Now for the Hard Part: Reg Reform Conference, Week Two

WASHINGTON — The conference committee made critical changes to the regulatory reform bill in its first substantive week of work, including overhauling the deposit insurance system and dialing back a key capital provision, but the hardest decisions are still ahead.

The committee has left itself just a week to tackle key parts of the legislation, including derivatives oversight, consumer protection, interchange fee regulation and risk retention.

“This is a very complicated bill and they are making considerable progress, but there are some pretty contentious issues left,” said William Longbrake, an executive in residence at the University of Maryland and a former vice chairman of Washington Mutual.

Many of the toughest subjects are scheduled to be taken up Tuesday when the committee returns to session, including provisions to require the Federal Reserve Board to regulate interchange rates and create a new consumer protection regulator.

But the derivatives provision, which is expected to come up later in the week, may be the trickiest. Although it has not been discussed in public, it has been the subject of ongoing negotiations behind the scenes. Banks have argued that spinning off their derivatives units would cost them millions of dollars, while regulators contend it could make the system riskier by driving such products overseas.

Despite the industry’s objections, the provision’s author, Sen. Blanche Lincoln, D-Ark., a conferee, is committed to making it part of the final bill. While industry observers expect the provision to be toned down, how far lawmakers will go remains unclear.

Some suggested the language may only be clarified to ensure bank holding companies can still operate swaps units outside the bank. (Some have said the provision would unintentionally stop banking companies from using any subsidiary to conduct derivatives activities.)

“It would be a separately capitalized subsidiary,” said Andrew Laperriere, the managing director of International Strategy and Investment.

“That’s not the worst-case scenario, but that’s not a great outcome, either. The issue which we don’t really know is if it’s going to mean more capital and it’s going to be pretty hard to tell even when the bill gets finished. It will probably be a regulatory matter.”

Almost as controversial is the provision to require the Fed to ensure interchange rates on debit cards are “reasonable and proportional” to the cost of processing payments. More than 130 members of the House sent a letter to conferees last week asking them to remove the measure from the bill, which was added by the Senate.

“Simply stated, this amendment hurts our constituents because it will raise the price of basic banking products,” said the letter.

But Sen. Richard Durbin, D-Ill., the author of the provision, has remained on the offensive. He released a Treasury Department report last week that said interchange rates cost the government millions of dollars each year, and held a hearing on the issue to drive the point home.

Still, Durbin was feeling some heat. After the hearing, he said he was willing to carve out prepaid debit cards issued by federal and state government agencies from the requirement in response to heavy lobbying by states on the issue.

But even House Financial Services Committee Chairman Barney Frank and Senate Banking Committee Chairman Chris Dodd have said some version of the provision is likely to survive. 

“It’s unrealistic to think that it is going to go away,” Frank said two weeks ago.

The easiest decision next week may be where to put a new consumer protection regulator. Under the House bill, it is a stand-alone, independent agency, while the Senate makes it an autonomous part of the Fed.

Although conferees are expected to vigorously debate the issue, most observers have said the Senate’s version is likely to prevail.

Even while the conference committee grapples with the remaining issues on the docket, however, other provisions dealt with last week are likely to come up again.

For example, House and Senate conferees agreed conceptually to grandfather existing trust-preferred securities from a provision that would eliminate their use as part of Tier 1 capital, but they were still ironing out the details.

House conferees wanted to grandfather trust-preferreds at all bank holding companies, while the Senate conference members sought to protect only those at firms with less than $10 billion of assets. (Larger firms would face a three-year phase-in.)

Citing conflicts among Senate members, Banking Committee Chairman Chris Dodd left the issue open to allow more fine-tuning. “We even have some difference of opinion on our side on that,” he said.

So far, at least, many of the changes have been beneficial to the banking industry. One of the most overlooked provisions was a measure designed to give small businesses relief from some of the paperwork requirements of Section 404 of the Sarbanes-Oxley Act. Conferees agreed to exempt institutions with a market capitalization of up to $75 million from having to submit an auditor attestation, something community bankers have argued since the law was enacted in 2002 was overly burdensome.

“The SOX 404 relief will save hundreds of community banks tens of thousands of dollars in unnecessary compliance costs,” said Steve Verdier, a senior vice president with the Independent Community Bankers of America.

The industry also welcomed the changes to the capital provision, which they had argued would cause firms to be undercapitalized and fail if some kind of transition period was not added.

Conferees also agreed to permanently raise the deposit insurance level to $250,000 per account and extend the Transaction Account Guarantee program, a priority for smaller institutions. The conference committee finalized language that said deposit insurance premiums are based on a bank’s assets, not its deposits, a change that greatly benefits many community banks. Additionally, conferees agreed to preserve the thrift charter and rejected efforts to create a $150 billion resolution fund. The industry had opposed the fund, which would be paid for with assessments on systemically important companies.

Analysts said further changes may continue to help bankers at least on the margins, although many of the remaining measures will remain tough. 

“Even if Congress moderates some of these provisions, they are going to be onerous,” said Jaret Seiberg, an analyst with Washington Research Group, a division of Concept Capital. “We continue to believe on issues like interchange and derivatives that the movement will be toward the banks, even though it will be hard to describe any of this as a real victory. It just won’t be as brutal a defeat.”

Longbrake agreed. “It’s really an uphill fight,” he said. “Anything that softens particular provisions has to be considered a win, but the banks probably won’t consider it that way, because there is still some pretty onerous stuff.”

But the industry has not been the only one to benefit from the conference committee’s actions. After the House included a provision allowing the Government Accountability Office to audit the Federal Reserve Board’s monetary policy activities in its version of reform last year, the central bank has been adamant it was a threat to its independence.

Ultimately, House and Senate conferees substantially weakened that provision.

Although the House version would have allowed an audit after only six months, the final language is set to give the central bank a two-year delay on any audit of monetary policy matters.