Top Risk No. 4: U.S. financial regulatory reform

By Ian Bremmer and David Gordon

On balance, 2010 is looking like a tougher year for President Obama than 2009 proved to be. Going into the new year, he has succeeded in kicking Afghanistan and climate change down the road, but pulling off real policy success on either still looks unlikely. Unemployment remains high as the country pulls weakly out of recession and mid-term elections appear on the horizon. While Obama’s popularity may take a beating, the coming year will see considerably less actual domestic policy risk in the United States than in 2009. But the exception is in the process of financial regulatory reform. That’s likely to be a tougher issue than people expect.

The reform package that passed the House of Representatives is comprehensive, though it will be moderated in the Senate, where for the first time under Obama a serious bipartisan effort is being undertaken. Either way, substantial change is afoot — more far-reaching than anything we’ve seen since the Great Depression. The result will be a structure put in place to monitor and address systemic risk, largely self-financed from the financial community, as well as changes on many other issues, ranging from derivatives regulation to the proper role of the Federal Reserve Bank.

Unlike cap and trade or immigration reform, there’s a very high likelihood that comprehensive financial regulatory reform will pass. But with mid-term elections approaching, it’s likely to turn populist and lose a considerable amount of its bipartisan flavor. Congress as a whole is likely to imitate what’s already come to pass in the United Kingdom, where an unpopular Gordon Brown government is going after the financial sector to try to lift its poll numbers from the morass. Congress doesn’t want to be tarred by Treasury Secretary Tim Geithner, bailouts, or billionaire bankers. The best way to avoid that fate is to include some visibly populist elements in the new legislation, especially on consumer protection and executive compensation. Members of Congress will look to score points by taking aim at the Fed, but actual policy change there is a step too far — the administration will likely ensure that nothing in the ultimate bill will undermine the Fed’s political independence.

But while Obama’s economic team will be wary of populist measures, Democrats in Congress and the president’s own political advisors will see such measures as a necessary piece of "mobilizing the base" before mid-term elections. Big banks are an easy target, especially in the context of high profits and a strong recovery for the financial markets, but a weak overall economic rebound. The legislation should pass by late spring.

Regulators will be given significant new discretionary powers, including some authority for breaking up institutions deemed a systemic risk. A key risk is that, depending on the political environment, the newly empowered regulators could use their capabilities to issue strict rulings that go well beyond what is specifically included in the legislation. Regulators will also likely issue proposals for revising capital requirements upward next year.

Another key risk to watch will be efforts to impose further fees and taxes on the financial system. With the U.S. government running record deficits in the wake of the financial crisis, trying to recoup these costs from the financial services industry will be seen as a relatively low-cost political option. Executive compensation is one likely possibility; taxes on carried interest for hedge funds are another.

Both the Americans and Europeans are aware of the risk of driving the financial industry into the ground with too much (or too drastic) regulation or taxation. But as reform becomes an election-year domestic battleground, the need to serve political interests will be increasingly at odds with the need to create an efficient framework for regulatory reform.

Next up: Japan.

Ian Bremmer is president of Eurasia Group, and David Gordon is the firm’s head of research.