July 11, 2010
The Financial Regulation Law—Posner's Comment
Five Major Defects of the Financial Reform Bill-Becker
A 2300 page bill is usually an indication of many political compromises. The Dodd-Frank financial reform bill is no exception, for it is a complex, disorderly, politically motivated, and not well thought out reaction to the financial crisis that erupted beginning with the panic of the fall of 2008. Not everything about the bill is bad-e.g., the requirement that various derivatives trade through exchanges may be a good suggestion- but the disturbing parts of the bill are far more important. I will concentrate on five major defects, including omissions.
- The bill adds regulations and rules about many activities that had little or nothing to do with the crisis. For example, it creates a consumer financial protection bureau to be housed at the Fed that is supposed to protect consumers from fraud and other abusive financial practices. Yet it is not apparent that many consumers were victimized during the financial boom years, or that consumer behavior had anything of importance to do with the crisis. For example, consumers who took out subprime mortgages that required almost no down payments and had low interest rates were not victimized since these conditions enabled them to cheaply own houses, at least for a while. The "victims" were the banks, and especially Fannie Mae and Freddie Mac, that were foolishly willing to hold such risky mortgages.
The bill gives the Fed authority to limit interchange or "swipe" fees that merchants pay for each debit-card transaction, although these fees had not the slightest connection to the financial crisis. Such price controls are in general undesirable, and hardly seem to require the attention of the Federal Reserve. The bill also gives the SEC authority to empower stockholders to run their own candidates for corporate boards of directors. Corporate boards often receive some blame for the crisis-mainly unjustified in my opinion- but stockholder election of some members will not improve corporate governance, and will probably make that worse.
- The Dodd-Frank bill gives several government agencies considerable additional discretion to try to forestall another crisis, even though they already had the authority to take many actions. The Fed could have tightened the monetary base and interest rates as the crisis was developing, but chose not to do so. The SEC and various Federal Reserve banks-especially the New York Fed- had the authority to stop questionable lending practices and increase liquidity requirements. These and other government bodies did not use their authority to try to head off the crisis partly because they got caught up in the same bubble hysteria as did banks and consumers. In addition, regulators are often "captured" by the firms they are regulating, not necessarily because the regulators are corrupt, but because they are mainly exposed to arguments made by the banks and other groups they are regulating.
Despite the fact that regulators failed to use the powers they already had, the bill mainly adds not clear rules of behavior for banks, but additional governmental discretionary power. For example, the bill creates the Financial Stability Oversight Council, a nine-member panel drawn from the Fed, SEC, and other government agencies, that is supposed to monitor Wall Street's largest companies and other market participants to spot and respond to any emerging growth in systemic risk in the economy. With a two-thirds vote this Council could impose higher capital requirements on lenders and place hedge funds and dealers under the Fed's authority. Given the regulators reluctance to use the power they already had to forestall the crisis, it seems highly unlikely that this Council will act decisively prior to the emergence of a crisis, especially when a two thirds majority is required.
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Insufficient capital relative to bank assets was an important cause of the financial crisis. The bill does reduce the ability of banks to count as bank capital certain risky assets, such as trust preferred securities, and gives the Fed authority to impose additional capital and liquidity requirements on banks and non-bank financial companies, including insurers. I would have preferred a simple rule that raised capital requirements of banks relative to their assets, especially capital of larger and more interconnected banks. As suggested by Raghu Rajan and the Squam Lake group of economists, the bill probably should have required larger banks to issue "contingent" capital, such as debt that automatically converts to equity when the banks are experiencing large losses, or when a bank's capital to asset ratio falls below a certain level.
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One of the most serious omissions is that the bill essentially says nothing about Freddie Mac or Fannie Mae. In 2008 these organizations were placed into conservatorship of the Federal Housing Finance Agency. During the run up to the crisis, Barney Frank and others in Congress encouraged Freddie and Fannie to absorb most of the subprime mortgages. In 2008 they held over half of all mortgages, and almost all the subprimes. They have absorbed even a larger fraction of the relatively few mortgages written after 2008. Freddie and Fannie deserve a considerable share of the blame for the crisis, but they continue to have strong political support. I would like to see both of them eventually dissolved, but that is unlikely to happen. Instead we are promised that they will be dealt with in future legislation, but I am skeptical that anything will be done to terminate either organization, or even improve their functioning.
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Many proposals in the bill will have highly uncertain impacts on the economy. These include, among many other provisions, the requirement that originators of mortgages and other assets retain at least 5% of the assets they originate, that many derivatives go on organized exchanges (may be an improvement but far from certain), that hedge funds become more closely regulated, and that consumer be "protected" from their financial decisions.
Most of these and other changes in the bill are not based on a serious analysis of what contributed to the financial crisis, but rather are the result of political and emotional reactions to the crisis. Usually, such reactions do more harm than good. That is likely to be the fate of the great majority of the provisions of the Dodd-Frank bill.
The Financial Regulation Law—Posner's Comment
I agree with Becker's criticisms of the new law (not quite a law yet—it has not been passed by the Senate, but I am guessing it will be, because an ignorant public demands action). It's a monstrosity, and a gratuitous one, as there is no urgency about legislating financial regulatory reform. The financial regulatory agencies have ample, indeed essentially plenary, authority over the financial industry; and because they were asleep at the switch when disaster struck, they are now hyper-alert to prevent a repetition of it. Indeed, bank examiners have become so fearful of condoning risky banking practices that they are making it difficult for banks to lend to small businesses and consumers and thus are retarding the economic recovery.
The principal factors in the financial and larger economic collapse appear to have been: (1) Incompetent monetary policy under Alan Greenspan and his successor Ben Bernanke, which enabled the housing bubble. The bubble's bursting brought down the financial industry, which was heavily invested in both residential and commercial real estate. (2) The inattention of the Federal Reserve and the Securities and Exchange Commission, which did not understand the changing nature of the banking industry, particularly the rise of "nonbank banks" dependent on short-term, uninsured capital. Solvency regulation of these banks was overly lax. (3) The overindebtedness of the American people and government, which has hampered the restoration of credit. And (4) the failure of the Treasury Department under Henry Paulson, and the Federal Reserve under Bernanke, to rescue Lehman Brothers; they didn't realize that Lehman's bankruptcy would trigger a run on the banking industry, causing a global credit freeze.
Obama's principal economic officials—Bernanke, Timothy Geithner, and Lawrence Summers—were implicated in the regulatory oversights that precipitated the crisis, as were key legislative officials, such as Christopher Dodd and Barney Frank. None of them wants to shoulder blame for the crisis. They want to change the subject. So instead of blaming government, they blame the banking industry. The industry did take risks that were excessive from an overall social standpoint, but industry will always take the risks that government permits them to take, if the risk taking is highly profitable and losses if the risks materialize will fall mainly on others, which is what happened. Some banks took a hit, but the big ones are doing well. The government saved them from bankruptcy and has allowed them to borrow from the Federal Reserve at interest rates close to zero, thus enabling them to return to profitability without doing much lending, which banks are reluctant to do during a deep economic downturn, when default risk soars.
But for government officials to say "we blew it—we had the powers we needed to prevent the crash but failed to use them because we were complacent and inattentive" would not be a politically satisfactory response to the economic debacle. Just as politics requires that the President be seen to "do something" about the oil leak in the Gulf of Mexico, though there is nothing he can do, so politics requires that Congress "do something" to prevent a repetition of the economic disaster, though there is nothing it needs to do.
Much that the 2300 page long "Dodd-Frank Wall Street Reform and Consumer Protection Act" ordains is within the existing powers of the financial regulatory agencies to effectuate. For example, although the Act creates a Financial Stability Oversight Council (consisting mainly of the chairman of the Fed, the Secretary of the Treasury, and the chairmen of the Federal Deposit Insurance Corporation and the SEC) to advise the President and Congress on systemic risk, these officials don't need legislation to hold regular meetings if that would be useful. The reason for creating such a Council is purely political: a governmental reorganization is a favorite response to a governmental failure because it is visible, easy to explain, usually cheap (it involves mainly just moving the boxes in a table of organization), and can be designed in such a way as to avoid ruffling too many interest-group and government-bureaucracy feathers. It also buys time, since no one expects a reorganization to be effective immediately.
In like vein the Act in several hundred pages directs the creation of a consumer protection bureau to be lodged in the Federal Reserve Board. The Fed already has such a bureau; it is ineffectual because the Fed cares about the solvency of banks, not the solvency of their customers. Congress proposes to correct this skew by making the head of the Fed's consumer protection bureau (renamed the Consumer Financial Protection Bureau—renaming being the least arduous and hence an irresistible form of reorganization) a Presidential appointee—so he can squabble with the Fed's chairman yet not be fired. The Federal Trade Commission, which is not protective of banks' solvency, has extensive experience in protecting consumers, including consumers of financial products (the Commission enforces the Truth in Lending Act, for example), and could be given additional resources to police unfair and deceptive practices in mortgage and other consumer lending. While subprime lending contributed to the financial crisis, most subprime borrowers were not deceived, abused, intimidated, etc. Adjustable rate mortgages, strongly encouraged by Alan Greenspan, enabled people who could not afford the down payment on a house to buy a house anyway, gambling that continued housing price increases would give them an equity in the house that they could use to refinance with a conventional 30-year mortgage. If the gamble failed, they would go back to renting.
The new law increases the amount of equity capital that banks must hold, relative to their total capital, in order to reduce bankruptcy risk. But the Federal Reserve, in the case of commercial banks, and the SEC, in the case of nonbank banks (or the nonbank subsidiaries of commercial banks, such as Merrill Lynch, now a part of Bank of America), already have the authority to decide how much equity capital, relative to debt, the firms they regulate must hold.
The legislation requires that most credit-default swaps (a form of credit insurance, but also a device for speculating on bond prices and defaults) be traded through clearinghouses and on public exchanges, as publicly traded stocks are. Uncertainty about the liabilities and solvency of issuers of credit-default swaps did contribute to the financial panic of 2008, but can be dispelled by requiring fuller public disclosure of firms' off-balance-sheet contingent liabilities, including not only credit-default swaps but also the "structured investment vehicles" in which banks parked their mortgage-backed securities. Requiring such disclosure is again within the existing authority of the financial regulatory agencies.
It may be argued in defense of the new law's apparent redundancy that the agencies didn't use their authority to avert the crisis (which is true), so they must be ordered to use it to avert future crises--which doesn't follow. It is a mistake for Congress to instruct regulatory agencies on the details of how to regulate. The idea behind administrative regulation is that agencies hire experts to deal with technical issues that Congress has neither the competence nor the time to resolve. Legislation once adopted is difficult to change, and can squeeze a regulatory agency into a straitjacket. This is a particularly serious concern in the case of finance, an industry that experiences continuous change.
Besides trying to micromanage the regulatory process in some respects, the new law in other provisions takes a different tack and directs the regulatory agencies merely to study particular problems. This is a waste of ink. All the senior financial regulators are appointees of the Obama Administration. If there are areas of financial regulation that would benefit from further study—and there are—the White House can tell its appointees to do so. There is no need for a congressional prod.
There are little nuggets here and there, such as the abolition of the faitnéant Office of Thrift Supervision, but on the whole, so far as I can judge, the new law is a political measure in the worst sense.