At the start of 2009, many members of Congress talked about a fundamental restructuring of financial regulation. Nine months later, Congress has passed little legislation in this area, and the expected regulatory revolution is turning out to be more of an evolution.

What types of regulatory reform will Congress likely enact? And what will these reforms mean for financial advisors? Let us begin with the proposed expansion of the SEC's direct authority over financial advisors. Then we will discuss the role of a new federal agency for certain financial products sold by advisors. Finally, we will review the implications for financial advisors of the new approach to systemic risk.

Expanded Powers for the SEC

The House Financial Services Committee has released a draft of the Investor Protection Act of 2009. Although still in preliminary form, the draft provides a good idea of where Congress is going on this subject. The draft bill would apply the standards of the Investment Advisers Act of 1940 to all brokerage reps who provide investment advice to retail customers. For many years, the SEC had exempted such brokerage reps from the Investment Advisors Act. However, this exemption was invalidated by a court case brought by financial planners who were registered under that Act.

According to the background materials for the draft bill, brokerage reps providing investment advice to retail customers will now be subject to a “fiduciary-type” duty. This clearly means something more than the traditional duty of brokers to recommend “suitable” securities, but the scope of this new duty is unclear. For example, will a brokerage rep be held to the ERISA standard of a “prudent expert?” Will a brokerage rep be prohibited from selling funds managed by an affiliate of the broker?

The draft bill would vastly expand the SEC's rulemaking powers over both investment advisors and brokerage reps regardless of whether they are providing investment advice. Specifically, the draft would empower the SEC to adopt “rules prohibiting sales practices, conflicts of interest and compensation schemes for financial intermediaries (including brokers, dealers and investment advisors) that it deems contrary to the public interest and the interest of investors.”

This bill would allow the SEC to regulate most of the sales practices and pricing issues now covered by FINRA's standards of fair practice. For instance, the SEC could set limits on dealer spreads in bond sales or it could prohibit mutual funds from offering B shares. More broadly, the SEC could require securities brokerage and advisory firms to defer payment on half of all annual bonuses for two or three years.

In addition, the draft bill would substantially increase government and private lawsuits against financial professionals. The bill provides the SEC with authority to pay bounties to whistleblowers equal to up to 30 percent of the monetary payments made by defendants in relevant enforcement cases. But, in my opinion, the Madoff scandal did not demonstrate the need to pay large bounties to whistleblowers; it showed the need for the SEC to adopt a more disciplined approach to following up on the leads of whistleblowers.

The bill would prohibit the inclusion of mandatory arbitration clauses in customer contracts with financial advisors. This would be unfortunate — arbitrations are much faster and less expensive than court cases. Although arbitration procedures were once thought to be biased against customers, most of these complaints have been resolved by recent reforms.

New Rules for Financial Products

The most controversial item before Congress is the bill to create a new Consumer Financial Products Commission (CFPC). The CFPC's proposed mandate is extremely broad: “To protect consumers of credit, savings, payment, and other consumer financial products and services, and to regulate providers of such products and services.” Because of its breadth, the CFPC has been publicly opposed by the chairman of the FDIC, the vice chairman of the Fed and the Comptroller of the Currency.

While the Treasury decided at the last minute to take securities products out of the CFPC's jurisdiction, it still covers all credit cards, mortgage originations, bank deposits and debt collection services aimed at retail consumers. The CFPC then would take away from the Federal Reserve its existing authority to set rules for mortgage originations and credit cards. There is a general consensus in Congress that the Fed did not do a good job in either area, and that one federal agency is needed to regulate mortgage originations.

However, there is a strong argument that the Comptroller of the Currency, rather than the CFPC, should be the primary regulator of credit cards. Almost all issuers of credit cards are now national banks under the Comptroller's jurisdiction; they want a national bank charter to pre-empt the myriad of state laws on credit cards. Unfortunately, the Obama Administration is proposing to allow each state to impose additional restrictions on credit cards and other retail financial products.

The CFPC's authority also extends to any annuities that are not deemed securities. This would appear to include fixed annuities currently regulated by the 50 states. Although the Treasury has urged coordination between federal and state agencies, this regulatory overlap on insurance products is likely to lead to confusion and conflict.

The CFPC's proposed authority to conduct examinations of the providers of bank deposits and loans is particularly troublesome. The CFPC would be examining exactly the same products that are examined by the banking regulators. In response, the House Financial Services Committee has exempted from the CFPC's examination authority 8,000 of the country's 8,200 banks.

In response to the financial crisis, Congress will surely create the CFPC in some form. To minimize regulatory overlap and maximize consumer benefits, the CFPC should be focused on financial services provided by nonbank lenders to low-income customers, such as subprime mortgages and payday loans.

New Regime for Systemic Risk

The Treasury is pushing hard to establish a new regime to address systemic risks — the chance that the failure of a financial institution or product will wreak havoc on the entire financial system. The Treasury has proposed that a Council of Regulators should monitor systemic risks and identify systemically risky institutions (SRIs), which would then be regulated by the Federal Reserve.

Congress will not pass this proposal because it gives too much power to the Federal Reserve. Nor does the Federal Reserve have the expertise to regulate all types of SRIs - e.g., insurance companies, money market funds and hedge funds as well as banks. Moreover, the very labeling of institutions as SRIs would create the possibly incorrect perception that they would never be allowed to fail.

Instead, Congress will allow SRIs to continue to be regulated by their current functional regulators, who will consult more with the Federal Reserve on systemic risks. For financial advisors affiliated with SRIs, this means that securities firms will continue to be regulated by the SEC, insurance companies by the states, and national banks by the Comptroller of the Currency. In addition, Congress will close the two glaring gaps in the current regulatory framework for systemic risks.

As shown by the near failure of Long-Term Capital in the late 1990s, a large and leveraged hedge fund can pose a serious threat to the entire financial system. Therefore, Congress will require a small number of very large hedge funds (e.g., with over $25 billion in assets) to file regular reports on their activities and holdings with the Federal Reserve. The reports will be kept confidential in order to protect the proprietary information of these hedge funds.

More broadly, Congress will probably require all managers of hedge funds beyond a certain size (e.g., $30 million in assets) to register with the SEC under the Investment Advisers Act. Such registration will not limit the investment strategies pursued by hedge fund managers, and will not prevent them from charging incentive fees as long as their clients meet high-net-worth tests. But hedge fund managers will have to make more detailed disclosures to their clients, and will be subject to periodic inspections by the SEC.

At the same time, Congress will strengthen the regulatory oversight of financial derivatives, including credit default swaps. Specifically, Congress will mandate that all financial derivatives traded between market professionals be processed through a clearing corporation, which will set margin requirements and mark them to market on a daily basis. In addition, the Treasury is pushing for all standardized financial derivatives to be traded on established exchanges, although this initiative is strongly opposed by the large banks that now dominate the over-the-counter market for financial derivatives.

But Congress will enact an exemption for customized financial derivatives utilized by industrial companies for commercial purposes, such as foreign currency hedging by technology giants. Many of these companies have specialized needs that could not be easily met by standardized contracts. If these customized derivatives are provided by financial institutions, they will have to meet higher capital requirements than for standardized contracts.

In short, despite the high-sounding rhetoric about fundamental reform, financial advisors will continue to be supervised by the same regulator. However, some of the products they use, such as home mortgages and hedge funds, will be more heavily regulated than before. Most important, the SEC may be vested with broad new powers to limit conflicts of interest, sales practices and compensation arrangements of financial advisors.

Robert Pozen is chairman of MFS Investment Management, a senior lecturer at Harvard Business School and author of Too Big to Save? How to Fix the U.S. Financial System (Wiley, November 2009).