The attack on Dodd-Frank
Rick Rowden lays out how Trump, Wall Street and the Republicans in Congress are committed to dismantling financial regulation in the US.
While much of the Trump administration’s political agenda has met with disarray, confusion and failure, the one area where the Trump team has managed to work effectively with the US Congress and Wall Street is financial sector reform. Specifically, this means a full-frontal assault on the so-called Dodd-Frank financial reform legislation passed in the wake of the 2008 global financial crisis.
Drafted by co-authors US Senator Christopher Dodd and US Representative Barney Frank, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President Barack Obama in 2010. Ostensibly, the new rules were to regulate the US financial sector better and limit the risky behaviour on Wall Street that was widely perceived as a trigger of the 2008 crisis.
Considered the most far-reaching overhaul of the US financial sector since the Great Depression, the reforms were intended to strengthen the country’s financial system, prevent any further financial crises and attendant bank bailouts by taxpayers, and protect consumers from the kinds of predatory lending and investment practices that had made the American economy so unstable.
While many of Dodd-Frank’s progressive critics say the reforms did not go far enough, its conservative critics complain it has gone too far. And now their guy is in power.
President Trump had made a campaign promise to repeal the Dodd-Frank reforms, and appears intent on fulfilling it. His Treasury Department under Steven Mnuchin has put forward an ambitious set of proposals to repeal Dodd-Frank and push for even further deregulation of the financial sector. Trump will also rely on his key appointments to head major US financial regulatory agencies such as the Federal Reserve’s regulatory wing, the Office of the Comptroller of the Currency (OCC), and the Securities and Exchange Commission (SEC).
In Congress, Wall Street lobbyists and congressional Republicans are promoting new legislation called the Financial Choice Act that will repeal most of Dodd-Frank or at least seriously water it down. The bill already passed in the US House of Representatives in June, and the legislation now awaits action in the Senate.
The Dodd-Frank reforms
The 2008 global financial crisis unfolded because of a badly regulated financial system that allowed millions of junk mortgages to be issued which were never expected to be repaid. These bad mortgages were packaged inside mortgage-backed securities and more complex instruments and then passed on to trusting buyers all over the world. On top of such investments, there were companies like AIG issuing hundreds of billions of dollars in credit default swaps – insurance on the investments – that they knew really had no ability to pay when the underlying mortgages went unpaid. Then other companies, with insider knowledge of the ticking time-bombs hidden within these investments, actually shorted the bad mortgages (bet against their ever being repaid). Arguably, this is the type of regulatory world that President Trump, the Republicans and Wall Street lobbyists would like to bring the US back to as they seek to repeal the Dodd-Frank reforms.
The chief reforms under Dodd-Frank were the introductions of:
l increased capital requirements;
l a bar on excessive risk-taking (the Volcker Rule);
l the Orderly Liquidation Authority;
l stress tests;
l the Consumer Financial Protection Bureau.
Increased capital requirements
The Dodd-Frank reforms sought to address the problem of financial fragility by raising the capital requirements and liquidity ratios at banks – this is money that cannot be lent out and must be kept on hand as emergency reserves in a financial crisis. The biggest banks which are designated as systemically important financial institutions (Sifis), or those considered to be “too big to fail”, trigger stricter oversight and greater capital requirements. In the US, the government has designated only two institutions as too big to fail – American International Group (AIG) and Prudential Insurance. The idea is that, in theory, such reserves could be used to prevent governments from having to use taxpayers’ money to bail out troubled banks in a crisis.
Dodd-Frank requires banks doing basic banking activities to keep a minimum risk-based capital ratio of 8% and a minimum leverage ratio of 4%. But banks engaged in more complex activities like securities trading need a minimum risk-based capital ratio of 10% and a minimum leverage ratio of 5%. But the financial services industry claims there is real confusion about what is considered as capital these days. The ambiguity is especially strong with many new hybrid instruments in use. For example, it is not clear whether a preferred stock, which is a kind of hybrid between a stock and a bond, is counted as part of the bank’s capital or not.
The proposed Financial Choice Act to repeal Dodd-Frank is seeking to remove these higher capital requirements for many banks, while keeping only a 10% leverage ratio on some banks.
The Volcker Rule
The Dodd-Frank reforms created the Volcker Rule, named after former Federal Reserve chairman Paul Volcker, which was intended to rein in excessive risk-taking. It bars banks from trading unless on their customers’ behalf and restricts their investments in hedge and private-equity funds.
But bankers and some regulators have argued that in practice the rule hasn’t worked because it is difficult to draw a clear line between a speculative trade and a transaction legitimately intended to serve clients. The industry claims that the rule effectively hurts the profitability of financial institutions. The Republicans’ Financial Choice Act bill would repeal the Volcker Rule completely.
Orderly Liquidation Authority
Dodd-Frank established the Orderly Liquidation Authority (OLA) to oversee the development of “living wills” by all of the major banks. These would enable firms to show regulators that they have sufficient capital reserves and adequate plans in place to carry out a resolution of debts and ensure an orderly unwinding of their investments during a financial crisis.
During the financial crisis in 2008, regulators had only two stark options for dealing with Lehman Brothers when it was facing collapse – either bankruptcy or government bailout. The OLA gives regulators a new third option for managing a slow and orderly unwinding for banks if they are hit with a crisis.
However, over the past few years, many of the biggest companies got failing grades on their tests from the Federal Deposit Insurance Corporation (FDIC), and many have failed to show they could unwind in a crisis without relying again on government intervention. There are serious doubts as to whether living wills will ever work in practice, especially given the fact that they are based on estimates of the value of assets and liabilities in normal times when those valuations may well turn out to be incorrect in times of financial crisis.
Because Republican critics inaccurately view the OLA as a means for providing “more government bailouts”, the Financial Choice Act seeks to eliminate the OLA.
Dodd-Frank established the requirement that the biggest banks needed to pass computer-simulated stress tests once a year. When the tests began in 2011, many institutions failed them. However, in the latest round in 2017, they all basically passed, although Capital One was given a conditional clearance. The good grades mean all the big banks have been judged to have sufficient capital reserves and equity to soak up losses – and a strong enough understanding of the risks they face – to keep trading even through the worst downturn imaginable. The positive test scores also provide fodder for Trump and Wall Street in their quest to get the test requirements watered down.
Consumer Financial Protection Bureau
Dodd-Frank established the Consumer Financial Protection Bureau (CFPB), which is widely perceived among consumer advocates as an important improvement in the regulatory oversight of the financial services industry. The CFPB has secured $10 billion in relief for 17 million consumers victimized by everything from predatory lending to mortgage fraud since beginning operations in 2011.
Most recently, the CFPB has proposed a new set of reforms that will make it easier for consumers to sue the large banks for any bad behaviour in the future. At issue is the question of the prevalence of “mandatory arbitration clauses” buried deep in the fine print of millions of contracts with consumers, covering products ranging from credit cards to home loans. The clauses have been used in recent years to block class-action lawsuits and instead require wronged customers to go through mediated arbitration as their only recourse. The new CFPB proposal includes rules to prevent financial institutions from requiring customers to give up the right to band together and sue over alleged wrongdoing. All new contracts will be required to explicitly state that any arbitration clauses cannot be used to block group lawsuits. Not surprisingly, the banks hate the proposal and, indeed, the whole CFPB.
Progressive criticisms of Dodd-Frank
Many progressive critics believe that Dodd-Frank was not bold enough, and that today’s financial system is still far too vulnerable to the possibility of future market crashes. Many wanted much stronger reforms in the wake of the 2008 crisis, such as requiring the “too big to fail” banks to be broken apart. But Dodd-Frank did not seek to do this; instead, several of the largest megabanks such as Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase and Wells Fargo have actually grown larger today than they were before the 2008 crisis, as measured by their share of financial assets.
The debate about being too big to fail was shifted from one about size – when is a bank too big – to one about scope – how broad a range of various activities banks should engage in and with what degree of regulation. But progressive critics of Dodd-Frank claimed the focus on greater scope was a misnomer, while the reforms neglected to address the problem of size. Simon Johnson of the Massachusetts Institute of Technology (MIT) has argued that banks’ size should be limited to 2% of gross domestic product, yet calling for such was too bold for Dodd-Frank. He has also suggested that any bank that is too big to fail is probably “too big to exist.”
Many progressive critics of Dodd-Frank also wanted the post-crisis reforms to reinstate earlier rules. An example is the Glass-Steagall legislation, which for 50 years had worked effectively in firmly separating investment and commercial banking activities to prohibit banks from using customers’ deposits to engage in risky proprietary investments or hedge-fund-type activity. Many trace the increase in the banking sector’s risky behaviour to the 1990s, when the Glass-Steagall rule was repealed under President Bill Clinton. Yet, critics were dismayed that the Dodd-Frank legislation failed to reinstate the Glass-Steagall law or any type of firm separation of investment and commercial banking.
Others noted that the Dodd-Frank reforms did little to undo the perverse incentives of modern executive compensation on Wall Street that contributed to the recklessness in finance that prevailed in 2008. For example, many Wall Street firms are continuing to finance their businesses primarily with debt rather than equity. Many are still using credit default swaps – basically insurance on securities – which in 2008 were considered directly responsible for turning a bursting housing market bubble into a full-blown global financial crisis.
According to Bill Black, a professor of economics and law at the University of Missouri, the Dodd-Frank reforms were designed to fail because the political leadership refused to meaningfully address the dysfunctional conflicts of interest afflicting the US financial sector. For example, chief executives create perverse compensation systems that put them at odds with the stability of their firms, but they also create conflicts of interest through combining investment and commercial banking. Then, as they grow into “systemically dangerous institutions” (too big to fail), they create more conflicts of interest with politicians dependent on their contributions and weak regulators treating them as untouchable.
It was bad enough that Wall Street chief executives were able to rig structures to institutionalize such perverse incentives. It’s worse when the political leadership – President Obama and Congress – refused to change those structures even after such a major economic catastrophe, and then failed politically to engage in a rigorous, honest investigation of those structural defects, let alone take any steps to fix them. According to Black: “Refusing to change those structures after a catastrophe was, of course, significantly insane … Astonishingly, Obama and Congress refused to fix any of these three primary conflicts of interest that drive our recurrent crises.”
Conservative criticisms of Dodd-Frank
Those leading the attack on Dodd-Frank have made many arguments claiming that the reforms have been harmful to the US economy by making it more difficult for businesses to get credit. However, there is much evidence to suggest otherwise, including:
l commercial and industrial (C&I) loans are now higher as a percentage of economic output than they’ve been since the 1980s;
l credit card and auto lending is at or near record highs; and
l mortgage loans outstanding are back close to their pre-crisis high.
Another argument by conservative critics is that the hundreds of new rules are too complicated and burdensome for small banks. But small banks are already exempted, so it’s only the big banks which must comply. For smaller businesses, according to the Federal Reserve Board’s data, banks made an average of more than $230 billion in new loans in the past three years, up from an average of just over $200 billion in the three years before the crash. Additionally, companies can easily raise money in the stock market and bond market, where very low interest rates prevail.
Conservative critics from Wall Street, such as Jamie Dimon, chief executive of America’s biggest bank, JPMorgan Chase, claimed that Dodd-Frank requirements force banks to keep too much capital on hand and that the new high levels of reserves had solved the too-big-to-fail problem. But Neel Kashkari, President of the Federal Reserve Bank of Minneapolis, responded that Dimon’s argument assumes that, in a crisis, after equity holders have been wiped out by losses at a bank, regulators will get bondholders to bear losses. “But we know that this seldom happens,” Kashkari explained. “When bondholders at a bank are forced to take losses, bondholders at other banks take flight, at the very least they will not roll over the bonds on maturity. The failure of any bank would thus result in contagion.”
Consequently, he argued, the only capital that really matters when it comes to absorbing losses at a bank in a crisis is equity capital. Yet the leverage ratios (the ratio of equity to assets) for banks set by the internationally agreed Basel III norms (at 3%) and at the top six US banks today (6.6%) are both far too low, suggesting there is not enough equity capital in the system at the moment if we hit a new financial crisis. What all this basically means is that the problem of too big to fail has not been resolved, and in a next crisis, taxpayers will still be expected to pay for the bailouts.
Everything will not be OK
To his credit, Stanley Fischer, the vice-chairman of the Federal Reserve’s board of governors, cautioned that, 10 years after the crisis, “There are troubling signs of a drive to return to the status quo that preceded it.” He called the political pressure in Washington to reverse the post-crisis drive for tougher regulation and to loosen constraints on banks “dangerous and extremely short-sighted”.
In some ways, however, whatever ultimately happens with Dodd-Frank is not the main point. It is the political attack on Dodd-Frank which reflects a deeper malaise afflicting America today, one that has been building for several decades: its political inability to adequately regulate its financial sector.
On the face of it, today the US financial sector appears far more stable: the number of bank failures has declined dramatically, recently US financial stocks closed at the highest level in nearly 10 years, and the S&P 500 financial index was up to 419.54 – a level not seen since before the 2008 crisis. And all of the major banks passed their latest stress tests given by the Federal Reserve. So everything looks great, right?
However, in fact, Frank Partnoy, professor at the University of San Diego Law School, cautioned in the Financial Times that today in 2017, just like in 2006 and 2007, we are again seeing financiers buying up billions of dollars of risky loans and repackaging them into complex investments with multiple layers of debt. Credit rating agencies are classifying the top layers as “triple A”. Institutional investors, including pension funds and charitable organizations, are rushing to buy these apparently risk-free yet high-yielding investments.
According to Partnoy, the unfortunate reality is that regulators have been flouting Dodd-Frank rules for years, thanks in particular to the green light of lax enforcement given by the SEC, which has basically been allowing the credit rating agencies to dodge the rules. While Dodd-Frank imposed liability on the agencies for making false ratings, the SEC exempted them. Likewise, when Congress barred the agencies from getting inside information about issuers they rate, the SEC permitted that, too.
Now, as a result, the shadow financial markets are buzzing. Only this time around the central culprit is likely to be the collateralized loan obligation (CLO). Like its earlier cousin, the collateralized debt obligation (CDO), a CLO bundles risky, low-grade loans into attractive packages and high credit ratings. Partnoy notes that if any of this sounds familiar, it should: “CLOs are just CDOs in new wrapping.”
Many critics from across the political spectrum have noted that no one has gone to jail for the practices that led to the 2008 financial crash – a fact that has political salience. More recently, ProPublica reporter Jesse Eisinger made the case that since the turn of the century, changes in the political landscape, the defence bar, the courts and, most importantly, the US Justice Department have undermined the ability and the resolve of America’s top prosecutors to go after corporations or their executives.
According to Eisinger, “Democrats as well as Republicans cozied up to big business, outsourcing the Treasury Department to Wall Street and the Justice Department to corporate law firms. Even after the financial system collapsed, the Obama administration’s priority was to bail out the megabanks.” The use of petty fines and arbitrated settlements proliferated as the numbers of prison convictions decreased.
The attack on Dodd-Frank is a barometer of this sad state of affairs. A more comprehensive view of the deeper problem was presented by MIT’s Johnson, who explained in a chilling 2009 post-crisis piece in The Atlantic called “The quiet coup” that the financial crash had laid bare many unpleasant truths about the US, with one of the most alarming being that “the finance industry has effectively captured our government – a state of affairs that more typically describes emerging markets” and is at the centre of many emerging-market crises.
The former International Monetary Fund (IMF) official added, “If the IMF’s staff could speak freely about the US, it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.”
Rick Rowden is a doctoral candidate in economics at Jawaharlal Nehru University in New Delhi. Previously he worked as an inter-regional adviser for the United Nations Conference on Trade and Development (UNCTAD) in Geneva and as a senior policy analyst for ActionAid. The above article was first published in The Mint (Issue 3, September 2017, www.themintmagazine.com).
Third World Economics, Issue No. 645, 16-31 July 2017, pp13-16