Senator Dodd's Proposed Finance-Regulatory 'Overhaul'
By Robert Hockett
Now that Senator Dodd has released his proposed plan for finance-regulatory reform, some DoL readers might appreciate a quick breakdown of its principal provisions, along with a brief bit of commentary. For what it might be worth, I think in sum that the bill represents a helpful, if nevertheless still but tentative, step forward. Among other things, it would bring the following long-awaited improvements to our presently hole-riddled 'system' of financial regulation.
First, the bill would impose more careful oversight of, and potentially required downsizing of, financial firms that approach 'too big to fail' size. It also would require these firms -- either in addition to or rather than taxpayers -- to finance a sort of 'bailout insurance' fund to the tune of $50 billion. Comment: It's often been heard of late that 'too big to fail' should be understood to carry the entailment 'too big to permit.' I confess to agnosticism about this, at least so long as non-American financial firms continue to reach the gargantuan sizes they long have done. (A ripe topic for future international finance-regulatory negotiations.) I propose and would eagerly embrace, however, a cognate proposition: 'Too big to fail' should entail 'too big to permit not to be fully self-insured.' Senator Dodd's bill seems to comport. One caveat, however: The very existence of the fund will of course import moral hazard vulnerability. Much will accordingly ride on who, precisely, the fund would make whole, and who would still stand to lose. Keep an eye, then, on proposed answers to this question as debate commences in Congress.
Second, the Dodd bill would impose greater transparency and safety on the over-the-counter (OTC) derivatives -- including the credit default swap (CDS) -- market. It would do so in part by channeling more derivatives trading through exchanges of the sort that most other securities have been trading on for decades, which exchanges would constitute focal points to which regulators and other concerned parties could direct their attentions. The bill would bring greater safety also in part by imposing substantial buffer capital requirements on firms like AIG which in recent years promised much more than they could deliver. Finally, the bill will also require that hedge fund advisors be registered with the SEC. Comment: Two cheers. There might have been some -- minimal -- merit to suggestions in the late 1990s that the then-developing derivatives markets, which once grown could well complement the non-derivative securities markets, should be given a bit of breathing space in which to flourish and realize their potential. We've long since got there, with the notional value of derivatives trading dwarfing that of trade in other securities. Moreover, there seems no reason whatever to continue to permit standardized bets which so comprehensively permeate the financial markets now -- bets like CDSs -- not to be backed up by margins of the sort required of trading in other instruments. Caveat: The bill thus far provides an exception for 'customized' contracts, and exempts private equity firm advisors from the SEC registration requirement. These are precisely the sorts of tail that finance always seems able to make a dog-wagger of. Keep an eye, then, on how this potential problem is addressed as debate commences in Congress.
Third, the Bill would end the current regulatory privileging of, and impose greater transparency and conflict-of-interest-prevention rules upon, the credit-ratings industry. It would also subject them to greater risk of liability for ratings, and empower the SEC to 'de-register' those that provide bad ratings over time. Comment: This industry of course failed spectacularly in assessing the risks posed by subprime-mortgage-backed securities, owing in part to insufficient competition in the industry, and in part to the current regime of compensation -- which long has been, perversely, by the very firms they were purporting to rate objectively. Attention to the conflict of interest inherent in the structure of audit and credit rating compensation is long overdue. My only concern here is that the bill will not go far enough in addressing this weakness. It is admittedly, however, a difficult problem. For the surest way to solve it -- essentially, by converting this to a not-for-profit public or quasi-public function -- would require public expenditure that might for the time being prove politically unpalatable, while the second best option -- opening the industry to many more entrants -- might be of only limited help too, in virtue of the scale economies that attend the development of sophisticated risk-measurement and valuation models.
Fourth, the bill would create a Consumer Financial Protection Bureau (CFPB), charged with looking out for the interests of less sophisticated clients of financial services firms, which would have its own funding, its own rule-making authority, and its own leader chosen by the President and confirmed by the Senate. Comment: Unification of the consumer-protection regime and regulatory apparatus is long overdue, as most of the most troubling practices have been developed by parties who have evaded provisions applicable in one financial services sub-industry by simply migrating to another such sub-industry where functionally equivalent practices are readily developed. The principal concern that has been raised in connection with Dodd's version of a CFPB stems from his housing it in the Fed, which is thought by many in recent decades to have been far more solicitous of the interests of banks than of consumers. A related concern stems from the plan to subject its decisions to review by an 'oversight council' comprising the other bank regulators less concerned about consumer safety than about the 'health' of the industry.
I share these concerns, but take some comfort in the independent funding, rule-making authority, and leader-selection provisions of Dodd's proposal. As often seems to be the case in our fragmented 'system' of financial regulation, much will ride on who has final word in events of inter-agency conflict. And most here will ride, more specifically, upon how much trumping authority the Fed will have in the event of such conflicts -- a question that finds an analogue in the system of 'functional regulation' we've moved toward in connection of financial holding companies (FHCs) holding multiple kinds of financial institution since 1999. Technically, the SEC still 'functionally' regulates, e.g., an investment bank qua investment held by an FHC, while the Fed serves as 'umbrella regulator' of the FHC qua FHC. But sometimes those 'qua's can get muddled up, and how precisly to mediate stark disagreement between Fed and functional regulator in such cases is a matter we're still working out. In view of the presumably plenary, trans-institutional (dare I say 'trans-qua'?) authority the CFPB will have in respect of consumer protection matters on the one hand, and the fuller Fed's emerging trans-institutional role as 'umbrella' and even 'systemic risk' regulator (more on which presently) on the other hand, one can imagine that disagreements might sometimes emerge, some of which disagreements might have trans-insitutional import. In theory this should not happen, because consumer protections seldom are in serious tension with bona fide systemic risk minimization. But in practice, the Fed has in recent decades been a bit slower to find risk and faster to champion growth, which latter can itself often easily be 'rationalized' as an industry 'health' -- hence 'systemic safety and soundness' -- concern. And measures that tend to fuel aggregate growth can of course come into conflict with measures designed to protect unwary consumers. One additional caveat: At present, the plan is for banks with assets under $10 billion to be exempt from the jurisdiction of the CFPB. It's not clear to me what rationale might justify restricting CFPB jurisdiction to a mere 100 or so of the nation's 8,000 plus banks. But a toehold for now, I suppose, is preferable to no hold. Stay tuned, then, in a big way on this one. There is apt to be much disputation in Congress on the proposed CFPB.
Fifth, the Dodd bill will bring the executive and trading desk pay practices of large financial firms, many of which reward successful risk-taking while not penalizing unsuccessful such risk-taking, under careful Fed oversight. It would also require explicit 'say on pay' shareholder approval of financial firms' compensation arrangements, and impose separations between listed companies' compensation committees on the one hand, their full boards on the other. Comment: I confess to some skepticism as to how important pay practices have been in brining on the crisis, as well as to how much difference an explicit shareholder vote on pay arrangements -- which already had a pretty good substitute in shareholders' ready ability to sell off their shares -- is apt to make. This provision probably affords more political 'feel good' value than anything else. But I'm happy to be shown wrong.
Sixth, the bill would extend orderly wind-down authority currently held by the FDIC with respect to commercial banks, to cover other large financial firms as well -- huge, systemically integrated nonbank securities firms such as Bear Stearns and Lehman Brothers until recently were -- most of which now pose systemic risks to the broader economy quite as fully as commercial banks do. Comment: Ra ra again. It's high time. This measure, moreover, serves as a nice complement to the first measure described above. It is no accident that, in the banking context, the same regulator that administers the deposit insurance system is the regulator that deals with bank insolvency. Extension of a functionally equivalent system to financial sectors additional to the banking sector is long overdue.
Seventh, at long last, the bill would establish a national monitor, within Treasury, of insurance companies deemed to be 'systemically important.' The insurance industry's exemption from federal regulation has been one of the chief -- and increasingly dangerous -- anachronisms of our 'system' of financial regulation. The experience of AIG seems at last to have driven the point part way home. Caveat: I think we're destined ultimately to go all the way where federal regulation of financially integrated insurance companies are concerned; but as with the CFPB, I suppose a toe-hold is better than no hold for now, particularly if the Fed takes seriously the role envisaged for it per the final feature of Dodd's bill...
Finally and relatedly eighth, and again at long last, the bill would formally recognize the need of a 'systemic risk regulator' charged with overseeing the whole of our vast, sprawling, complex finance economy, and assign this role to that regulator best situated to fulfill it -- the Fed. The Fed would also be aided in discharging this task by a 'risk council.' Comment: I'm entirely on board with the need of a systemic risk regulator, and am also in agreement with the proposition that that institution whose principal concern is the monetary economy as a whole -- which economy effectively includes the credit and broader financial economy, as any good student of Keynes will tell you -- is best situated to play this role.
My only concern here, of course, is that the Fed seems to me to have been a bit cavalier about systemic risk in recent decades. But that's largely owing to the influence of one particular Chairman, as well as of a tired finance-monetary-economic orthodoxy. It seems that both of these have now by and large passed, and the Fed might well be situated to re-embrace its more time-honored role, associated with the past Chairmanships of William McChesney Martin and Paul Volcker, among others, as countercyclical smoothener of the monetary boom and bust cycle. Like Joseph's advice to Pharaoh, and Martin's advice to his Fed, so should be ours to Senator Dodd: Remove and store moneys and grain in the fat years, that you may have replenishment in the lean years. For more on this all-important matter, please see: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1367278 .
Now that Senator Dodd has released his proposed plan for finance-regulatory reform, some DoL readers might appreciate a quick breakdown of its principal provisions, along with a brief bit of commentary. For what it might be worth, I think in sum that the bill represents a helpful, if nevertheless still but tentative, step forward. Among other things, it would bring the following long-awaited improvements to our presently hole-riddled 'system' of financial regulation.
First, the bill would impose more careful oversight of, and potentially required downsizing of, financial firms that approach 'too big to fail' size. It also would require these firms -- either in addition to or rather than taxpayers -- to finance a sort of 'bailout insurance' fund to the tune of $50 billion. Comment: It's often been heard of late that 'too big to fail' should be understood to carry the entailment 'too big to permit.' I confess to agnosticism about this, at least so long as non-American financial firms continue to reach the gargantuan sizes they long have done. (A ripe topic for future international finance-regulatory negotiations.) I propose and would eagerly embrace, however, a cognate proposition: 'Too big to fail' should entail 'too big to permit not to be fully self-insured.' Senator Dodd's bill seems to comport. One caveat, however: The very existence of the fund will of course import moral hazard vulnerability. Much will accordingly ride on who, precisely, the fund would make whole, and who would still stand to lose. Keep an eye, then, on proposed answers to this question as debate commences in Congress.
Second, the Dodd bill would impose greater transparency and safety on the over-the-counter (OTC) derivatives -- including the credit default swap (CDS) -- market. It would do so in part by channeling more derivatives trading through exchanges of the sort that most other securities have been trading on for decades, which exchanges would constitute focal points to which regulators and other concerned parties could direct their attentions. The bill would bring greater safety also in part by imposing substantial buffer capital requirements on firms like AIG which in recent years promised much more than they could deliver. Finally, the bill will also require that hedge fund advisors be registered with the SEC. Comment: Two cheers. There might have been some -- minimal -- merit to suggestions in the late 1990s that the then-developing derivatives markets, which once grown could well complement the non-derivative securities markets, should be given a bit of breathing space in which to flourish and realize their potential. We've long since got there, with the notional value of derivatives trading dwarfing that of trade in other securities. Moreover, there seems no reason whatever to continue to permit standardized bets which so comprehensively permeate the financial markets now -- bets like CDSs -- not to be backed up by margins of the sort required of trading in other instruments. Caveat: The bill thus far provides an exception for 'customized' contracts, and exempts private equity firm advisors from the SEC registration requirement. These are precisely the sorts of tail that finance always seems able to make a dog-wagger of. Keep an eye, then, on how this potential problem is addressed as debate commences in Congress.
Third, the Bill would end the current regulatory privileging of, and impose greater transparency and conflict-of-interest-prevention rules upon, the credit-ratings industry. It would also subject them to greater risk of liability for ratings, and empower the SEC to 'de-register' those that provide bad ratings over time. Comment: This industry of course failed spectacularly in assessing the risks posed by subprime-mortgage-backed securities, owing in part to insufficient competition in the industry, and in part to the current regime of compensation -- which long has been, perversely, by the very firms they were purporting to rate objectively. Attention to the conflict of interest inherent in the structure of audit and credit rating compensation is long overdue. My only concern here is that the bill will not go far enough in addressing this weakness. It is admittedly, however, a difficult problem. For the surest way to solve it -- essentially, by converting this to a not-for-profit public or quasi-public function -- would require public expenditure that might for the time being prove politically unpalatable, while the second best option -- opening the industry to many more entrants -- might be of only limited help too, in virtue of the scale economies that attend the development of sophisticated risk-measurement and valuation models.
Fourth, the bill would create a Consumer Financial Protection Bureau (CFPB), charged with looking out for the interests of less sophisticated clients of financial services firms, which would have its own funding, its own rule-making authority, and its own leader chosen by the President and confirmed by the Senate. Comment: Unification of the consumer-protection regime and regulatory apparatus is long overdue, as most of the most troubling practices have been developed by parties who have evaded provisions applicable in one financial services sub-industry by simply migrating to another such sub-industry where functionally equivalent practices are readily developed. The principal concern that has been raised in connection with Dodd's version of a CFPB stems from his housing it in the Fed, which is thought by many in recent decades to have been far more solicitous of the interests of banks than of consumers. A related concern stems from the plan to subject its decisions to review by an 'oversight council' comprising the other bank regulators less concerned about consumer safety than about the 'health' of the industry.
I share these concerns, but take some comfort in the independent funding, rule-making authority, and leader-selection provisions of Dodd's proposal. As often seems to be the case in our fragmented 'system' of financial regulation, much will ride on who has final word in events of inter-agency conflict. And most here will ride, more specifically, upon how much trumping authority the Fed will have in the event of such conflicts -- a question that finds an analogue in the system of 'functional regulation' we've moved toward in connection of financial holding companies (FHCs) holding multiple kinds of financial institution since 1999. Technically, the SEC still 'functionally' regulates, e.g., an investment bank qua investment held by an FHC, while the Fed serves as 'umbrella regulator' of the FHC qua FHC. But sometimes those 'qua's can get muddled up, and how precisly to mediate stark disagreement between Fed and functional regulator in such cases is a matter we're still working out. In view of the presumably plenary, trans-institutional (dare I say 'trans-qua'?) authority the CFPB will have in respect of consumer protection matters on the one hand, and the fuller Fed's emerging trans-institutional role as 'umbrella' and even 'systemic risk' regulator (more on which presently) on the other hand, one can imagine that disagreements might sometimes emerge, some of which disagreements might have trans-insitutional import. In theory this should not happen, because consumer protections seldom are in serious tension with bona fide systemic risk minimization. But in practice, the Fed has in recent decades been a bit slower to find risk and faster to champion growth, which latter can itself often easily be 'rationalized' as an industry 'health' -- hence 'systemic safety and soundness' -- concern. And measures that tend to fuel aggregate growth can of course come into conflict with measures designed to protect unwary consumers. One additional caveat: At present, the plan is for banks with assets under $10 billion to be exempt from the jurisdiction of the CFPB. It's not clear to me what rationale might justify restricting CFPB jurisdiction to a mere 100 or so of the nation's 8,000 plus banks. But a toehold for now, I suppose, is preferable to no hold. Stay tuned, then, in a big way on this one. There is apt to be much disputation in Congress on the proposed CFPB.
Fifth, the Dodd bill will bring the executive and trading desk pay practices of large financial firms, many of which reward successful risk-taking while not penalizing unsuccessful such risk-taking, under careful Fed oversight. It would also require explicit 'say on pay' shareholder approval of financial firms' compensation arrangements, and impose separations between listed companies' compensation committees on the one hand, their full boards on the other. Comment: I confess to some skepticism as to how important pay practices have been in brining on the crisis, as well as to how much difference an explicit shareholder vote on pay arrangements -- which already had a pretty good substitute in shareholders' ready ability to sell off their shares -- is apt to make. This provision probably affords more political 'feel good' value than anything else. But I'm happy to be shown wrong.
Sixth, the bill would extend orderly wind-down authority currently held by the FDIC with respect to commercial banks, to cover other large financial firms as well -- huge, systemically integrated nonbank securities firms such as Bear Stearns and Lehman Brothers until recently were -- most of which now pose systemic risks to the broader economy quite as fully as commercial banks do. Comment: Ra ra again. It's high time. This measure, moreover, serves as a nice complement to the first measure described above. It is no accident that, in the banking context, the same regulator that administers the deposit insurance system is the regulator that deals with bank insolvency. Extension of a functionally equivalent system to financial sectors additional to the banking sector is long overdue.
Seventh, at long last, the bill would establish a national monitor, within Treasury, of insurance companies deemed to be 'systemically important.' The insurance industry's exemption from federal regulation has been one of the chief -- and increasingly dangerous -- anachronisms of our 'system' of financial regulation. The experience of AIG seems at last to have driven the point part way home. Caveat: I think we're destined ultimately to go all the way where federal regulation of financially integrated insurance companies are concerned; but as with the CFPB, I suppose a toe-hold is better than no hold for now, particularly if the Fed takes seriously the role envisaged for it per the final feature of Dodd's bill...
Finally and relatedly eighth, and again at long last, the bill would formally recognize the need of a 'systemic risk regulator' charged with overseeing the whole of our vast, sprawling, complex finance economy, and assign this role to that regulator best situated to fulfill it -- the Fed. The Fed would also be aided in discharging this task by a 'risk council.' Comment: I'm entirely on board with the need of a systemic risk regulator, and am also in agreement with the proposition that that institution whose principal concern is the monetary economy as a whole -- which economy effectively includes the credit and broader financial economy, as any good student of Keynes will tell you -- is best situated to play this role.
My only concern here, of course, is that the Fed seems to me to have been a bit cavalier about systemic risk in recent decades. But that's largely owing to the influence of one particular Chairman, as well as of a tired finance-monetary-economic orthodoxy. It seems that both of these have now by and large passed, and the Fed might well be situated to re-embrace its more time-honored role, associated with the past Chairmanships of William McChesney Martin and Paul Volcker, among others, as countercyclical smoothener of the monetary boom and bust cycle. Like Joseph's advice to Pharaoh, and Martin's advice to his Fed, so should be ours to Senator Dodd: Remove and store moneys and grain in the fat years, that you may have replenishment in the lean years. For more on this all-important matter, please see: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1367278 .