Financial Reform to the Rescue?
Approximately two years after the commencement of the Great Recession of 2008-?, the U.S. Congress has finally acted by passing financial reform legislation also known as the Dodd-Frank bill. Interested parties hailed it as either a panacea for all that ails us or another government intrusion that will create roadblocks to the restoration of normal financial and economic activities. If you use the stock market as your guide, the legislation will have minimal impact. It is very likely that few have had time to digest all the intricacies of the provisions. In addition to the sheer size of the legislative document, it is riddled with jargon and ambiguities. There was one telling moment during the final debate, when one senator inquired about the meaning of a particular section. As he waited for the reply, there were a lot of blank looks around the table. At first it seemed that the delay in response was just due to exhaustion and lack of attention given the time of day, which was approximately 1:00 am. However, even after the congressman responsible for penning that section was summoned to respond, he was unable to pull together any kind of explanation for the opaque phrases written on the page. The only thing that saved further embarrassment was that time had expired for debate on that particular section, and a vote was swiftly initiated and completed with the section adopted with no adjustments.
The other reason for the lack of any sharp market response is that many of the initiatives and virtually all of the material provisions are dependent on the completion of a study or the drafting of regulations. The oft quoted idiom, “the devil is in the details” rings true and in this case the details are yet to be written. Therefore, the changes proposed by this bill and its impact will not be apparent for another two to five years. It also means that the typical political, business and consumer oriented forces that help to shape public interest rules will continue to work in the background and can still change the trajectory of the proposed reforms.
The primary impetus for the legislation was to create a more stable financial system – One that could withstand economic shocks without adding to the turmoil. Of course there is still significant debate about what caused the problems in the first place. However, it is difficult to disagree with the general assessment that the old financial system failed to provide any firewalls, safe havens, or ability to restore confidence in the midst of economic distress. So, most would agree that some type of change was necessary. Some would say that the U.S. government and other world regulatory agencies have moved too slowly to make reforms, but an alternate perspective is that we are still sifting through the facts to make an accurate determination about the fragility of the old system.
The Dodd-Frank bill has many parts to it. Perhaps the best way to understand its impact is to assess it based on the various shortcomings that it attempts to remedy. A short list of these shortcomings includes the follows:
- Inadequate consumer protection
- Excessive risk taking by financial institutions
- Lack of transparency regarding counterparty risk especially for newer financial instruments
- Failure of regulatory agencies to identify and address systemic risk
- Inadequate system to address failure of large financial institutions
Consumer Protection
Despite the length of the bill some of the proposed remedies are not particularly novel or complex. For example, in order to provide better consumer protection, the bill creates a new regulatory agency dedicated exclusively to ensuring that financial institutions deal fairly with consumers. The existing banking regulators had previously had responsibility for consumer protection, but the new agency will have broader jurisdiction. The agency will be able to regulate the non-bank or so-called shadow banking industry. The agency will be relatively well funded, but will have a lot of ground to cover. In addition, there is a rather cumbersome process for getting new regulations approved. Some critics argue that this new agency will become a type of government big brother and stifle innovation. However, the history of regulatory agencies in the US has almost always tended towards the meek and timid side, so these fears seem unfounded.
Excessive Risk Taking by Financial Institutions
The cornerstone of the model set forth following the Great Depression was Glass-Steagall, which restricted risk taking by government insured banks and insurance companies and allowed the market discipline to keep a check on financial companies that were not backed by some type of government support program. This model seemed to work relatively well for a long time; however, a number of trends gradually chipped away at the foundation that provided the stability. First, barriers erected by Glass-Steagall were gradually eroded by regulatory interpretation and then eliminated by legislation in 1999. Second, securitization of many lending activities, eliminated some of the safer assets from banks’ balance sheet forcing them to engage in higher risk activities. One of the more lucrative new activities pursued by banks was dealing in some of the new exotic financial products such as credit default swaps. Some banks would take positions for their own account, but even if they covered their exposure by selling the opposite side of the transaction to someone else, they created counterparty risk. It was this counterparty risk that lacked transparency, and created uncertainty, and panic even among very sophisticated investors. The final trend that increased the risk was a sharp uptick in proprietary trading often funded through short-term borrowing sources.
The primary tool in the legislation designed to reduce risk-taking by financial institutions is a limit on proprietary trading by any firm that has access to emergency borrowing from the Federal Reserve. In the final hours of debate, this provision was watered down somewhat, but will still require a relatively material shift for some of the larger financial institutions. During the recent earnings announcements, several large financial institutions indicated that this provision will negatively impact their earnings. Some of the large banks have emphasized that shareholders should begin viewing bank stocks as a lower return, but safer and more stable investment. If this is the end result then at least one of the objectives of the legislation will have been met.
Improved Transparency
In order to improve transparency the legislation imposes a requirement for trades of many of the new financial instruments to be cleared through a clearinghouse or at a minimum traded on an exchange. Both of these provisions will require time to develop and implement, with many of the details to be worked out by various regulatory agencies. These reforms should help to reduce investor concerns regarding contagion. However, margin calls and increased collateral calls from the clearinghouse will actually introduce a new risk. In fact it is the same risk that required government intervention of AIG, which had large collateral calls from the counterparties of outstanding credit default swaps. In other words the changes are not a panacea, but it will help shed some light in an area that has operated in the shadows for too long.
Systemic Risk Monitoring
On the question of systemic risk, the legislation opted for a fairly straightforward approach similar to the solution for consumer protection. A new agency is created whose sole responsibility will be to monitor systemic risk and make recommendations to address any growing risks. It is interesting to note that the Federal Reserve was clearly the governmental body previously responsible for monitoring systemic risk. So, the prior error was not so much that no one was responsible, but rather judgements about risk to the system were erroneous. Alan Greenspan having been Fed Chairman for an 18 year span ending only in 2006 has to take a lion’s share of the blame for the erroneous judgements. He has made a number of frank omissions in testimony over the past year. In addition, the laissez faire political climate that has been more or less prevalent since 1980 also helped to turn a blind eye to the excesses and imbalances that were developing. So, the real question is whether the creation of a separate agency can rectify the past problems, which primarily stem from erroneous human judgement and political philosophy. There is a possibility the new regulatory structure will create more difficulties since it demands coordination and agreement from a large number of independent regulatory agencies. For example the board of directors is composed of more than a dozen regulatory agency chiefs, who will each bring their own parochial perspective to the Board room.
In order to better assess and control systemic risks the new regulator will identify all firms that have the potential to create systemic risk – in other words, all the too big to fail (TBTF) firms. The Fed along with the new systemic risk regulator will have power to create regulations that will apply to all the TBTF firms. The specific identification of a basket of TBTF firms is new; however the Fed has always had the power to write regulations that apply to firms beyond commercial banks. And, the SEC of course has always had direct regulatory authority over the securities firms. So, it is little unclear how this new regulatory structure provides any material advancement over the old structure. Although, it should provide some regulatory clarity for firms like AIG, which had so many different businesses across the globe that is was unclear who had regulatory responsibility and what level of authority existed to take action. In the end, the effectiveness of the regulatory regime will depend more on the quality of the political and regulatory leadership than the actual structure.
Liquidation Process for Large Financial Institutions
The last major area addressed by financial reform is the liquidation of large financial institutions. The provisions in the bill are supposed to prevent the so-called bailouts, which occurred during the recent crisis. In order to accomplish this, the legislation creates a liquidation or wind-down process for any TBTF financial firms not already covered by a government guarantee program. The FDIC will administer this new liquidation process and is given fairly broad powers to take control of the company assets, pay off creditors, and to lend funds to the failing company to preserve key operations. The key argument for creating a separate process is that the normal bankruptcy process does not work for the TBTF firms. Many point to the Lehman bankruptcy as evidence that we must put the TBTF firms into a special category. However, it is interesting to note that the Lehman bankruptcy has progressed in a manner that would be expected for a large complex institution. Many financial gurus have pointed out that the Lehman bankruptcy created market-wide uncertainty and thus created the spark that spawned the financial firestorm. A significant portion of the panic stemmed from the uncertainty regarding how risk would be transmitted to other firms if several large financial firms declared bankruptcy. However, it remains unclear how a new and untested liquidation process will enhance transparency and provide greater confidence. The current bankruptcy process can be cumbersome, but has many decades of precedent. The new liquidation process will rely on regulators making potentially arbitrary interpretations of newly written guidelines. The legislative solutions advanced for most of the other problems are at least some improvement over the status quo; however, the so-called solution to the TBTF problem could turn out to be counter-productive. For example, this time around once the government stepped in to back-stop the large banks, brokerage firms, and AIG it sent a strong message to the market that the government would keep them operating, which allowed creditors to adjust their positions. With the new process, even if the FDIC provides emergency funding, it could decide to liquidate that firm at any point in time. It seems that uncertainty due to the contagion effect form failed firms would still remain.
Preventing a Future Financial Crisis
Even with this brief summary of the problems and related reforms, one can see how deep and fundamental the changes need to be in order to adequately recreate stability and trust in the system. And, despite the attempt at creating a comprehensive solution, some of these problems were not fully addressed in the recent legislation. Many of the financial experts have commented that despite the significant number of reforms included in this package, it will not prevent another financial crisis. Perhaps the most insightful comment comes from a grade-school child. When Jamie Diamond received a call from his daughter, who was calling from school, she asked “what’s a financial crisis?” Trying to be succinct and simple as possible Jamie responded “it’s something that happens every 5-7 years.” The follow-up question from his daughter was “then why is everyone so surprised when it happens?”
A.K.A Banker Bashing Grows Up.
Timothy Geithner is undoubtly in an uneviable position. He 
MM Archive 