We ended part i, with some questions. The answers to these questions could fill volumes. Yet, a high-level response is in order.
First, can Dodd-Frank prevent another similar crisis? This is far from certain. The law depends too much on regulators to actually use the powers they have been granted. Past behavior suggests that they will not. And, even regulators who wish to act will have trouble completing the job of derisking and downscaling the banks to prevent collapse. Given the various advantages of being too bit to fail, we cannot expect the firms themselves to complete that task.
Second, what should we celebrate and where are the gaps? There is much to celebrate. Getting this first law enacted and to its first year, was a tremendous accomplishment. As noted yesterday, we just need more to follow in its footsteps to make up for its weaknesses. And, some parts of the statute, such as the consumer financial protection bureau deserve particular praise. However, even while the consumer protection measures are worth celebrating, it is shameful that the law fails to do more for troubled homeowners.
Let me provide an explanation for this skeptical view.Here goes. Dodd-Frank provides a number of tools to prevent banks and other financial firms from engaging in excessive borrowing and betting that result in taxpayer-funded bailouts. Some of these tools appear more effective than others. Without a doubt, many need to be strengthened. And, shadow banks that still remain outside of regulatory scrutiny need to be brought into the light. Similarly, Dodd-Frank provides strong tools to better protect consumers, but industry-funded politicians are trying to weaken this part of the law.
So what are the meltdown prevention tools? First, Dodd-Frank attempts to reduce leverage. Section 171, the “Collins Amendment,” establishes, for the first time, a cap on how much bank holding companies, thrift holding companies and nonbank financial firms (“nonbanks”) can borrow. However, the leverage cap is still too high. About $96 in borrowing for every $100 in total (non-risk-weighted) assets is allowed, and possibly as high as $97. Experts like Professor Anat Admati suggest a 15 to 20% equity cushion – or only $80 to $85 in borrowing should be permitted for every $100 in assets. Moreover, the limit does not apply to all. While banks are broadly covered, only a small number of nonbanks will be affected.Even though nonbanks include a variety of financial firms such as hedge funds, industrial loan firms and insurance companies, and though these have been prone to messy insolvencies and bailouts, they are not all covered. In fact, so far, none are. Only those nonbanks designated by the new Financial Stability Oversight Council (“FSCOC”) as systemically important financial institution (“SIFIs”) will be subject to this restriction. So far, the FSOC has not revealed the criteria by which nonbanks will be designated as SIFIs.
In addition, Dodd-Frank provides extra tools to control the borrowing and other risky activities of large bank holding companies (those with more than $50 billion in total consolidated assets) and nonbank SIFIs. Once again, only those nonbanks that get designated, and so far none have been. Under Section 165, the Federal Reserve is given the power to impose enhanced supervision and prudential standards on these companies. These “more stringent prudential standards” are supposed to “prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions.”
While leverage is still too high, liquidity is barely even touched. A key weakness of the statute is the failure to deal with short-term debt. For example, it is unfortunate hat Dodd-Frank failed to roll back the special treatment in bankruptcy that repurchase agreements backed by mortgage-related collateral were granted in 2005. Policy makers and academics supported this rollback, including Florida Senator Bill Nelson, who attempted to get this into Dodd-Frank, yet his amendment never received a floor vote. There is continued support for such a roll back, including by Professor Stephen Lubben, Professor David Skeel and President of the Kansas City Federal Reserve Bank, Thomas Hoenig. Though under an FDIC “orderly resolution” there is a 24 hour hold on the safe harbors, this is not sufficient, as resolution, is hopefully rare. Many financial firms are only eligible or may otherwise end up in a Chapter 11 bankruptcy. So, this still needs fixing.
Another way the law tries to avoid another meltdown is through “early remediation.” Under Section 166, the Fed is required to take preemptive action, up to and including selling off assets of, (or breaking up) the giant bank holding companies and nonbank SIFIs. The Fed is supposed to take such action if the company experiences “increasing financial distress, in order to minimize the probability that the company will become insolvent and the potential harm of such insolvency to the financial stability of the United States.”
Dodd-Frank also attempts to limit public subsidies of private speculation through Sections 619 – 621 (the “Volcker Rule”). The Volcker Rule limits the ability of banking entities that have access to FDIC deposit insurance or the Federal Reserve discount window to also engage in certain high risk, speculative practices. This part of Dodd-Frank precludes them (subject to exceptions identified below) from owning or sponsoring hedge funds and private equity funds. It also forbids them from trading for their own accounts. Importantly, it also includes a prudential backstop, allowing regulators blanket authority to prohibit a whole host of activities if they create a threat to the financial system. This part of Dodd-Frank also prohibits firms from betting against their clients and other similar conflicts of interest.
There are notable gaps in Volcker, largely due to political expediency. In order to get 60 Senators on board and thus avoid a filibuster, it was necessary to provide a number of exemptions. One such exemption permits banks to operate or invest in hedge funds and private equity to start them up, so long as the amount of such investments does not exceed 3 percent of their Tier 1 capital. (Roughly, but not exactly, the amount left after subtracting the amount the bank owes from the value of its assets). Much of the details of this rule are unknown. Some complain that the line between permissible “market making” and impermissible “proprietary trading” will be difficult to draw. It is expected that the regulators will leave a lot of discretion to the internal compliance organizations at the covered banks to make those determinations.
And if prevention doesn’t work, Dodd-Frank sets out tools for intervention. Under Title II, the FDIC was given, subject to certain approvals, orderly liquidation authority. This encompasses the power to close down and sell off failing bank holding companies and nonbank SIFIs. Resolution authority is a third alternative – instead of the choice between a government-funded bailout (a la Bear Stearns) and a chaotic bankruptcy (such as Lehman). Whether resolution authority will be used or will be equally chaotic is a question many have raised. Some believe it will create even larger firms as they will buy up pieces of failed ones. And others express concern about whether this will work in a cross-boarder, complex financial firm.
Moreover, the funding for an FDIC resolution is first provided by the US Treasury. The taxpayers are fronting the funeral expenses. This means, if the sale of the failed firms assets are not enough to pay back Treasury, large financial firms may be asked to chip in after the fact, possibly when they are also weak. Of course, we remember that a bank-assessment to fill the orderly liquidation fund was strenuously opposed by Republicans in Congress who curiously called it a taxpayer-funded bailout.
So what to do? Prevention tools are not strong enough (and may not even be used by captured regulators) and intervention tools may be too discretionary and untested. Meanwhile, banks are still too big. The top five banks’ assets amount to 60 percent of GDP. In 1980, the top five held assets equal to only 16 percent of GDP. Perhaps we need a revival of the Brown-Kaufman “Safe Banking Act” amendment, which would have reduced bank size by limiting the total borrowing (liabilities) of any bank to no more than 3 percent of GDP. This would include amounts banks have on deposit from customers. And, it would have limited the non-deposit liabilities of any bank to no more than 2 percent of GDP. Or, better yet, perhaps we need a new Glass-Steagall, fully separating utility banking from securities operations, swaps trading and other high-risk, complex activities that are unrelated to deposit taking and credit extension.
On the consumer protection front, unmitigated praise is due for the creation and “standing up” of the Consumer Financial Protection Bureau. Though we hear repeated complaints about the weakness of Dodd-Frank, the CFPB is an example of a very strong and potentially very effective agency. That is why in the case of the CFPB, the financial services industry and sympathetic politicians in Congress are working hard to undermine it at every turn. This new agency has three major powers – rulemaking, supervision and enforcement. It will efficiently consolidate authority for numerous federal statutes related to consumer financial transactions. It also has “organic” rulemaking authority. This means it can prohibit a range of “unfair and deceptive acts or practices.” The CFPB is intended to create a level playing field and uniformity. For example, nonbanks such as payday lenders, mortgage brokers and private student lenders will now be subject to rules, oversight and enforcement.
While this part of Dodd-Frank has tremendous natural strengths, it is in a very tough environment. This is why the CFPB does not have a director. This week, the President bypassed Professor Elizabeth Warren (who initially conceived of the agency and stood it up before the transfer date) and nominated Richard Cordray, the former Ohio Attorney General. While this decision disappointed progressives, it did not mollify conservatives. A group of 44 Republican Senators have not budged. They recently vowed to block the appointment of any director of the CFPB unless the agency’s power and funding are substantially diminished.
The demands fit the acronym, “B.A.D.” Board. Appropriations. Diminished authority. They want a board and not a director to guide the agency. They want to subject the agency to the Congressional appropriations process. This would put the budget of the bureau in jeopardy based on Congressional whim. Even the expected $400 million budget is barely enough, given what industry lawyers estimate are 35,000 entities that might fall under its jurisdiction. Such lawyers have noted that the SEC has oversight over half as many firms with about three times that budget. And, the 44 wants to diminish the agency’s ability to make rules by giving the new Financial Services Oversight Counsel (FSOC) greater veto power.
Meanwhile, without a director, it may be that the Bureau is restricted from making rules in certain areas. And, some contend that the CFPB cannot supervise or bring enforcement actions against payday lenders, mortgage brokers and other nonbanks until a director is appointed. Unless the Republicans bend, there will not be enough votes in the Senate to block a filibuster. Thus, many believe that President Obama may resort to a recess appointment in August to assure that Cordray is appointed.
While Dodd-Frank via the CFPB and other provisions may help future homeowners, it does not do enough for existing homeowners who are drowning in debt. An individual who owes more on his mortgage than his home is worth is still not able to use the bankruptcy process to reduce the principal outstanding to the home’s value. Yet, a wealthier person with a vacation home can do so. And, a business with commercial real estate can as well. The bankruptcy code should have been amended long ago to fix this anomaly. The existence of the bankruptcy principal-reduction option would give all homeowners more bargaining power when they face foreclosure. Moreover helping consumers deleverage will be good for the economy and will discourage lenders in the future from using overvalued appraisals, risky mortgages, and poor underwriting standards, to extract too-big-to-pay commitments from borrowers.
In short, Dodd-Frank provides many tools for prevention and intervention. But it also has notable weaknesses. No surprise; the one-year-old law is not perfect. Yet, we should not throw the baby out with the birthday cake. We can and must do more to help this law succeed and to enact future legislation to compensate for its limitations. But, we had better act fast. As Professor Tom Ferguson notes ”the big banks are more dangerous and reckless than ever” and Admati warns that “the next crisis will happen sooner than later."
(This post and part i, initially appeared on The Pareto Commons)