Q. What’s the latest on financial reform?

A. Last week the Senate passed major financial reform legislation that is in now being reconciled with a bill passed by the House last year. Once the differences are ironed out, it will be signed into law.

The legislation, not without controversy, contains a number of provisions intended to try to reign in banks, set up new regulatory agencies and avoid future taxpayer-funded bailouts. Among other things, the legislation would:

- Create a council of risk regulators tasked with preventing the failures of massive companies which could threaten the entire financial system;

- Establish a consumer protection division for financial products;

- Allow the government in extreme scenarios to seize and close down failing financial companies in order to protect taxpayers from future bailouts;

- Call for a one-time audit of the Federal Reserve;

- Force most derivatives to be traded on exchanges, where regulators will have more transparency and power to oversee them.

On Wall Street, most of the angst revolves around one particular aspect of the proposed reform. The Senate version of the bill directs regulators to restrict banks from proprietary trading – currently a huge source of profits for the banks. Whether or not the banks are forced to spin off, or completely separate from, their derivatives trading business remains to be seen. The Street and its lobbyists appear to be trying quite hard to derail this provision.

In general, the changes in the proposed legislation seem to imply that our financial system was sound, but the credit crisis and Great Recession were caused by a lack of regulation and oversight. As a result, the legislation will reduce the size of the industry’s profits, but will not address the size and/or political power of Wall Street. Read into that whatever you may.

One particular part of the reform that I was particularly glad to see dealt with the credit rating agencies. A system where the banks getting rated pay the firms doing the rating is hard to defend. The end of that practice alone is something to be noted.

Q. What’s going on with financial reform in Congress?

A. As you have probably heard by now, there is a significant financial reform bill currently making its way through Congress. The House passed its proposed reform bill at the end of last year, and the Senate will take up its own version at the end of this month. Prepare for heavy spin.

As one Senator memorably said a year ago in the midst of the credit crisis, “The banks are still the most powerful lobby on Capitol Hill. And frankly, they own the place.” So I think it’s notable that some fairly serious reform efforts have survived thus far.

The reform of our financial system is an issue that should be bigger than politics. The massive bailouts of “too big to fail” Wall Street banks were deeply offensive to just about everyone, regardless of political beliefs. They demonstrated at a shocking level the unholy alliance that has grown between politics and finance over the last few decades. In what may be one of the great ironies of our time, it turned out that Wall Street banks were bad for free markets.

I think it’s also important to understand that Wall Street banks didn’t get to be so big because of their economic advantages – they got there because of subtle political ones. What also should be kept in mind, however, is that regulation can unequivocally make the risk in the system worse. And it doesn’t make any sense to leave financial reform up to the same regulators who just failed us all so miserably.

I think Teddy Roosevelt had it right. The big banks should be broken up – not because that alone will guarantee our financial system will be safer, but because it will end this dangerous mix of politics and finance that nearly led to the collapse of the most advanced economy in history. One year later, the surviving Wall Street banks that helped cause the crisis are even bigger and more powerful. And until we address “too big to fail,” we’re really just kicking the can down the road.

Okay, so it’s two sentences. More here, from the battle on financial reform taking place on the Hill. And here’s a paper I wrote a few years ago about the problem of credit default swaps.

It’s probably fair to say that the amount of lobbying dollars spent by the Wall Street banks in DC is directly correlated to the size of their profit margins under threat. So this is going to be one heckua fight. But let’s be clear – the debate over derivatives you’ll be hearing about in the weeks ahead has nothing to do with economic freedom, limiting customers’ flexibility, or any other rhetoric. Banks don’t want any transparency into derivatives because the margins are so large. Sunlight means less profit – full stop. And while there’s no bigger fan of profit than me, if it comes at the expense of pulling the wool over your customers’ eyes, then it’s fair to question how sustainable those profits really are.

Politics aside, I think the huge pushback the Wall Street banks are mounting to what really should be a no-brainer part of reform underscores one key insight for investors: these banks don’t have sustainable moats.

Whatever economies of scale they might have are dwarfed by the complexity of their businesses, and that scale is certainly not evident in their internal returns. While there are plenty of sharp folks who work for the big banks, from a business owner’s perspective, that’s kind of like seeing your competitive advantage walk out the door every night.

So a point that I think gets lost in all the rhetoric these days is that these banks are lousy businesses. I would have thought that obvious to anyone alive in 2008, yet somehow it is not. Wall Street banks don’t represent the best of American companies, nor do they have any interest in truly free markets. I suppose you might respect their power and their unique political connections, but they shouldn’t get any credit at all for building enduring businesses. And shouldn’t that be at least a little relevant here?

When it comes to financial reform, Wall Street banks certainly don’t deserve a seat at the negotiating table because they’ve earned it. They bought it. Here’s to hoping we see that change.

Update: Um, never mind. This is now the most amazing sentence I’ve read this week:

“U.S. Accuses Goldman Sachs of Fraud.”

Sounds similar to the Magnetar trade.

And from a political strategy perspective, this announcement is arguably brilliant in terms of timing. Not only has Goldman’s seat at the reform table imploded, but the other big banks just saw the height of their chairs drop by about a foot.

Well-played, Forces of Good. Now, break up the banks, and I’ll quit badmouthing you for at least a week.