An overhaul of the financial system has overcome a major hurdle, writes NIALL STANAGEin New York

AN ATTEMPT to overhaul the US financial system looks set to become law after it overcame a major hurdle in the Senate yesterday.

The legislation now on the brink of passage is said by advocates to be the most comprehensive effort since the Great Depression to insulate the economy from excessive risk and regulate the behaviour of banks and other financial institutions.

The Senate voted 60-40 yesterday afternoon to end three weeks of debate on the issue. (This procedure is known as a cloture vote, and is vital under the famously arcane Senate rules.) A vote on the legislation itself was expected to take place late last night or today.

Yesterday’s win came as a relief to Democrats after the Bill had run into trouble the previous day. The 60-40 supermajority is the minimum required to invoke cloture, and when the Democratic party’s leader in the Senate, Harry Reid, proposed such a vote on Wednesday, it failed. Two Democrats on the left of the party, Russ Feingold and Maria Cantwell, voted against it.

Mr Feingold and Ms Cantwell remained opposed yesterday but Mr Reid was able to gain the support of Scott Brown, the Republican who won Edward Kennedy’s old seat representing Massachusetts in January. Mr Brown’s vote, combined with the existing backing of two other moderate Republicans, Susan Collins and Olympia Snowe, and the return of Democrat Arlen Specter, who had been absent from the chamber on Wednesday, was enough to move the Bill forward.

The Bill would provide for the setting-up of a new consumer protection agency, strengthen the oversight powers of the Federal Reserve, and close various regulatory loopholes. Its final shape is still uncertain, however. An enormous number of amendments – around 375 – have been offered by various senators. Only a tiny minority of these have received serious consideration; others may yet squeeze in.

One key question is whether any steps will be taken by the Democratic leadership to address the concerns of Ms Cantwell and Mr Feingold. They want to see provisions first enshrined in the Glass-Steagall Act reinstated. The Act, passed in 1933 in response to the Great Depression, comprised many bank-industry regulations, including the imposition of a strict wall of separation between investment and consumer banking.

A series of measures passed in the 1980s and 1990s overrode Glass-Steagall, and many experts argue that these deregulatory moves played a key role in the crisis that began in 2008.

This view is held even by some in the Republican Party – and by some on Wall Street who lobbied for the dismantling of Glass-Steagall. Ms Cantwell drew up her amendment to reimpose the separation between investment and retail banking in conjunction with Senator John McCain.

Ms Cantwell has also pressed for an amendment to strengthen provisions regarding the derivatives market.

Derivatives, which are complex financial instruments whose value is based upon the value of other assets such as loans or commodity prices, have been traded opaquely, another weakness that contributed to the recession.

A particularly strict provision, unexpectedly proposed by moderate Democrat Blanche Lincoln of Arkansas, would force banks to split off their derivatives-trading arms into separate entities. This proposal was received coolly by the White House, which fears placing US firms at a disadvantage to foreign competitors, but it remains in the Bill.

Ms Cantwell wants another restriction, requiring all derivatives contracts to be traded through exchanges.

There were chaotic scenes on the usually staid Senate floor on Wednesday, as Democratic leaders realised Ms Cantwell and Mr Feingold intended to dissent on the cloture vote. According to the Washington Post, during a heated discussion between Ms Cantwell and Mr Reid, Ms Cantwell was heard to exclaim, “Jesus Christ, Harry”. But yesterday, the party tried to put all that behind it. “We have made great progress,” Mr Reid said. “It has been hard to get to this point.”

Republican glee on Wednesday turned to dismay yesterday. Republican senators complained that the proposed legislation would give the federal government too much power and would interfere with the running of small businesses and local banks. Senator John Ensign of Nevada, said that the Bill was “setting up our country on a course we cannot correct and creating unintended consequences”.

The Republican leadership had hoped to delay passage of the Bill for as long as possible, disrupting Barack Obama’s agenda. But their intentions to block the Bill were undermined at the outset by the laying of fraud charges by the Securities and Exchange Commission against Wall Street giant Goldman Sachs – a move that made being seen to side with the banks politically untenable in what is, for some, an electoral year.

US Senate bill: Key points

Consumer protection

A new Consumer Financial Protection Bureau would be set up inside the Federal Reserve, but with complete independence from the central bank.

It would tackle “abusive” mis-selling of mortgages, credit cards and other loan products. Banks and other finance providers worry about onerous reporting standards, the possibility of credit products being banned and the dearth of checks on the power of the bureau chairman.

Derivatives

Derivatives that trade in “over-the-counter” bilateral deals would be forced through central clearing houses to curb the risk from one counterparty going bankrupt and on to electronic exchanges to increase transparency.

There would be exemptions for non-financial companies using the contracts to hedge risk. Banks would be forced to spin off their derivatives-dealing operations.

Resolution authority

Government can seize and wind up a large institution if it faces impending failure and poses a risk to the broader financial system.

It would have powers to wipe out shareholders and fire executives. Payments to creditors would be paid by the government but recouped later from levies on the industry. It is designed to stop a repetition of the market shock from Lehman Brothers’ bankruptcy and end implicit government guarantees that reduce funding costs for banks deemed “too big to fail”.

Systemic risk regulation

A Financial Stability Oversight Council of regulators chaired by the US treasury secretary would identify systemically significant companies and monitor markets for bubbles.

Companies branded as systemically significant would face stricter capital, leverage and liquidity standards and be obliged to draw up a “living will” to describe how they would be broken up in the event of failure.

Volcker rule

Deposit-taking banks would be forced to spin off proprietary trading arms and sell ownership interests in hedge funds and private equity firms. The rule is named after Paul Volcker, former Federal Reserve chairman, who said banks should not be allowed to engage in “casino” activities while benefiting from government insurance over their deposits.

Copyright The Financial Times Limited 2010