Financial overhaul: Get ready for a fight

(breakingviews.com) -- President Barack Obama had better be ready for fisticuffs. Though the administration's plan to overhaul U.S. financial regulation appears designed to avoid some big battles, the president's careful political calculus won't spare him from sparring with lawmakers and financial firms.

First comes the brewing battle over the Federal Reserve. Obama's plan envisages the central bank with new powers to oversee pretty much any financial institution that it thinks poses a systemic risk, among other things.

The Fed is the most logical place to keep tabs on system-wide risks, but a case can be made for doing the job elsewhere, too. Some lawmakers are already objecting to the possible expansion of the central bank's already extensive powers. Sheila Bair, who runs the Federal Deposit Insurance Corporation, has said debate over the Fed's role is "legitimate".

There's an added wrinkle. Advisory input on systemic oversight falls, under the administration's plan, to a new Financial Services Oversight Council of eight regulators. The division of responsibilities with the Fed could result in dropped balls or a lack of accountability. That would be a disappointing echo of problems with the existing regulatory jigsaw.

A second series of fights, this time with the corporate sector, could follow from plans to reclassify financial firms and, in some cases, impose tougher regulation than presently.

One of these concerns companies in the new "too big to fail" category, dubbed "Tier 1 FHCs". Being one of these is supposed to be a dubious honor -- banks like, say, Citigroup (C, Fortune 500) would get a higher implicit level of government backing than other institutions, but would pay for it by having to hold more capital and abide by other more stringent rules.

If the U.S. can strike the right balance, the idea makes sense. But there's plenty of potential for market distortions and for some of the regulatory forum-shopping Obama and his team want to sweep away.

General Electric (GE, Fortune 500), for one, is already opposing this aspect of the plan, which could force it to offload its GE Capital Corporation finance arm. Whether companies should have no option about such a split, even with a transition period, is arguable -- though in GE's case it might not be a bad idea, for shareholders as well as taxpayers, given that the finance unit has lately dragged down the value of the industrial business.

GE could also be affected by proposals for heavier regulation of industrial loan corporations. ILCs have historically been regulated lightly compared with standard banks because of their small size and limited purposes. But the administration argues they resemble banks and should be regulated as such. That sounds right -- but some ILC-owning companies and their supporters are already on the warpath.

Then there are the gaps in Obama's plan -- which are mostly fights deferred.

One is the future of mortgage giants Fannie Mae and Freddie Mac. The right answer in a more or less market-driven economy is for these flawed, state-sponsored behemoths to be wound down or broken up and sold. But they are politically powerful. Obama has effectively punted the issue.

There's also a hole in the sensible objective of bringing over-the-counter derivatives under the regulatory umbrella. Which watchdog(s) will take charge, and exactly how, isn't clear. Banks make a lot of money out of OTC derivatives -- there are $450 trillion of them outstanding, according to the International Swaps and Derivatives Association. With profits at stake, the shortage of details looks like a recipe for hot tempers later.

A third hole is how Obama's instructions to accounting standard-setters will translate into action. His plan hints that they should consider standards that allow financial firms to value assets taking into account more factors beyond strict market values, so as to make balance sheets less susceptible to market swings.

Yet the Financial Accounting Standards Board in the U.S. and its international counterpart are supposed to be cushioned from political pressure. The big fight could come over whether that needs to change. That would probably be a bad idea -- politicians would be too prone to bending the rules in tough times.

The administration's lengthy "white paper" will throw up other battles too, including over the proposed Consumer Financial Protection Agency, which some see as an unneeded new layer of bureaucracy.

Obama has already backed off any serious consolidation of the confusing array of watchdogs. Now he has tried to pick his battles of substance, too. Whether he has done enough to get his big ideas through Congress -- especially with a heavy agenda, including healthcare reform, vying for attention -- is another matter.