David Coates

Building Walls or Designing Colanders? Legislative Change in the Wake of the Financial Tsunami

The financial crisis, when it broke in September 2008, arrived with remarkable speed and total lack of fanfare. The legislative response to it, by contrast, has come slowly and with much public deliberation. That legislative process is not yet complete. Indeed the unexpected death of Senator Byrd may still extend it beyond the previously announced deadline of July 4th. But the process of responding to the events of September 2008 took a huge step forward this month. Legislation proposed by the President a year ago, legislation passed by the House in December, legislation passed by the Senate in May: all that legislation has been renegotiated into a final bill – the Dodd-Frank Wall Street Reform and Consumer Protection Act – which the House and Senate must now pass before the President can sign. Hailed by its supporters as the most significant piece of financial reform since the 1930s, and justified – by them at least – as the way to avoid a repetition of the 2008 crash, the new legislation deserves our full and critical attention.

THE CHANGES

The agreed bill contains at least the following new elements

  • An independent Consumer Financial Protection Bureau, housed in the Federal Reserve, to prevent the mis-selling of mortgages, credit cards and other financial products (though not auto loans) through hidden fees, abusive terms and deceptive practices.
  • A Financial Stability Oversight Council of regulators chaired by the Treasury Secretary, to identify and address risks posed by large complex companies and products before they threaten the stability of the whole financial system.
  • New procedures to enable the government to seize and wind up failing financial firms without cost to the taxpayers – the costs of the wind up originally to be paid by a retrospective levy on other financial institutions.[1]
  • New rules on capital and leverage requirements for large financial institutions; and restrictions on the use of their own tax-payer backed funds for speculative investment in hedge funds and private equity firms.
  • New transparency and accountability requirements on over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders. The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to have the authority to regulate over-the-counter derivatives. The ‘shadow banking system’ to be ended by requiring hedge funds and private equity advisers to register with the SEC.
  • A new Office of Credit Ratings at the SEC to regulate credit rating agencies and expose conflicts of interest; with credit agencies liable to private law suits for negligence.
  • A one-time GAO audit of all Federal Reserve emergency lending during the financial crisis, and on-going (two-year lagged) GAO audit of loans made by the Fed to banks through its discount window.
  • The establishment of a simple federal standard for all home loans, with prohibitions on (and penalties for) unfair lending practices by mortgage brokers.
  • A requirement that companies selling mortgage-backed securities and similar financial products retain at least five percent of the risk, so keeping “a skin in the game.”
  • Shareholders to have an enhanced say on executive compensation and golden parachutes.[2]

THE EVALUATION

So does the new legislation do the job?

The answer to that key question, of course, depends on what you think the job actually requires. Judging the adequacy and appropriateness of this legislation depends entirely on your understanding of why the financial collapse of September 2008 occurred. My own view (laid out more fully in Chapter 10 of Answering Back) is that at least the following processes were in play in the run-up to the most serious bank collapse since the Great Depression.

  • The lowering of underwriting standards on mortgages, and the selling of mortgages on dubious terms to people ultimately unable to pay their monthly premiums – first by private mortgage brokers and later by the GSEs Fannie Mae and Freddie Mac.
  • The securitization of those mortgages, and their dissemination through the US (and eventually global) financial system as new and unregulated financial products – products then given triple A ratings by credit rating agencies which were often overwhelmed by the volume of business and were subject to serious conflicts of interest.
  • The systematic easing of financial regulatory structures and standards over time, including the 1999 dismantling of the Glass-Steagall separation of commercial and investment banking.
  • The rapid development of new and complex financial instruments, and the  associated build up of high debt to asset ratios in major financial institutions.
  • Policy from the Federal Reserve that kept US interest rates low and regulatory regimes deliberately light.

Judged by those criteria, the new legislation is clearly a step in the right direction, but not by itself complete. The creation of the Consumer Protection Bureau and the establishment of a new tough underwriting standard for US mortgages must help to stabilize US housing and financial markets over the long term, as will the requirement for banks to keep “a skin in the game” when selling securitized products.  The creation of an Oversight Council, and the insistence that any failed bank will be liquidated at its own expense and not that of the taxpayer, should remove the need for a second TARP. Any barriers that slow down the ability of commercial banks to speculate wildly via investments in hedge funds and private equity firms is definitely to be welcomed, given how insolvent such speculation left many key financial institutions in the more lightly regulated conditions that preceded the 2008 melt-down.

However the failure to create a complete wall between commercial and investment banking leaves intact the possibility of such insolvency in the future; as do the many exceptions and loopholes around the supervision and regulation of new financial products. The cry in 2008 was that “banks were too big to fail”, and so had to be rescued. They were rescued. They remain big. Indeed they are now even bigger; but they were neither taken into public ownership nor broken up into smaller units – though both of those “solutions” were at the time widely canvassed. The 2008 crisis was caused by unregulated financial institutions of excessive size. The new legislation tightens the regulations but does nothing about the size. The Wall Street Journal reported it out this way.

The early verdict from bankers, lawyers, economists and government officials: the bill takes important steps [to cut the odds of repeating the recent financial crisis and the devastating recession and taxpayer bailouts that followed] by widening the regulatory net, installing better shock absorbers in the financial system and setting out a road-map to close big firms that fail. But it’s no cure all.[3]

THE DEBATE

Of course not everyone shares my view of why the 2008 financial tsunami occurred. For those who place full responsibility for that disaster on GSE misbehavior, government oversight and lax monetary policy, more government regulation is the last thing the banking sector now requires. “Killing an ant with a nuclear weapon,” was how House Minority Leader John Boehner characterized the Dodd-Frank Act in an interview today.[4] From a conservative perspective, more regulation will only make “too big to fail” worse. The Dodd Bill promises “bailouts forever” according to Peter J. Wallison & David Skeel: when passed, “like Fannie and Freddie, large financial institutions will be seen as protected by the government and, with lower funding costs, will squeeze out their Main Street competitors.”[5] Nor can an overhaul of the financial regulatory system work, on this perspective, if it does not also stretch out to encompass the two main GSEs. “Outrageous” was how NYU Professor Lawrence White described the omission of Fannie and Freddie from the remit of the new legislation.[6] Naill Ferguson and Ted Forstmann put it this way: the “widespread but erroneous belief that the financial crisis has its origins in deregulation dating all the way back to the 1970s…is really bad financial history.” After all, “the crisis of 2008-9 originated in one of the most highly regulated sectors of the financial system: the U.S. residential mortgage market”; and “it is not at all clear that our crisis was exclusively caused by a failure of regulation as opposed to a failure of monetary policy.”[7] As researchers at the Heritage Foundation put it

This legislation is the wrong approach to fixing the financial industry. Rather than end the “too big to fail” mindset, it reinforces it. Rather than end bailouts, it ignores the ongoing bailout of Fannie Mae and Freddie Mac. Rather than make the financial system safer, it reduces firms’ ability to handle risk. And rather than help consumers, it raises their costs, reduces their choices, and hinders the capital formation necessary to make them more prosperous.[8]

By contrast, for those who place full responsibility for the financial crash and the resulting recession on a private banking system out of control, regulating major financial institutions only lightly – in the manner now proposed – leaves a series of hostages to fortune. Response to the new legislation in liberal circles has so far been partly self-congratulatory (particularly noting how Senator Lincoln toughened her stance when strongly challenged by a liberal candidate in her Senate primary race).[9] But it has also been highly cautionary, troubled by omissions and concessions tucked away in the detail of the legislation as it finally emerged.[10] Retreats on both the Volker Rule and the Lincoln derivatives amendment remain serious causes for concern.[11]

  • The initial Volker Rule would have entirely banned banks from using their own funds to speculate in the financial markets – i.e. no proprietary trading – on the grounds that those funds were underwritten by the tax payer, and that banks had access to cheap funds from the Fed.[12] A last minute change in the bill allowed banks to use up to 3 percent of their Tier 1 capital to so speculate by investing in hedge funds and private equity firms; and excluded certain classes of financial institutions from the restrictions – exclusions which particularly favored Massachusetts-based banks important to the new Republican Senator from that state.
  • The initial Blanche Lincoln proposal to have the big banks separate off their swap-dealing units into a separately-capitalized institution within the overall hooding company – a proposal designed to oblige the big banks to hold enough reserves to cover their swaps if the bets went bad – was also watered down at the eleventh hour, allowing banks like JP Morgan Chase and Bank of America to keep in-house most of their key swap-dealing units (those dealing in interest rate and foreign exchange swaps, and in derivatives addressed to gold and silver), obliged only to push out to affiliates other less central and less lucrative swap activities.[13]
  • In any case certain things just never made it even to the eleventh hour. In particular, the Brown-Kaufman amendment setting an absolute size on any particular financial institution – as a set percentage of US GDP – never came out of committee, and that – according to critics like the widely-respected Simon Johnson – was an opportunity lost.[14] 18,000 auto-dealers are not to be covered by the new Consumer Financial Protection Bureau – heaven knows why!

THE JUDGEMENT

So overall: what is the judgment? Do we give this new legislation a full A grade, an A-, a B+ or a straight F? In truth we probably have to give it only a provisional grade, and the jury has still to stay out. Why? Because (a) it is not yet certain that there are enough votes in the Senate to overcome a Republican filibuster – the bill may not even pass; and (b) even if it does pass, much of the regulatory detail that will be so important to its effectiveness remains to be settled by the new/more empowered oversight agencies that will then come into existence. The devil will be in the detail, and the detail remains to be fixed. That fixing will no doubt attract heavy lobbying – as heavy at least as the lobbying reported on the bill itself.[15]

It is hard, however, not to concede at least these two things: that the new legislation, if passed, will act as a sea-wall against the full impact of any future financial shock-wave; but that, in the form in which it will be passed, the top of the wall it creates is still seriously holed. When small bodies of water hit walls which are strong at their base but fractured at their top, those walls invariably stand. But when huge bodies of water hit walls that can be penetrated, those walls invariably fall if and when the volume of water hitting them is sufficiently large. The way forward, therefore, ought to be this: the passing of this legislation and then the enactment of a set of supplementary reforms, each designed to fill one of the remaining holes. Building walls is good. Filling in residual holes is better. This week was a good week for financial re-regulation. Let us simply hope that it is not the last week of its kind!


[1] Even this changed overnight, in the new precarious voting environment created by the death of Senator Bryd. This is how The New York Times reported the overnight development (June 30, 2010). “Congressional negotiators briefly reopened the conference proceedings on a sweeping financial regulatory bill on Tuesday after Senate Republicans who had supported an earlier version of the measure threatened to block final approval unless Democrats removed a proposed tax on big banks and hedge funds. Conference negotiators voted to eliminate the proposed tax and adopted a new plan to pay the projected five-year, $20 billion cost of the legislation. The new plan would bring an early end to the Troubled Asset Relief Program, the mammoth financial system bailout effort enacted in 2008, and redirect about $11 billion toward heightened regulation of the financial industry.”

[2] An extensive summary of the legislation is available at http://online.wsj.com/article/BT-CO-20100626-701056.html. Its relationship to the earlier proposals (the President’s original package of measures, and the bills earlier passed in the House and Senate) can be established by checking back on this website (updates to Chapter 10 tabled in December 2009, May 2010 and June 2010)

[3] Jon Hilsenrath, “Important Steps, No Cure-All”, The Wall Street Journal, June 26-27, 2010

[4] http://voices.washingtonpost.com/44/2010/06/boehner-suggests-raising-socia.html

[5] The Wall Street Journal, April 7, 2010

[6] Quoted in The New York Times, May 2, 2010

[7] The Wall Street Journal, April 23, 2010

[8] The full Heritage Foundation report, Financial Reform in Congress: A Disorderly Failure is at http://www.heritage.org/Research/Reports/2010/06/Financial-Reform-in-Congress-A-Disorderly-Failure

A similarly critical report by Mark Calabria – Financial Reform Bill Won’t Stop Next Crisis – is on the Cato Institute website at http://www.cato.org/pub_display.php?pub_id=11916

[9] An e-mail to members from Aaron Swartz, BoldProgressives.org, June 25, 2010

[10] The fullest and most carefully balanced specification of the liberal case for reform – put by a star cast that includes Simon Johnson, Elizabeth Warren, Robert Kuttner and Nomi Prins – can be found in the special report “Still At Risk”, in the June 2010 edition of The American Prospect. For a punchier and altogether bleaker view of the legislation, see Dylan Ratigan, Wall Street Reform in a Nutshell: The Politicians Lied, Media Applauded and We Americans Will Suffer; posted on Alternet.org, June 26, at http://www.alternet.org/story/147339

[11] But of course only for liberals: for bankers’ relief, see Christine Harper, “Banks intact as Congress softens trading regulations”, Bloomsberg News, June 28, 2010, at http://www.txcn.com/sharedcontent/dws/bus/stories/DN-regulate_28bus.ART.State.Edition1.3a36c4c.html

[12] Paul Volker put it this way in the June 24, 2010 edition of The New York Review of Books. “The central issue with which we have been grappling is the doctrine of ‘too big to fail’. It’s corollary is so-called ‘moral hazard’: the sense that an institution…will be inclined to tolerate aggressive risk in the expectation that it will be rescued from possible failure by official financial support. That is not a new concern. Commercial banks in the ordinary course of their business have deposit insurance and access to Federal Reserve credit in times of stress. In practice, creditors of the largest banking institutions have been protected. The quid pro quo has been extensive regulation to limit risk. The underlying assumption has been, correctly in my view, that these banking institutions perform absolutely critical functions in our economy….[in the new legislation] there would continue to be a federal safety net implicitly subsidizing strongly regulated commercial banks, as has been the practice for decade…here and abroad. Other institutions, and their creditors, should not expect official protection. The clear possibility of failure without a ‘bailout’ will be reflected in lower credit ratings, in higher financing costs, and in market-imposed restraints.” (pp. 12&14)

[13] “in a deal negotiated between Mrs. Lincoln and a bloc of House members called the New Democrat Coalition, banks will be required to segregate their dealings only in the riskiest categories of derivatives, including the highly structured products like credit-default swaps based on bundles of mortgage loans, and in certain types of derivatives that are based on commodities that banks are already prohibited from investing in, like precious metals, agricultural products and energy.” The New York Times, June 25, 2010. Details of this watering down of the new regulations were posted on the June 25th Huffington Post at http://www.huffingtonpost.com/2010/06/25/financial-reform-bill-pas_n_625191.html?ir=Daily%20Brief

[14] See, for example, http://www.huffingtonpost.com/simon-johnson/dont-forget-the-kanjorski_b_610937.html?ir=Daily%20Brief

[15] For the huge scale of this lobbying, see the Center for Public Integrity report at http://www.publicintegrity.org/articles/entry/2133/

David Coates holds the Worrell Chair in Anglo-American Studies at Wake Forest University. He is the author of Answering Back: Liberal Responses to Conservative Arguments, New York: Continuum Books, 2010.

He writes here in a personal capacity.

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