The House of Representatives passed its version of financial reform in December.
VIDEO: Dodd's comments READ: A summary of the bill.
Dodd's new plan on Monday faced an immediate barrage of criticism. The American Bankers Association said it imposed too much regulation; consumer groups said it imposed too little. "It's a far distance from what we had hoped for," says John Taylor, president of the National Community Reinvestment Coalition.
Political observers expressed doubts that the plan would become law, considering that Dodd, D-Conn., would need to win over Republican votes to get the 60 required to break a filibuster and ensure passage in the Senate.
Brian Gardner, who follows regulatory issues for investment firm Keefe, Bruyette & Woods, gives it a 40% chance of passage. "It's going to be tough," he says.
But Dodd, who has announced his retirement next year, made an impassioned plea for reform in the wake of a financial crisis that sent the economy tumbling into recession and required a $700 billion taxpayer bailout.
Americans have "lost faith in our markets," he said. "And they wonder if anyone is looking out for them."
The crisis exposed the weakness of a patchwork regulatory system with different agencies monitoring different types of institutions — and plenty of leeway for banks and other lenders to shop around for the laxest regulation.
Dodd's bill aims to clarify the regulatory apparatus, making the Federal Reserve responsible for bank holding companies with assets exceeding $50 billion and for policing the entire financial system for risk. The Fed would also house a new consumer financial protection bureau.
The Fed's enhanced role is a switch. Dodd originally wanted to end the Fed's bank regulatory duties.
Before unveiling the bill Monday, Dodd had tried to work out a bipartisan compromise with Sen. Richard Shelby, R-Ala., and then with Sen. Bob Corker, R-Tenn. When the talks broke down, he went it alone, hoping to win bipartisan support in the Senate.
On Monday, Shelby sounded a conciliatory note, telling CNBC that there was agreement on 85% to 90% of the bill.
Some observers expect the Senate to ditch the most contentious parts of the legislation — beefing up consumer protection and regulating the murky market in derivatives — and pass a narrower bill.
"No one, regardless of party, is going to want to face the electorate without having passed financial reform," says Rob Johnson, former chief economist of the Senate Banking Committee, and now with the Roosevelt Institute. "No matter how weak it is, in terms of its real structure, the cosmetic ritual is something these guys will want to pass."
CONSUMBER ABUSES
Problem: No regulatory agency has sole responsibility for protecting consumers from predatory lending and other financial abuses. In the absence of single-minded oversight, home buyers were steered into mortgages they couldn't afford, and consumers were fleeced by hidden fees and high interest rates.
Why it matters: Fannie Mae has estimated that up to half of subprime borrowers could have qualified for prime mortgages, but many were sold higher-interest loans by unscrupulous mortgage brokers looking for higher commissions. But many regulatory agencies have put consumer protection on the back burner — or have seen it as a threat to banks' financial health. The Office of the Comptroller of the Currency, for instance, went to court to stop state regulators from investigating allegations of abuse at the national banks it oversees.
Proposed solutions: Dodd's bill would create a Consumer Financial Protection Bureau, housed within the Federal Reserve, to protect consumers. His plan falls short of the independent, stand-alone agency that the Obama administration wanted and that the House included in its bill.
Critics note that the Fed has a lackluster record for protecting consumers. Dodd argues that the new agency's address matters less than the power it gets. Under his plan, the consumer watchdog would have an independent leader picked by the president and confirmed by the Senate; get its own budget, paid by the Fed; and have independent rule-writing authority. However, the vast majority of banks — those with assets below $10 billion — would be exempt from the watchdog's examinations in both Dodd's bill and the House bill. The House version also exempts auto dealers. In a statement, President Obama said he would work with Dodd to make the bill stronger.
"I will not accept attempts to undermine the independence of the consumer protection agency, or to exclude from its purview banks, credit card companies or non-bank firms such as debt collectors, credit bureaus, payday lenders or auto dealers," he said.
The financial services industry argues that consumer protection should be handled by the regulators responsible for keeping banks safe and sound.
COMPENSATION
Problem: Bankers, traders and mortgage brokers are compensated in ways that let them enjoy big paydays when things go well and stick shareholders or the taxpayers with losses when they don't.
Why it matters: "Heads I win, tails you lose" is the way critics describe Wall Street's pay policies. Executives who drove their banks into the ground could walk away rich.
Lehman Bros. CEO Dick Fuld, for instance, received a $22 million bonus a few months before his firm went bankrupt in September 2008. Harvard Law School researchers found that senior executives at Lehman and Bear Stearns (merged into JPMorgan Chase with the government's financial help in March 2008) pulled $2.4 billion out of the doomed companies between 2000 and 2008 in cash bonuses and stock sales.
A year ago, insurer American International Group paid $165 million in bonuses to 400 employees of the unit that drove the firm to the brink of failure.
The problems aren't only in the executive suite: Loan officers were often paid for churning out loans, regardless of whether they were likely to be repaid. And traders could — and sometimes did — put their entire firms at risk in attempts to hit the jackpot.
Proposed solutions: Regulators are going further than Congress in trying to rein in destructive pay practices. Dodd's bill and a bill passed in December by the House of Representatives would give shareholders only a non-binding vote on top executives' compensation.
The Federal Reserve has proposed expanding its oversight of pay. Two dozen unidentified banking giants would be required to submit compensation policies to the central bank. The Fed would inspect them and approve the ones that do the best job of making sure employees aren't encouraged to take on excessive risks. The rules would apply to top executives, to traders who can gamble billions, and to groups of employees, such as loan officers, whose collective decisions can put a firm at risk.
LEGAL AUTHORITY
Problem: Federal policymakers lack clear authority to shut down non-bank financial institutions, leading to an inconsistent policy of bailouts, bankruptcies and forced mergers.
Why it matters: Banking regulators have the power to shut down troubled banks, sell their assets and pay insured depositors from the Federal Deposit Insurance Corp.'s fund. But federal policymakers did not have clear-cut options to shut down failing non-bank institutions such as brokerages and insurance companies. Simply putting big financial firms, which often have complicated dealings with other banks and firms, into bankruptcy might put the entire financial system at risk.
So when the meltdown in subprime mortgages started threatening large financial firms in 2008, policymakers were forced to make a series of ad hoc decisions that ended up causing confusion and panic.
When investment firm Bear Stearns faced collapse in March 2008, the Federal Reserve stretched its authority to the limit to finance a takeover by JPMorgan Chase. But when Lehman Bros. was on the brink in September 2008, the government let it fail, triggering panic on Wall Street. Ultimately, the Treasury Department asked for — and got — $700 billion from Congress to restore calm, helping finance a government takeover of American International Group.
But critics have lambasted the government's inconsistent decision-making, and the public is outraged about the bailout. Fed Chairman Ben Bernanke has said the government needs "the tools to restructure or wind down a failing systemically important firm in a way that mitigates the risks to financial stability and the economy and thus protects the public interest."
Proposed solutions: Dodd's bill is similar to the House's. He would set up an orderly process to shut down non-bank firms such as Lehman or Bear Stearns, forcing shareholders and unsecured creditors — not taxpayers — to absorb losses. Additional losses would be borne by a fund financed by big financial institutions. Big financial firms would be required to write their own funeral plans, detailing how they would be shut down.
TOO BIG TO FAIL
Problem: Some financial institutions are so big and so interconnected that letting one of them fail can bring down others, threatening the entire economy.
Background: Federal regulators decided they had no choice but to rescue insurance giant American International Group with $180 billion in taxpayer money. If AIG went under, they feared, it might drag down big financial firms that AIG owed money to and risk toppling the financial system.
But labeling some firms too big to fail creates big distortions in the financial marketplace. Investors and creditors are more willing to put their money in financial giants they believe won't be allowed to fail. That means big banks and financial institutions can raise money on more favorable terms than smaller ones that would never be rescued by Uncle Sam. The Center for Economic and Policy Research estimates that the too-big-to-fail subsidy is worth up to $34 billion a year.
Managers of firms deemed too big to fail also have an incentive to take big risks — and earn potentially big returns for the firm and bonuses for themselves — if there's a government safety net to break their fall.
Proposed solutions: Dodd and the House would create a regulatory council to identify big financial firms whose collapse would threaten the entire system. Those firms would face stricter regulation and possibly be required to set aside more capital as a buffer against losses.
Under Dodd's plan, big financial firms could be forced to break up if their size posed a risk to the financial system, provided the Fed and two-thirds of the regulatory council agreed. If the big firms failed, shareholders and secured creditors would absorb losses first; additional losses would be taken by an emergency fund financed by assessments on big financial institutions.
As Washington has debated the issue, the biggest banks have gotten even bigger. A report in January by the think tank Demos found that the five biggest banks have doubled their share of the nation's deposits to 40% since 1998 and increased their share of banking assets to 48% from 26% a decade ago.
CREDIT-RATING AGENCIES
Problem: The credit-rating agencies gave their seal of approval to securities that turned out to be virtually worthless, misleading investors and regulators.
Why it matters: Three companies — Moody's, Standard & Poor's and Fitch — dominate the business of rating the risk of bonds and other forms of debt. Federal regulations have required banks and other institutions to rely on the agencies' ratings when deciding how much capital to set aside to cover potential losses on bonds or other investments.
The agencies are paid by the companies that issue the debt, not by the investors who must decide whether to buy them.
During the housing boom that ended in 2007, critics say, the rating agencies loosened their standards to build business.
The Securities and Exchange Commission has released e-mails in which an employee at one rating agency (whose identity was not made public) joked that securities written by "cows" would get a clean bill of health, and another called the whole system a "house of cards."
The ratings of mortgage-backed securities proved worthless when the U.S. housing market collapsed. For example, Lehman Bros. debt was rated investment grade the morning the investment firm filed for bankruptcy protection.
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