Unfinished Business: Dodd-Frank’s Many Questions

Even before JPMorgan made its trading-loss announcement and spurred a new round of debate about the Volcker Rule, many critics had said—both through the official comment process and in the media—that the language of the rule is unworkable, as it fails to distinguish, for example, between a bank purchasing securities in advance of customer demand and a bank purchasing securities in anticipation of a short-term price rise. Questions include:

• Could regulators improve the Volcker Rule by changing the language of the proposed text, or are their hands tied by the fact that the law explicitly allows for hedging of “aggregated” positions (that is, entire portfolios)?
• Does the Volcker Rule affect overseas subsidiaries of American banks—for example, the London operations of Goldman Sachs?
• What will be the consequences of compliance in terms of cost to financial institutions?
• Would the Volcker Rule affect capital markets’ liquidity?
• If so, could rule-makers ameliorate the impact by changing the language?
• Do banks violate the Volcker Rule when they purchase legacy AIG securities from the Federal Reserve with plans to sell them on to customers for a profit?

Reducing “Systemic Risk”

The law also gave regulators powers to protect the economy from systemic risk—that is, the risk that broad swaths of the financial sector could fail all at once, taking the economy down, too. As the president said, the law would “bring the shadowy deals that caused this crisis into the light of day.”

Dodd-Frank gave the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) the authority to regulate over-the-counter derivatives and/or swaps. Regulators have already completed much of their rule-making in this area. New rules will push “standardized” derivatives and swaps onto central counterparties (CCPs, or clearinghouses) and will require participants in this market to put up margin (a way of limiting their borrowing via incurring potential liabilities). Questions include:

• If the new rules were already in place, would they have blunted the over-the-counter trading that precipitated JPMorgan Chase’s surprise loss, perhaps by requiring JPMorgan to put up more initial margin against its trades?

• Similarly, would the rules have prevented AIG’s meltdown and bailout?
• If so, how?
• If not, why not?
• Do the new rules contain too many exemptions, for example for “end users” such as agriculture companies when it comes to margin requirements?
• If so, could an end user conceivably exploit these exemptions and pose systemic risk to the economy?
• Do the new rules introduce a risk that a CCP/clearinghouse will fail, requiring a government bailout?
• How will regulators ensure that “customized” over-the-counter derivatives (as opposed to “standardized”) do not dominate the market?
• How will regulators and participants know if margin requirements on such custom derivatives are adequate?
• Is there a risk that much derivatives activity will move abroad, posing the same risk to the global economy? Can regulators address this risk?

To protect the economy further from financial meltdown, the law gave regulators several other powers. Regulators can now limit financial firms’ exposure both to each other and to risks such as a large exposure to one company or one sector of the economy.

• Are such rules necessary?
• Will they reduce the pool available credit and/or increase credit’s cost?

Furthermore, Dodd-Frank also requires regulators to stop relying on credit ratings when they set capital requirements.

• Will this mandate reduce systemic risk?
• If so, how?
• If regulators cannot rely on credit ratings, how should they determine the risk of an investment, or should regulators refrain from trying to make such a determination at all?

Protecting Consumers

Dodd-Frank created the Consumer Financial Protection Bureau (CFPB), an autonomous arm of the Federal Reserve. The president’s words were that the law would implement “common-sense reforms to protect consumers.” One of the CFPB’s tasks is to write rules to ensure that financial institutions treat individuals responsibly.

To that end, the CFPB is creating at least 19 rules to govern areas from private student lending to defaulted debt collection. By end-June, for example, the CFPB was set to create a rule to govern mortgage issuance, mandating that lenders ensure that a borrower can repay a mortgage loan over that loan’s life; the agency will carve out an exemption for “qualified residential mortgages.” The CFPB will create another rule governing how mortgage servicers communicate with borrowers on behalf of lenders and investors. Further, the CFPB was to release a June report on the private student-loan market, ahead of likely rule issuance on that topic as well.

• Observers have raised many questions about the CFPB, starting with its governance. One presidential appointee heads the bureau.
• Should the bureau instead have a commission at its head, as the SEC does?
• Can the CFPB preempt state consumer-fraud laws?
• If so, when?
• Should Congress amend Dodd-Frank to make it clear that information financial institutions share with the CFPB remains confidential?

Questions having to do with the rules that the CFPB will create to achieve its goal of protecting consumers include:

• Can financial firms simplify their credit-card, mortgage and other disclosures to customers without running afoul of other disclosure regulations?
• Will mortgage servicers face liability for inadequate communication with borrowers?
• If so, what kind of liability?
• Will rules governing mortgage issuance and possibly private student-loan issuance affect the mortgage market?
• If so, how?
• Will rules governing debt collections affect financial firms’ ability to sell bad debts to third parties?
• What kind of liability could financial firms face for such sales, particularly, for example, when financial firms sell debt that has already been repaid or is otherwise legally uncollectible?
• How will the CFPB govern payday lenders and rent-to-own lenders, if at all?

Moreover, observers may wonder if the CFPB’s authority is adequate, given its mandate. For example, in the past two decades, consumers have gotten into deep debt in two areas: government-guaranteed housing finance and government-guaranteed student-loan finance. Yet the CFPB has no authority in these areas. Questions include:

• Should the CFPB have such authority?
• If not, is there a risk that the CFPB, in regulating only a tiny portion of the lending market, will push private markets in these areas out of business even as government lending markets grow?
• Should Congress allow borrowers of private student loan debt to declare bankruptcy, allowing the market risk of loss to govern such lending, rather than new regulations?

The CFPB also raises a philosophical issue. Congress has mandated the agency to police “abusive” practices.

• What does it mean to be abusive in finance?
• Is a high interest rate alone abusive?
• Is a “payment protection” program for credit-card borrowers automatically abusive, for instance, in that it is likely a bad economic deal for most people who sign up for the service?

Missing Pages/Unfinished Business

Dodd-Frank left untouched many of the elements that led to the financial and economic crisis.

Fannie Mae and Freddie Mac continue to exist. Together with the Federal Housing Administration, they now back virtually all new mortgages. The SEC and the CFTC are still two separate agencies. Congress has given little thought to whether regulators could better enforce existing laws. On unfinished business, questions include:

• Should Congress direct regulatory agencies to merge?
• If so, which ones would be good candidates for mergers?
• How can Congress better ensure enforcement of pre-existing laws—for example, laws against fraud, and laws to ensure the segregation of customer accounts at brokerage firms such as MF Global?
• Can Dodd-Frank protect the economy absent reform of Fannie and Freddie and of the government student-loan market?
• Is there a risk that more financial activity will simply recede into the “shadow banking” industry or overseas?
• Did or can Dodd-Frank address this risk?
• Can Dodd-Frank work well within the framework of Basel III, which governs global financial regulation?