As winter gave way to spring, health care reform gave way to financial reform. We were all deluged with information regarding the many complex features and the erratic legislative path of the financial reform bill, debuting as the “Restoring American Financial Stability Act of 2010,” or RAFSA, on May 20, 2010. During the depths of the financial crisis in 2008, when even nationalization of the U.S. banking system seemed a real possibility, it appeared inevitable that a true overhaul was finally at hand. So is that what we are getting with RAFSA? Or, will the final legislation disappoint as suggested by Michael Hirsh in Newsweek’s May 21, 2010 article “Bonfire of the Loopholes”?

There is now a general consensus on the origins of the crisis. Absurdly lax lending standards produced many billions of dollars of mortgage loans that made no economic sense for lenders and stretched the finances of many households beyond reason. Aided and abetted by rating agencies that suffered from a fundamental conflict of interest, investment bankers packaged these loans into purportedly high quality investments, and sold them to all manner of so-called sophisticated investors, including highly leveraged banks, insurers, and hedge funds. Often poorly capitalized buyers and sellers of exotic derivatives then multiplied the risks by betting on the success or failure of the whole sub-prime endeavor.

Astonishingly, the regulators were completely absent at each step in the above described process. Most fundamentally, the capital requirements for financial institutions proved vastly inadequate. Underlying much of the problem were compensation structures that were blind to conflicts of interest and rewarded irresponsible risk-taking. The grand finale was a taxpayer-funded rescue and the loss of millions of jobs. While this is by no means a comprehensive list of ills—having ignored mortgage giants Fannie Mae and Freddie Mac, for example, or the complete lack of comprehensive insurance industry regulation—it surely describes the majority of the disease. Is RAFSA the vaccine our system needs?

The Senate and the House versions of financial regulatory reform create a Consumer Financial Protection Agency empowered to make rules, examine financial institutions’ practices, and take enforcement action to protect consumers from the kinds of business practices that were at the core of the sub-prime lending crisis. It seems obvious that consumer protection should be a key concern of a powerful regulator. In the past, the Federal Reserve had been charged with this duty. Clearly it had not been a priority for the Fed. The House version appears stronger than the Senate proposal, as the Senate would create the agency within the Federal Reserve with some protections for the agency’s independence, while the House would establish a fully independent agency. Due to the critically important nature of the task, we favor a strong, independent agency.

For decades the fiduciary standards applicable to investment advisers and broker-dealers have been quite different from each other. Both the Senate and the House versions direct the SEC to improve the standards of fiduciary duty owed to customers of broker-dealers, albeit in different ways. Perhaps Goldman Sachs could have avoided its current battle with the SEC over allegedly failing to disclose critical information to investors had such standards been in effect. Here again, the House version appears superior, as the SEC study and rulemaking mandated by RAFSA could easily be hijacked by industry and lobbyists over time. Also noteworthy, both houses of Congress would require the registration and regulation of hedge funds and other private equity funds in order to prevent many of the abusive practices that are widely believed to have exacerbated the crisis.

Both versions of the proposed legislation require much of the business of trading derivatives to move onto an exchange with regulatory oversight. This would subject market participants to capital, margin, and collateral requirements as well as provide greater visibility for investors and regulators to assess risk. The Senate version is considerably stronger on this point due to its prohibition of Fed or FDIC backing for derivative dealers. Most analysts believe this provision would drive financial conglomerates to divest such businesses. Rest assured that the legion of lobbyists camped in the Capitol are focused on limiting proposals to regulate derivatives. At this writing, there is a move afoot in Washington to enact stronger derivatives reform than currently appears in either bill. We at Walden are enthusiastic proponents of the strongest possible regulation of the derivatives business.

Both versions of proposed reform also establish a council of regulators empowered to closely monitor and, as appropriate, enhance regulation of any financial company determined to be systemically significant. This provision, among others, is designed to address the “too big to fail” conundrum. We wonder if breaking up the mega-banks would have proven more successful in the long term, despite its greater near term complexity.

Neither the House nor Senate proposes comprehensive changes to bank capital requirements. Insufficient capital, in the form of equity available to absorb losses and prevent financial institution failure, was a key issue in both the highly regulated and less well regulated areas of the financial system It is important to note that key changes in permissible leverage and other capital enhancements have not yet been fully established. Treasury Secretary Timothy Geithner has been traveling extensively to press for a coordinated, comprehensive set of standards that would lessen the probability of a future global financial crisis. There is hope that Basel III, a global set of financial institution capital standards, will establish such a regime in the coming months.

These are, at best, a bird’s eye view of a few key areas and shortcomings of the proposed legislation—those that appear directly responsive to the pain of recent experience. Walden had been active in public policy advocacy in other important areas addressed by the financial reform legislation prior to the crisis. Key among these are areas of good corporate governance such as “Say on Pay,” proxy access, and majority voting.

Walden’s advocacy work in “Say on Pay” began in 2006 with questions raised concerning the escalation of compensation packages and the frequent lack of relationship between executive compensation and shareholder value. Walden wished to create the opportunity for shareholders to weigh in on compensation structures. The near collapse of the financial system and the widespread realization that many now-disgraced financial executives received hugely inflated compensation packages based upon profit that has proven phantom changed the intensity of public and investor scrutiny of pay. Walden worked to focus both House and Senate attention on this important issue that is now part of RAFSA.

In addition, Walden wrote to Senators Christopher Dodd and Scott Brown and offered our comments. We focused on our support for greater industry oversight and stronger regulation, the establishment of a systemic risk regulator, reform of credit rating agencies, an independent and stronger consumer protection agency, regulation of hedge funds and derivatives, majority voting for directors, and compensation “clawback” provisions.

As the wheels in Washington grind forward to the final legislation powered by lobbyists, election year politicians, and bitter partisans, we hope that the strongest provisions will survive. We risk, however, having missed a once-in-a-lifetime opportunity to really streamline and strengthen our regulatory infrastructure. We believe that the final legislation will trigger many changes for the better in financial business practices. Some will surely reduce the profitability of financial companies, a fair price to pay for greater financial stability. Will they prevent the next bubble or the need for future bailouts? Not likely. History suggests that human nature will, over time, discover and exploit each and every loophole in the system.