In 2008 and 2009, the failure of financial institutions and plans for their rescue placed heavy burdens on taxpayers. To deter future misdeeds, Massachusetts Rep. Barney Frank, chairman of the House Financial Services Committee, and other Washington legislators drafted the Wall Street Reform and Consumer Protection Act of 2009 (HR 4173, passed by the House in December 2009), and the Senate bill, the “Restoring American Financial Stability Act of 2009.”

The proposed legislation, if enacted in its current iteration, will have significant repercussions for capital markets and the banking system, according to Rodrigo Quintanilla and Tanya Azarchs, analysts in the New York office of Standard & Poor’s (S&P).

In its recent Global Credit Portal report, S&P notes these two bills have positive provisions regarding leverage and the prudential regulations and supervision of financial institutions—but certain sections of the proposals could increase bank bondholder risk.

Government support (e.g. prudential regulation and central bank liquidity) and extraordinary support (e.g. targeted capital injections, guarantees or special liquidity programs) for financial institutions could become more uncertain or more cumbersome, according to the authors. (For more, see “Obama And The Banks” in this issue.)

Specifically, HR 4173 implies that future extraordinary government support may decrease.

Say the analysts, “If we were to conclude that future extraordinary support is less likely as a result of a change in law or otherwise, we could determine that it would be appropriate under our criteria to revise our ratings…on one or more of American International Group Inc. (AIG), Bank of America Corp., Citigroup Inc., The Goldman Sachs Group Inc. and Morgan Stanley.”

Immediate impact. The House version, in its current form, negatively affects S&P’s view of the creditworthiness of U.S. financial institutions and could cause downward pressure on credit ratings. Two aspects of the House bill represent immediate and significant implications.

First, the proposed legislation requires that unsecured bondholders and secured creditors will suffer losses before taxpayers during the resolution of a failing, systemically important financial institution. It provides that such institutions must be taken into receivership by the Federal Deposit Insurance Corp. (FDIC). As a receiver, the FDIC would provide support only to effect an orderly liquidation—not to maintain the firm as a going concern. In other words, a default event would need to occur before any support is provided.

Also, unsecured creditors and shareholders would, under HR 4173, lose money before taxpayers. The requirement that unsecured creditors share losses would likely mean that S&P would not assume enough government support for banks to prevent losses for senior creditors and thus would lower some credit ratings.

Secondly, HR 4173 reduces the authority of the Federal Reserve to provide liquidity or guarantees in a generalized emergency liquidity event. Such support would be restricted to programs available to all solvent institutions and not targeted to a specific failing institution and would not include any provision for equity holders.

The Federal Reserve would be required to seek approval from the board, the Treasury, and the President to institute any program. Had these rules been in effect earlier, the Troubled Asset Relief Program (TARP) and capital and debt guarantees that helped stabilize the system in 2008 and 2009 might not have been possible outside of a liquidation scenario for the receiving institutions, although a sector-wide program such as the Temporary Liquidity Guarantee Program could still have been permitted.

Bear Stearns, GMAC Inc., AIG, and Citigroup could have gone into receivership with an expectation of liquidation. Wachovia, if no buyer had been found, would likely have been included in that list. Other recipients of TARP that might have been deemed undercapitalized or succumbed to funding pressures might have been taken over as well.

Long-term impact. The proposed legislation also has long-term horizons. If secured creditors are subject to a 20% loss if assets are insufficient to cover insured depositors, another important and generally reliable avenue of funding for financial institutions might be called into question. Because banking is highly confidence-sensitive, secured creditors could lose interest to provide funding or roll over maturing debt in a very procyclical manner, even though perceived problems may later prove to have been relatively benign.

“If senior creditors take losses in a stressed environment, we believe there is a potential for contagion by engendering doubt about all financial institutions, even those considered healthy before,” say the authors.

Also, crisis management could become more cumbersome. Depending on how the bill is enacted and whether the Federal Reserve Act is amended, the Fed could be less independent and less able to maintain long-term system stability.

Under the House bill, the Fed would be required to obtain a two-thirds majority vote of all 12 Federal Reserve Board governors or of the newly established interregulatory council, plus the written recommendation of the Treasury and consent of the President, before determining that a failing institution is systemically important and deserves to be liquidated in an orderly manner using the special receivership provisions. Considering that Congress must be notified within 48 hours and may stay the actions decided upon, this could considerably hamper the kind of rapid response often necessary in moments of crisis.

“Even to respond to a more generalized disruption of market liquidity condition, the Fed must get a two-thirds vote of a newly created interagency regulatory council and written approval of Treasury to create liquidity facilities. In our view, this means the Fed could not as readily have created the whole range of special facilities to provide funding for the money-market funds, commercial paper borrowers, primary dealers, and term funding facilities that it did in 2007 and 2008,” write the authors.

“In sum, these provisions, if enacted in their current form, could lead us to reassess our view of the banking industry risk of the U.S. We had classified the U.S. as a ‘supportive banking system,’ but it is possible that, after further analysis, we could revise this opinion to ‘support uncertain.’ Such a designation would, under our criteria, limit the average rating level of U.S. banks.”

In the long term, competitive dynamics could shift business to smaller (or even foreign-owned) firms not subject to those standards, disadvantaging the larger ones. Also, an unintended consequence could be higher lending rates and more frequent bouts of illiquidity in capital markets.