US financial reform law: weak and wanting
For all his efforts to reform Wall Street, the weak and watered-down financial sector reform legislation that President Obama finally managed to salvage after a protracted battle in the US Congress is woefully inadequate in averting the next financial crisis.
President Barack Obama signed into law the over-2,300-page Dodd-Frank
Wall Street Reform and Consumer Protection Act on 21 July, 22 months
There is little in the legislation that will fundamentally change the way that Wall Street does business, and Dodd himself has admitted that the legislation 'will not stop the next crisis from coming'. Although regulation of the financial sector will be improved in some ways, the legislation failed to produce the much more extensive structural reform that is necessary, given the severity of the economic crisis caused by regulatory failures.
The overarching problem is that the legislation fails to do anything to change the basic balance of power between Wall Street and Washington. Commenting on the spectacular achievements of the financial services industry lobbyists who diluted what needed to be done, Bill Gross, founder and co-chief investment officer for PIMCO and portfolio manager of The PIMCO Total Return Fund, the world's largest mutual fund, concluded, 'Wall Street still owns Washington.'
Lobbyists get to work
A study by the US Chamber of Commerce found the new legislation calls for 433 new regulations that will have to be written over the next couple of years. For the Wall Street lobbyists, the high-profile passage of the legislation was only the beginning. For them the fight just shifts from Capitol Hill to the regulatory agencies, which offers a more favourable lobbying environment where there are no TV cameras, and where lobbyists can argue their cases in a heavy-handed manner behind closed doors.
Of the many shortcomings of the Dodd-Frank Act, perhaps its biggest is that it heavily relies on the will of regulators. It gives a network of new regulatory agencies greater discretionary powers over financial firms but it does not fundamentally alter the structure of the banking industry. The problem is that there can be no guarantee that supervisors will possess the expertise or will to exercise their discretion wisely, or be under any less influence by industry lobbyists than before the crisis. Nor can we be certain that regulators will be capable of predicting future crises soon enough to impose some of the new precautionary measures, such as increased capital requirements. Therefore, things look set to continue pretty much as usual on Wall Street.
The legislation makes several cosmetic regulatory changes, some of which are administrative, and several of which will take some modest steps towards improving things. For example, there will be a new audit of the Federal Reserve's special lending facilities, as well as the ongoing audits of its open market operations and discount window loans, which provide a big step towards increased transparency at the Fed. And the legislation established new position limits in commodity markets regarding how much a trader can hold in a certain commodity, and it then aggregated these limits across all the different markets, which should prove helpful in preventing big swings in global food prices that had been previously exacerbated by commodity speculators.
But the astonishing thing about the new legislation is that many of the most high-profile and important new principles for reforms are established in bold fashion, only to then be followed by major exemptions a few pages later, actually undoing the very re-regulating that is supposed to be achieved.
The new reforms and their shortcomings
* New orderly liquidation authority
Dodd-Frank purports to solve the 'too big to fail' problem by creating an 'orderly liquidation authority' which can seize failing financial institutions, force creditors to accept losses and meet shortfalls with a retrospective levy on financial firms, rather than taxpayers.
The creation of this authority for banks as well as large non-bank financial institutions is a positive step, but there are several shortcomings to this approach, not least of which is the fact that no pre-funding mechanism was put in place for the new authority. The biggest concern is that everything relies entirely on the regulators to see a crisis coming and to have the political will to do the right thing in time.
For example, suppose Citigroup gets into difficulties again. Can society be sure that regulators will use the new liquidation machinery adequately and in time? Will they seize its assets, impose heavy losses on creditors and wind it up, and then seek billions in compensation from other financial firms that were well managed? Doing so will depend entirely on political will. In practice, a future administration will worry about contagion effects if it imposes losses on Citigroup's creditors. And given that the White House was not willing to let AIG or even auto companies fail, can we expect it will really be willing to allow a financial titan to fail in the future? Lobbyists will be quick to argue that Citigroup must be saved on national competitiveness grounds, pointing to the fact that the European governments would save their banks.
The legislation gives the impression that the government has more new powers to liquidate financial institutions, and although this may be technically true, the issue is not about such powers. The issue is one of 'moral hazard' or taking risks because you know you will be bailed out by the public taxpayers, and the problem will continue to be the same as before the crisis: If you are too big to fail, government will always bail you out and it will bail out the shareholders and the bondholders. The political reality is that the six largest banks, Goldman Sachs, Citigroup, Morgan Stanley, Bank of America, JPMorgan Chase and Wells Fargo, still enjoy this enormous implicit subsidy that results from the expectation that the federal government will bail them out in the event of a crisis - and they will likely continue taking dangerous risks accordingly.
* New Financial Stability Oversight Council
by the Treasury Secretary, this new Financial Stability Oversight Council
will bring together the heads of the Federal Reserve and other major
regulatory agencies in the hope that by pooling information regulators
will have a better chance of identifying emerging systemic risks. The
Council is tasked with meeting quarterly to identify risks to the financial
stability of the
The new Council will have 10 voting members: Secretary of the Treasury (chairs the Council), Chairman of the Federal Reserve, Comptroller of the Currency, Director of the new Bureau of Consumer Financial Protection, Chairpersons of the Securities and Exchange Commission (SEC), Federal Deposit Insurance Corporation (FDIC) and Commodity Futures Trading Commission (CFTC), Director of the Federal Housing Finance Agency, Chairman of the National Credit Union Administration Board, and an independent member (with insurance expertise), appointed by the President, with the advice and consent of the Senate, for a term of six years.
There are also five non-voting advisory members who may go into the equivalent of executive session when discussing confidential supervisory information: Director of the new Office of Financial Research who is the Council's executive director, Director of the new Federal Insurance Office (part of the Treasury Department), a state insurance commissioner, to be designated by a selection process determined by the state insurance commissioners (two-year term), a state banking supervisor, to be designated by a selection process determined by the state banking supervisors (two-year term), and a state securities commissioner (or officer performing like function) to be designated by a selection process determined by such state securities commissioners (two-year term).
The Federal Reserve still shares responsibility for overseeing the financial system with the US Treasury. And the new law requires the Fed to get the Treasury's go-ahead before using its extraordinary authority to lend to almost anyone, and limits loans to sectors of the economy rather than individual firms, such as Bear Stearns or AIG. But the Fed's role is in most respects expanded by the legislation. It alone will decide whether the new Financial Stability Oversight Council should hold a vote on breaking up big companies if they are determined by the Council to pose a threat to the stability of the entire financial system. The Fed will also have new powers to force big financial companies - not just banks - to boost their capital and liquidity. It will have the power to scrutinise the largest hedge funds.
But a major concern with this new approach is that this could suck the Fed into political controversies. The politics of such a major decision to break up a big bank because of its systemic risk to the economy would likely subject the Fed to conflicting pressures from lobbyists and politicians. Again, how this is actually handled will ultimately rely on the political will of regulators to do the right thing, and in a timely manner.
* New ban on some proprietary trading by banks
The new ban will oblige banks to spin off about a third of their derivatives business; and any remaining standardised, but not exotic, derivatives will have to be traded on open exchanges.
The legislation is a positive step forward in that it brings to life important new principles that proprietary trading, in which a bank can use its own capital to speculate, must be reduced to some extent, and that their investments in hedge funds and private equity funds - the more shadowy types of funds - must also be reduced. But there are several exemptions to this. Firstly, how much these activities will actually be reduced remains unclear. And given the way the law is written, it could be up to seven years before anything is implemented in terms of banks reducing their investments in hedge funds or other similar types of liquid assets. So the Dodd-Frank Act boldly establishes the good new principles, but then the fine print further down actually undermines those principles in practice, a problem that repeats itself throughout the legislation.
* New Consumer Financial Protection Bureau
The creation of a strong independent Consumer Financial Protection Bureau stands out as an important accomplishment. Such an agency would have prevented some of the worst lending practices that contributed to the housing bubble. The new bureau will regulate the sale of mortgages and other financial products to consumers. In theory such an agency could reduce the information asymmetry that places so much power to manipulate in the hands of financial firms by first examining the types of loans and credit cards that are given to individuals, preventing predatory lending, improving the documentation, transparency, and promoting the consumer side of financial transactions.
However, whether or not the new agency does in fact protect consumers from risks or outright fraud will depend on how it is led. Many had hoped that President Obama would choose a strong and effective person, such as Elizabeth Warren, as the first head of the Bureau to establish its independence, but industry lobbyists are already attacking her. And what is troubling is that the new agency will be housed inside the Federal Reserve, the same Federal Reserve that completely failed to see the crisis coming and refused to look at data it was receiving on housing, on lending, on leverage every day from the institutions it was supposed to be regulating. So placing the new agency within the Fed suggests that internal disputes could be frequent, and may be quite intense for whoever will run the agency. Again, the whole success of this new effort will rest solely on the political will of such regulators to do the right thing, and in a timely matter.
* New higher capital requirements for banks
Dodd-Frank Act seeks new higher capital requirements for banks but leaves
the details unclear because the
However, banks are already lobbying hard against this newest, third round of Basel Committee reforms. In a July interview with the Financial Times, Sheila Bair, chairman of the US Federal Deposit Insurance Corporation (FDIC), has said some members of the Basel Committee charged with setting international capital standards are already 'succumbing' to 'disingenuous' lobbying from large banks. Bair, who is a leading voice in the US regulatory debate and involved in drafting the new Basel III standards, said she thought most watchdogs deciding new rules at the Bank for International Settlements wanted banks to hold significantly more - and higher-quality - capital. But, in another sign of the rifts that have been an obstacle to a global accord on the exact levels of higher capital requirements, the banking industry lobbyists are arguing that raising capital requirements would stifle the global economic recovery and cause banks to cut back on lending, which Bair calls 'really disingenuous arguments'.
ongoing wrangling between countries has pitted the
Again, the bold new principle of better counter-cyclical capital requirements was elaborated in the Dodd-Frank legislation, but the actual outcome regarding the levels for the requirements is left unclear, and at the mercy of other governments and global banking industry lobbyists.
* The Kanjorski Amendment
amendment to the legislation added by US Representative Paul Kanjorski,
Chairman of the Capital Market Subcommittee of the House Financial Services
Committee, will allow federal regulators to limit the activities of,
or even preemptively break up large financial institutions that for
any reason pose a threat to financial or economic stability in the
However, what is troubling is that already the big six megabanks listed above currently fit the Kanjorski criteria - they are, by any definition, 'too big to fail'. Congress should have simply moved by statute to mandate their break-up rather than leaving this to the judgment of regulators 'after further study'. But again, rather than Congress itself taking such action in a clear and forceful manner, the new legislation leaves such crucial decisions to the judgment of regulators to be named later, hoping they will have the political fortitude to do the right thing, and in a timely manner. And the problem with this is that such regulators were not enforcing the laws previously in place that would have prevented the last meltdown. In spite of their incompetence and negligence, no regulator has been fired and several have been promoted. Evidently, according to Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, the banks figured that they did not need to have their lobbyists gut this amendment since they have already captured the regulators.
The handiwork of the lobbyists
Several elements of the financial reform agenda that had appeared in earlier drafts of the legislation were successfully watered down, eviscerated or completely gutted by the political power of the industry lobbyists in the months and weeks before the legislation was finally approved by Congress. Examples include:
* Transparency in financial markets
The crisis made clear that much greater transparency in financial markets is needed, particularly for derivatives because of the $180 billion bailout of AIG. And while the new legislation establishes this need in principle, it ended up leaving 30% of the market exempt from the new transparency rules.
* The Volcker Rule banning derivatives trading by banks
The original proposal for prohibiting US banks from making certain kinds of speculative investments if they are not on behalf of their customers, known as the Volcker Rule (proposed by American economist and former United States Federal Reserve Chairman Paul Volcker), also had sought to prohibit banks from owning or investing in a hedge fund or private equity fund, as well as to limit the liabilities that the largest banks could hold. But the new legislation ended up restricting proprietary trading and hedge fund ownership by banks, but not prohibiting these activities altogether.
The new watered-down rules will still allow the bulk of derivatives to be traded directly out of banks, rather than separately capitalised divisions of the holding company, and will still allow banks to risk substantial sums in proprietary trading. The legislation allows all but a few banks to still engage in proprietary trading in the same way they have in the past. Moreover, the rule inexplicitly limits the amount of a private equity venture or hedge fund that a bank can own to 3%. This ultimately benefits banks, because they will not have to put as much of their own assets at risk to convince outside investors to participate in a venture or fund.
* Fees on large financial institutions to pay for increased regulation
* Auto loan dealers exclusion
Another example of lobbyist influence was a key exclusion from the new Consumer Financial Protection Bureau. Although the Bureau will help consumers to better scrutinise future home mortgage loans and credit cards, car loans - one of the most prevalent types of consumer loan - are excluded entirely from its reach. Shady auto loans may never be responsible for sparking a financial crisis, yet many auto loan shops have often used dastardly tactics.
* Derivatives spin-off provision
In earlier drafts of the legislation, all banks would have been forced to put their derivatives business in a separately capitalised subsidiary. But by the time the lobbyists got through with this provision, the final legislation will now only restrict banks from creating certain sorts of derivatives, but not other sorts. While commodities and energy swaps are no longer allowed, foreign exchange and interest rate swaps, for example, still are. But there is no reason to suggest that corn futures are any riskier than euro futures.
Some suggested a turf war between bank lobbyists and futures exchange lobbyists is behind the outcome: futures exchanges may have pushed for the ban on commodity and energy derivatives created by banks because trading in the over-the-counter derivatives market (run by banks) ate away at the exchanges' market share once banks started getting into the business. Now banks are out of the picture regarding these products.
Left out: Fannie Mae and Freddie Mac
The two quasi-public home mortgage financing companies, Fannie Mae and Freddie Mac, were essentially left out of the new legislation. While the Dodd-Frank Act includes over 2,300 pages, it provides just two-and-a-half pages on these institutions which only call for a study on ending their current conservatorship, despite the fact that Fannie Mae and Freddie Mac were deeply involved in trading in the mortgage-backed securities which contributed to triggering the financial crisis, and have since been among the largest bailout recipients.
Federal National Mortgage Association (FNMA), commonly known as Fannie
Mae, was set up as a stockholder-owned corporation chartered by Congress
in 1968 as a government-sponsored enterprise (GSE), but founded in 1938
during the Great Depression to buy mortgages from lenders and package
them into bonds that are resold to investors. In 1970, the federal government
authorised Fannie Mae to purchase private mortgages (those not subsidised
by any other government agency programmes) and created the Federal Home
Loan Mortgage Corporation (FHLMC), known as Freddie Mac, to compete
with Fannie Mae and thus facilitate a more robust and efficient secondary
mortgage market. Together they currently own or guarantee almost 31
million home loans worth about $5.5 trillion, or about half of all
During the housing boom, the two loosened their lending standards for borrowers, but the crash in the housing market then hit Fannie Mae and Freddie Mac with heavy loan losses since 2007. The government took the pair into conservatorship in September 2008 under the authority of a law passed by Congress. The government increased its explicit support for the companies with more than $145 billion in bailouts, which has helped to push the cost of home loans to record lows and restore some stability to a teetering housing market.
Acting separately from the new financial reform legislation, the Obama administration says a good case remains for the government to preserve some type of public guarantee to make sure people can finance a house even in a very damaging recession. The White House is developing plans for reforming the companies and is working on a housing finance reform proposal for delivery to Congress by January 2011. In recent years, the two companies have been the target of an attack by Wall Street and Republicans, which would like to see the companies eliminated or privatised, as their publicly subsidised loans represent competition for the mortgage-backed securities business that Wall Street will one day want again.
Waiting for the next crisis
The inescapable conclusion is that more radical restructuring is required, but did not happen. Rather than breaking up the biggest banks and implementing much more serious structural changes to the financial system to deal with all the kinds of excessive risk-taking and all the problems of lack of transparency that were at the core of this crisis, the new legislation merely provides for marginal improvements, which themselves are likely to be further watered down in the coming months by lobbyists and will be overly reliant on the will of regulators. 'All we can do is create the structures and hope that good people will be appointed who will attract other good people,' according to co-sponsor Dodd. As a result, the success of even these minor reforms, in the words of their supposed architect, depends on hoping that presidents will appoint good people and that that will be enough.
The fact that no regulators, most obviously Fed Chairman Ben Bernanke, were fired for failing to prevent the crisis creates serious doubts about incentives for regulators. Implementing measures to curb reckless behaviour by politically powerful financial institutions will always be hard for regulators. But if regulators know that failing to crack down carries no consequences, even when it leads to disastrous crises, they will not surprisingly be more likely to just continue ignoring reckless behaviour.
The general philosophy of the new legislation, which reflects that of the Obama administration, is that the current structure of the financial system is basically sound. Everything will be fine as long as a range of supervisory mechanisms is tightened up a bit, and so long as modest restraints are placed on the most risky activities of the very large interconnected financial institutions - those now regarded as Too Big To Fail. However, the troubling historical record is replete with examples of how an over-reliance on discretionary interventions by regulators fails, and how there is a disturbing tendency for regulators to become 'captured' by, and internalise the assumptions of, those they regulate. It becomes quite reasonable to ask if regulators will actually have the wherewithal to impose the higher capital requirements during good times, even as they will now have enhanced powers to do so.
The fact that no one from any of the financial institutions has yet gone to jail is also sending a dangerous signal. In the 1930s, the Glass-Steagall Act did not content itself with promises of vague future controls on some proprietary trading. It used the state to make financial firms choose irrevocably between commercial and investment banking, and it forcibly broke up the House of Morgan. Top bankers were not just summoned to testify before Congress; they went to jail. By contrast, the new reforms are expected to merely cut profits at Goldman Sachs and JP Morgan by just 9% - and that will be temporary because their legions of lawyers are already finding and drafting loopholes in the legislation.
According to prosecutors such as William Black, the correct model for dealing with reform should have been the aftermath of the 1980s Savings & Loan (S&L) scandal, when a thousand industry insiders went to prison. Meaningful reform today should have begun by restoring the rule of law on Wall Street, which should have involved a rigorous audit of the banks and of the Federal Reserve. This should have meant investigations, criminal referrals from the Financial Crisis Inquiry Commission, from the regulators, from Congress, and from the new management of troubled banks as they clean house. It should have meant indictments, prosecutions, convictions, and imprisonments. Bankers should have been made to feel the full force of the law. Such convictions are necessary for helping to restore sanity to the economy, and would have helped dispel the illusions that bad assets can be made into good ones, that bad loans will someday be repaid, and that gamblers can run banks. Debt crises are only resolved when debts are actually written down, when the institutions that peddled bad debts are restructured, and when the people who ran the greatest scams have gone to jail. We know all of these things, and yet the fact that none of them happened should be setting off alarm bells.
In the tradition of economic historians such as Hyman Minsky, Charles Kindleberger and Carlota Perez, we can look back at the history of financial bubbles and crashes and see the danger signs, see when the financial bubbles began, see when the investor euphoria reached a crescendo, see how they each burst, and how each was followed by a period of tightened re-regulation. What is striking, however, about the aftermath of the two most recent burst bubbles, the 'dot.com' crash of 2000 and the recent 'real estate' crash, is that we did not ever get to the stage of tightened re-regulation that has always historically followed such episodes. And we should ask why.
Like many others, Adair Turner, chairman of the British Financial Services Authority (and a career investment banker), has said publicly that much financial activity is socially useless and exists only because it is highly profitable for those in the industry. He thinks finance should shrink as a share of GDP. But has the size and political strength of the financial services industry today become so immense that it is immune to ever being brought back under the control of the public interest? Or have these recent crises just not been harsh enough and deep enough to politically mobilise the degree of public pressure to bring about more meaningful structural reforms that are needed? Unfortunately, it appears that we will have to wait for the next crisis to know the answer.
Rowden worked in Washington DC for nine years with non-governmental
advocacy organisations engaged on foreign aid and development issues,
including six years as senior policy analyst for the US office of ActionAid.
He is currently pursuing a PhD in economics at the Centre for Economic
Studies and Planning (CESP) at
*Third World Resurgence No. 238/239, June-July 2010, pp 17-22