The House of Representatives passed a sweeping financial reform bill Dec. 11, and soon the Senate will begin action on its version. The House bill passed by a partisan split; time will tell whether the Senate bill breaches the political divide.

Whatever form the ultimate legislation takes, there are some things on which critics and supporters agree: The legislation passed by the House, and the version expected in the Senate, will not prevent the largest institutions from growing so big or interconnected that they pose a threat to the financial system. And, eventually, a major firm will fail. When that happens, the new safeguards will face the first real test.

Eugene Ludwig, CEO of Promontory Financial Group LLC and a former U.S. comptroller of the currency, stresses that no matter how well crafted, financial reform legislation can't possibly put an end to all future crises. "Irrespective of how good the ultimate congressional product is, there's no silver bullet here. Nothing can permanently prevent volatile situations. The question is whether or not the mechanisms put in place, taken as a whole, markedly decrease the likelihood of serious systemic events.

"One problem with any governmental solution is that you can't test-drive the car before you buy it," Ludwig adds. He compares the reforms contemplated today with the uncharted nature of the changes ushered in during the Great Depression. "Nobody could say definitively whether the establishment of the FDIC and the SEC would make a difference, but in fact it did. With the creation of a new regulatory framework, what followed was an era of relative tranquility."

Any reform that is enacted will have two core components. First, it will empower a council of financial regulators. The big issue that must be hashed out is whether, as the House bill stipulates, the Fed will be the lead member or, as Senate Banking Committee Chairman Christopher Dodd, D-Conn., prefers, such power would be spread among the regulators. Second, the federal government will be permitted to seize and wind down failing firms using government money, if necessary, to fund ongoing operations if the regulators believe an abrupt shutdown will harm the financial system.

Ludwig says that he expects the Senate bill to improve upon the House's. "I think Congress has elements on the table that will make a great deal of difference" in the safety and soundness of the financial system. Assigning a council of regulators to keep an eye on "macroprudential issues" is a positive development, he says. "It's an extra level of protection our system hasn't had."

Ostensibly, the council of regulators is intended to prevent the largest financial institutions from engaging in risky credit or trading activities that could have harmful spillover effects on counterparties and the economy as a whole. In reality, such a task is probably impossible in a global economy where the biggest firms do business all over the world. That task was made even more improbable in the past year after the largest institutions got bigger by taking over troubled competitors.

The sweeping 1,300-page legislation is intended to address many of the regulatory gaps and speculative excesses that led to the past year's global financial panic. Aside from establishing a council of financial regulators and giving federal regulators authority to break up failing nonbank financial institutions, the bill also requires most over-the-counter derivatives to be traded on an exchange or centralized platform, mandates that hedge funds register with the Securities and Exchange Commission and creates an agency to set and enforce standards for financial consumer protection.

The bill that passed the House was approved over GOP opposition. Republicans warned the bill's provisions would give federal officials wide discretion to decide which companies to prop up and which to let fail. They argued that the new Consumer Financial Protection Agency will make it difficult for financial institutions to create new lending products.

Even after passage through the House, significant revisions would be needed to ensure enactment. The Senate Banking Committee is in talks to produce a bipartisan bill that the Senate is expected to vote on in the next few weeks. The biggest improvement the Senate bill could bring would be to give regulators more discretion to deal with failing firms on a case-by-case basis.

Ron Feldman, the senior vice president for supervision, regulation and credit at the Federal Reserve Bank of Minneapolis, says that whatever the details, the government must convince Wall Street that it is serious about making creditors take the first hits. He is less troubled by the size of the biggest institutions than with the federal government's preparedness for their failure.

Feldman, along with recently retired Minneapolis Fed President Gary Stern, was one of the first to publicly warn about the threats brewing in overleveraged financial firms, so he's no apologist for too-big-to-fail firms. In 2004, the duo began making speeches and publishing papers predicting that a failure of one or more firms would trigger a systemic shock to the financial system. Last June, they urged Congress to impose modest new requirements on financial firms, including a special deposit-insurance assessment on banks identified as too big too fail. Bank mergers, they said, should also be reviewed by regulators for their impact on systemic risk. They also recommended retaining the 10% cap on nationwide deposits -- as the House bill does.

Feldman stresses that government reforms should not impose strict new limits on the size or activities of financial institutions. Instead, they should put their business partners on notice that they will bear the losses if a firm fails. "It's not about financial firms per se; it's about their creditors."

The version passed by the House mandates that shareholders and unsecured creditors be wiped out before the government injects funds into a firm. After all stockholders and junior creditors are wiped out, a 10% "haircut" must be levied on secured creditors. To ensure that creditors take the new resolution authority seriously, Feldman says the Federal Reserve Board chairman should frequently communicate that creditors are at risk and even testify before Congress, along the lines of the semiannual Humphrey-Hawkins monetary policy report, on data that is collected on firms' exposure to each other.

"If we're not clear what we're up to, we're not fixing the problem," he says. "When the next crisis happens, people are going to recognize there is a huge cost, and then they will try to find ways to avoid it."

Just as lawmakers should resist putting strict limits on a financial firms' activities or size, analogous one-size-fits-all hikes in capital requirements would be a mistake, Feldman warns. "I'm very skeptical that we can impose draconian action on the full range of firms that have potential to create spillover. Nobody would have told Bear Stearns to break themselves up." Similarly, he adds, limits on specific activities are "superficially attractive."

A better approach is for supervisors to examine the specific operations of systemically important firms -- of which he says there are "not 100 but more than a handful."

Supervisors should walk through what would happen if a firm failed and then say what capital any particular one needs or what activities it can't engage in, Feldman says.

Feldman says he likes the idea of a "living will" that maps out ahead of time how a firm would wind down, but it cannot be just a bureaucratic exercise. The supervisory community should collect data on firms' exposures and run failure simulations. "If it becomes a checklist, it is really useless. The benefit isn't the product produced but forcing supervisors to conduct analysis on a firm and take action."

Also missing from the congressional reform effort is how policymakers should revise financial firms' capital requirements and loan securitization rules. That's a huge omission, says Robert Pozen, chairman of MFS Investment Management and author of "Too Big to Save? How to Fix the U.S. Financial System." While new capital requirements are largely being addressed at the international level by the Basel Committee on Banking Supervision, the group of regulators from around the globe that has established capital guidelines, Pozen says the Basel Committee continues to rely on the basic structure of its Basel II Accord, which allow banks to set their own capital requirements based on the institutions' internal risk models. Basel II is widely recognized as having failed to sufficiently cushion institutions against the risks they were incurring. However, the Basel Committee appears on a course to simply prod firms to design better models that include some new factors. "Internal risk models are extremely complex, aren't well understood and, in the past, were wrong," Pozen says.

A better course, he says, would be to revive the approach of the first Basel Accord, which established fixed capital requirements for various types of risk-weighted assets. The original Basel approach was too simple, he acknowledges, because it deemed all assets within a category to be of equal risk. The world, of course, has become painfully aware that not all mortgages are equal. By creating subcategories that differentiate between, say, prime mortgages with 30% down payments and subprime loans with little or no money down, regulators could establish more appropriate capital levels.

Another problem, Pozen says, is that regulators are threatening to make loan securitizations unprofitable. The Financial Standards Accounting Board earlier this year adopted rules that would effectively force banks to move securitized loan portfolios and other off-balance-sheet items onto their books. The result will be higher capital requirements. U.S. bank regulators only recently began a rulemaking process to determine what the capital levels should be for those assets.

Securitized loan portfolios were moved onto the books Jan. 1, but the regulators gave banks an extra six months to post the capital for those holdings. If the new capital levels are not set by then, banks will have to hold the same level of capital on their securitized portfolios as they do whole loans they hold, even though the securitized portfolio poses less risk.

"We will have gone from hiding off-balance-sheet assets and mandating no capital to requiring 100% capital. Neither makes sense," Pozen says. Capital levels for securitized loans should be set based on the actual level of risk retained by the sponsoring bank -- which could range from 30% to 70% of the level for whole loans on the balance sheet.

Pozen agrees that Congress should create a resolution regime that will allow federal regulators to seize and wind down nonbank firms deemed to be systemically important. The incarnation passed by the House, however, is too broad, he argues. The House bill grants the Federal Reserve Board and the Treasury discretion to either put a nonbank into receivership or bail it out. "You need the Fed and Treasury to start writing a rationale for bailing out any institution other than a bank and have that decision reviewed by the Government Accountability Office afterward to put some discipline into the process," he says.

Pozen also questions whether the proposed authority of federal regulators to break up systemically risky institutions is justified by the factual record.

In congressional hearings, the most popular suggestion was to reinstate the Glass-Steagall Act's prohibition on the underwriting of corporate securities by banks and their affiliates. Although the House bill would not formally bring back the Glass-Steagall Act, as many of the financial industry's harshest critics have demanded, the breakup power would most likely be used as a backdoor way to separate commercial and investment banking. After all, if a big firm is to be broken up, the most natural move would be to separate the commercial banking operation from investment banking. "What else would they say should be broken up? They aren't going to tell a national bank to get rid of its branches in California," Pozen says.

De facto reinstatement of Glass-Steagall would hurt financial firms without making the system safer. "The evidence shows it wasn't securities underwriting that brought down the big banks; it was their investment portfolios and bad loans," Pozen says. "It seems like a bad idea to re-create large, independent investment banks that have no retail deposits or access to the Fed window. They are the most likely to fail, as shown by Bear Stearns and Lehman. Moreover, the reinstatement of Glass-Steagall for U.S. banks would not be effective unless other major countries agreed to these restrictions on their banks."

Ludwig agrees that forcing institutions to break up would be bad both for individual industry participants and the health of the financial system. "I don't think that going back to a pre-Glass-Steagall world solves the problem of having institutions too interconnected to fail. None of the entities that failed and have cost the taxpayer serious money -- Lehman, Bear Stearns, AIG, Fannie or Freddie -- failed because they had banking and nonbanking entities under one roof," he notes. He thinks that breaking up banking firms is "an odd prescription" because it does not deal with the large nonbank financials where the problem has resided.

When it comes to resolving troubled firms, Ludwig says lawmakers should provide the same kind of specificity as is found in the Bankruptcy Code for dealing with resolutions under this framework. But while there should be clear indications to counterparties and other market participants as to how much exposure they would face if a firm fails, regulators should have sufficient flexibility to deal with the varied levels of distress that firms may face. For instance, firms that face a liquidity crunch but not insolvency should not necessarily be wound down, he says.

The House bill also requires most advisers to private pools of capital to register with the SEC and subject them to the council's systemic risk oversight. The primary aim is to increase oversight of hedge funds, but private equity funds are covered too.

Pozen says increased oversight of hedge funds is a good idea because many are high-volume, leveraged traders that affect the market. It's unfair to pull in private equity funds, he says, because they don't raise systemic issues.

The House bill also establishes regulation for the $600 trillion over-the-counter derivatives marketplace. All standardized swap transactions between dealers and major swap participants would have to be cleared and traded on an exchange or electronic platform. Major participants are defined as parties that maintain a substantial net position in swaps, exclusive of hedging for commercial risk, or whose positions create such significant exposure to others. The exclusion for those not defined as major participants was added to the bill to shield small businesses and manufacturers that hedge against business risks from oversight.

Rep. Dennis Kucinich, D-Ohio, derided the derivatives exemption on the eve of the House vote as a loophole that will be exploited by "sophisticated financial insiders." The exemption, he charged, "jeopardized the integrity of the whole reform" of derivatives trading.

Pozen calls the House plan a "reasonable compromise" that will target the large traders that created systemic risk while leaving alone those who seek only to mitigate interest-rate or other economic exposures their businesses face.

Whatever shortcomings an eventual reform law will have, taken as whole, Ludwig expects it to be a major improvement. He says he is heartened that the bill-writing committees in both the House and Senate have delved deep into the causes of the crisis and have educated themselves on the specific remedies that might forestall another crisis. "Congress is seriously focused on substance," Ludwig says. "They don't want to go back to the electorate in 2010 having done nothing. For the financial industry, that means everybody has to take these issues dead seriously. This is not an exercise."

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