Now that Congress has passed the Restoring American Financial Stability Act of 2010, more commonly known as the Dodd-Frank bill, it is useful to stand back and assess what Congress did and did not do in this legislation. As with most contested legislation, it is not as extensive as some had hoped and, naturally, it is deemed excessively burdensome by others. But in the quiet period following final passage, we can now separate the likely impact of the bill from the rhetoric and evaluate it in a dispassionate light.
Let's start by identifying what the bill does not do.
It does not end "too big to fail."
People seem to have forgotten that the same promise of ending "too big to fail" was made in 1991 with passage on the Prompt Corrective Action sections of the FDIC Improvement Act. But in less than a decade it was clear that the PCA provisions of that bill did not give regulators the tools necessary to address the financial risks of modern financial institutions. Each crisis has its own unique characteristics, and when a legislative solution is aimed at fixing the previous crisis, as is always the case, the fix does not anticipate the characteristics of the next crisis.
But even more fundamentally, size was not the dominant factor in determining which institutions needed to be bailed out during the recent crisis. The dominant variable in 2008 was the impact an institutional failure could have on the capital markets. If Bear Stearns was considered too big to fail, it is difficult to see why Lehman Brothers was not. In fact, many now believe Lehman also should have been saved. This problem is complicated by an increasingly widespread intolerance for market volatility. Prospectively, regulators need to balance the implications of market interconnectedness against our society's growing intolerance for the kinds of volatility that other nations experience and seemingly weather. A focus on size as a threshold misses the mark and the commonly heard judgment that "A bank that is too big to fail is too big," is little more than an inane tautology.
It will not ensure that financial institutions will never again be bailed out with taxpayer dollars.
This promise is unlikely to hold up. There are several reasons why. First, all government activities ultimately involve taxpayer dollars, and any financial rescue will involve government intervention. Second, there is an implicit presumption in the construct of the special assessments provision to cover the cost of a rescue that when one failure occurs other fund participants will be sufficiently healthy to provide the funding. But imagine a repeat of our recent crisis, where much of the financial sector is struggling financially; imposing a levy on the rest of the industry to fund that bailout could imperil the health of the entire sector.
The Glass-Steagall Act was not "reinstated."
Of all the claims, this one is perhaps the most puzzling. Most of the Glass-Steagall provisions have been unchanged since passage in 1933. In 1999, the Gramm-Leach-Bliley Act repealed two sections of Glass-Steagall, which then allowed banking, insurance underwriting and securities activities to coexist in separate subsidiaries of the same financial holding company. But restrictions on the banking industry's ability to mix banking and securities activities are unchanged since the original legislation was passed. Importantly, no new authority granted in 1999 contributed to the collateralized mortgage debacle of the last few years. The ability to originate mortgages including subprime mortages, securitize pools of mortgages, and sell those securitized pools into the secondary market has been a common banking practice for decades.
So what did get accomplished in this bill?
When analyzing any new financial legislation, it is always instructive to review the crisis or perceived crisis that inspired the legislation. In our recent experience the factors have included abuses in mortgage underwriting fueled by historically low interest rates, massive pools of liquidity, and dramatic expansion of a secondary market for mortgage products. The crisis was exacerbated by massive mispricing of market and credit risks, complicit rating agencies, and narrowly focused or inattentive regulators. Not content with the investment options available, Wall Street created derivative and synthetic financial products which in some cases mitigated and in other cases magnified risk exposures. All of this occurred at a time when the equity markets were not providing appealing alternatives. As a net result, historically large numbers of people were saddled with financial commitments they did not understand and could not satisfy. As a consequence, financial institutions suffered major losses and many failed. Finally, all this was conducted during a period when expansion of home financing to previously underserved markets was being encouraged and rewarded by federal policy makers. In 2000 pages, the bill manages to address all the above — except for the final point.
Have the factors causing the crisis been fully addressed by the legislation?
Predictably, an important if not primary focus of the bill was to ensure an improved regulatory environment for consumers. That was addressed through the creation of a new bureau that centralizes and elevates the focus on consumer issues. It will consolidate the responsibilities of existing agencies, be headed by a new director appointed by the President and confirmed by the Senate. Rather than being funded like most government agencies through the congressional appropriation funding process, it will enjoy a dedicated funding source from a portion of the Federal Reserve System's revenue flow. As a new entity with new leadership, it will be energized to fulfill what it believes to be its mandate to be a better consumer watchdog.
The bill also addresses the limitation of regulation outside of insured financial institutions by expanding the coverage of the agency to include nonbank providers of retail financial products. Most banks will welcome this extension of authority as bankers largely believe that the primary abuses in mortgage underwriting and pricing occurred in the lesser regulated segments of the marketplace.
The legislation additionally requires that derivative financial instruments that have for the most part traded outside the exchanges be settled and cleared within entities regulated by the CFTC. This provision, if not exactly welcomed by the financial community, was largely anticipated.
In prior years, derivatives avoided the oversight of the SEC and CFTC because they were perceived to be sophisticated financial transactions involving sophisticated financial partners that did not require the level of oversight expected of retail products. But the extraordinary growth and reach of derivatives and the systemic risks uncovered during this last crisis ensured that derivatives would now be regulated more carefully.
The so-called Volcker Rule survived the vetting process relatively intact. Though some securities professionals pleaded that implementation of the Volcker Rule as originally articulated was difficult if not impossible, the fundamental logic of not allowing banks to assume excessive market risks funded by insured deposits carried the day and the provision is now law.
The creation of a systemic-risk oversight body is a welcome concept whose ultimate success or failure will be difficult to gauge until the next crisis. Regulators clearly had difficulty addressing some of the emerging issues of the past crisis beginning with an inability to identify the sources of risk due to lack of transparency in both investment pools and financial products. The history of task forces and bureaus made up of the heads of multiple agencies has not been positive and the possibility of stalemate in that construct is a constant threat. But with the appropriate leadership and focus, it can be a positive improvement.
While Congress may not have ended "too big to fail," financial regulators, particularly the Fed, now have the authority to require the largest complex financial institutions either to obtain more capital or to divest certain activities when they are deemed to be unacceptably risky to the financial system. Regulators also will have new tools to arrange resolutions for failed institutions. The ability to impose more stringent requirements on larger complex and interconnected financial organizations is an important tool for regulators going forward.
Where is the hidden land mine this time?
In recent financial legislation one or two provisions thought at the time to be either boilerplate or benign turned out to be the most controversial (see Sarbanes-Oxley, section 404). What are the candidates this year? While accounting for only 27 pages of this bill, there are two key governance provisions that are beginning to attract attention from both the investor community and corporate boards. These include: 1.) proxy access provisions that allow a small minority of shareholders access to the proxy statement; and 2.) the nonbinding "say on pay." In combination, these two provisions could have a significant impact on the role of compensation committees for all listed corporations.
In sum, the bill is a monumental, perhaps even historic effort. It does not have the reach many had hoped and yet far exceeds what others thought necessary. As with other major legislative initiatives, we will not fully know its value until the next crisis.