and current chairman of LECG's global financial services.

He said it may take years due to the snail-paced rulemaking process, but regulators need to address mark-to-market accounting, capital rules and loan loss reserve policies.

All of them make businesses appear better in boom times and dismally worse during downturns, Isaac said.

But he said financial institutions may not have a whole lot to worry about, as regulators are, at their core, institutions reluctant to change.

"The bias in the system is business as usual," Isaac said.