THE HISTORICAL echoes are hard to resist. In 1933, in the midst of a slump caused by a financial crisis, two US congressmen – Carter Glass and Henry Bascom Steagall – put their names to a legislative overhaul that changed the face of banking.

By separating securities houses from commercial banks and placing the latter under strict federal supervision, the Glass-Steagall Act revolutionised the sector and ushered in more than half a century of financial stability. Now, following another devastating meltdown, a hyphen links the surnames of Senator Chris Dodd and Representative Barney Frank as they headline the latest overhaul in US financial rules.

Moments after a 21-hour congressional session 10 days ago established the outlines of the Dodd-Frank Bill, Barack Obama seized on the parallel. “We are poised to pass the toughest financial reform since the ones we created in the aftermath of the Great Depression,” the president said.

Such rhetorical flourishes were somewhat dimmed by last week’s unseemly scramble that brought the scrapping of a $19 billion (€15.5 billion) tax on the industry to secure the vote of Scott Brown, freshman Republican senator from the finance-heavy state of Massachusetts.

Even that last bout of horsetrading though cannot hide the fundamental questions surrounding the 2,319-page Bill: will Dodd-Frank be enough to bring about lasting structural and cultural changes in an industry that was found to be so sorely wanting during the turmoil? Will it make the system less crisis-prone, so that American taxpayer dollars will not again be used to bail out failing institutions?

Proponents argue that the reforms, due to be voted through within days, will go a long way towards making US finance a safer place. “The American people have called on us to set clear rules of the road for the financial industry, to prevent a repeat of the financial collapse that cost so many so dearly,” says Dodd, chairman of the Senate banking committee. “This Bill meets that challenge.”

Others contend that the changes are not radical enough. “If you have bullets flying from every direction, they [banks] will change their behaviour just by virtue of their survival. But I don’t think the legislation in and of itself is going to have a dramatic impact on their businesses,” says Arthur Levitt, a former Securities and Exchange Commission chairman who advises Goldman Sachs and others.

On one issue, though, the two sides agree: the Bill will dent profitability. By mandating tougher rules on consumer products, a partial spin-off of derivatives businesses, a ban on trading bets using in-house funds and a sharp cut in investments in private equity and hedge funds, the reforms will reduce earnings at large banks and credit card groups by about 9 per cent, says Keith Horowitz, a Citigroup analyst.

More stringent capital standards – funds that banks have to set aside on their balance sheet – could place a further burden on investors’ returns once they have been thrashed out by international regulators. Even those hits though will be tiny when compared with the rewards reaped by banks, their employees and shareholders during the era of deregulation that began in the late 1970s and culminated in the repeal of Glass-Steagall in 1999. Between 1980 and 2005, financial sector profits grew at an inflation-adjusted 800 per cent, compared with 250 per cent for other companies.

Shareholders have taken the latest changes in their stride. Banking stocks rose as worries about regulatory uncertainty gave way to relief at the lack of big surprises in the final Bill.

Central to the legislation is its attempt to deal with a chronic problem laid bare during the latest crisis: the existence of institutions such as Citigroup and AIG deemed “TBTF” – too big to fail.

The TBTF brigade, which includes most large financial groups in the US, benefits from a reduced cost of capital because of the assumption that in a crisis the government will not allow them to go under. In 2008, Washington proved the assumption correct when it bailed out AIG and its counterparties as well as Citi.

The weapon to be deployed is a new “orderly liquidation authority”, which gives regulators the power to seize a failing “systemically important” institution, stabilise its viable parts, sack executives, impose losses on unsecured creditors and then use the assets to pay secured creditors. If the plan works, the implicit government guarantee should end. Creditors will no longer feel they can lend to a large or highly interconnected group in the knowledge that if it gets into trouble the government will step in.

“Yes . . . I think it ends,” Mark Warner, the Democratic senator from Virginia who helped craft the mechanism, says of the guarantee. “I think it is the best effort possible.”

Regulators are also broadly content.

“I think over time this is designed to rid the market of thinking that government is always going to bail these entities out so you don’t need to do your own homework,” says Sheila Bair, chairman of the Federal Deposit Insurance Corporation, charged with protecting consumer funds. “The results should be that they are more demanding of transparency, of good risk management . . . whether they [the borrowers] are prudent.”

For the past year, Republicans in the House of Representatives have accused the Democrats of perpetuating the moral hazard of TBTF by keeping a safety net underneath big banks. Buyers and sellers of their debt and equity will now be the best judge of whether the accusations are correct.

If the market works properly, creditors in a company seen as at a higher risk of default should demand an enhanced interest rate on their bonds, while credit rating agencies should downgrade them accordingly.

Bair’s hope that the market will change its view of groups such as Citi and price in a greater chance of default should be borne out by higher funding costs. “I anticipate that their cost of capital will go up,” she says. Banks agree and have been setting aside capital in anticipation of a rise.

Similarly, the taxpayer exposure to the orderly liquidation authority – subject to hours of turgid argument in Congress – can also be measured. The White House, the Democrats, some Republicans and the FDIC peg it at zero.

Funds needed in the liquidation will first be taken from the bank’s own assets; then, if needed, borrowed from the Treasury and later clawed back from the financial industry through a retrospective levy.

The problem, largely overlooked by both Republican critics of the Bill and its Democratic supporters, is that the impartial Congressional Budget Office estimates a $20.3 billion cost to the economy over 10 years. This is the main budget hole that Democrats have struggled to fill in the final messy tinkering with the Bill. Without total credibility in the new mechanisms, the problem will linger.

The sceptics also argue that the legislation’s lack of provisions to curtail significantly the size and diversification of modern banking behemoths could exacerbate the problem of TBTF. Roy Smith, a former top banker at Goldman who now teaches finance at New York University, says: “Banks will still be huge, diversified across many different risk platforms, and subject to regulation by the same folks that missed the last bubble.”

It is certainly true the regulatory shake-up relies largely on the ability of a council to be convened from existing supervisors – including the Federal Reserve, the SEC and FDIC – to change mindset and spend more time thinking outside their individual silos and more about the wider system.

Warner argues that the new system also builds in a range of failsafes – more data-gathering, better corporate governance, more sharing of information between agencies, higher capital standards for the largest and most interconnected companies – that should, taken together, reduce the chances of a future crisis.

Enhanced regulatory cohesion is intended to eliminate the need for a drastic reshaping of financial institutions. Indeed, as structural changes go, the proposed spin-off of about one-third of banks’ derivatives activities and the ban on proprietary trading (deals that use a bank’s own money) fall a long way short of the break-ups decreed by Glass-Steagall.

To take just one example, that law forced JPMorgan to split off its investment bank which led to the creation of Morgan Stanley and the end of the all-powerful House of Morgan.

Any reform of the world’s largest and most sophisticated financial system has to do more than look at “1,000-year floods”, as treasury secretary Tim Geithner, likes to call devastating financial crises. Critics have long decried the heads-we-win-tails-you-lose system – where the “you” are clients, investors and, in extreme cases, taxpayers – that is central to the culture of modern Wall Street.

Goldman, the most aggressive and successful specimen of this breed until it recently got into trouble with the SEC, even summarised this modus operandi in a slogan. As Lloyd Blankfein, Goldman’s chief executive, puts it, the bank should “manage rather than avoid conflicts” while at the same time try to make as much money for itself and its bankers by using information gleaned from all corners of the market.

The reforms attempt to wean banks off these practices, not only by banning proprietary trading but also limiting their investments in private equity and hedge funds, forcing them to disclose potential conflicts of interest to customers and keeping a portion of the asset-backed securities they originate in order to sell.

The most substantial change will have to occur in areas where regulators’ sway is limited: the inner workings and compensation systems of institutions that use their collective smarts to gain an edge on rivals, even when it is unfair or only borderline legal.

If it is to find its place in history, the Dodd-Frank Bill will have to ensure that Wall Street keeps the greater good, not just its own greed, firmly in its sights. – Copyright The Financial Times Limited 2010