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Financial Planning > Behavioral Finance

How Financial Reform Became a Fiasco

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Three years ago this summer, President Barack Obama enacted the biggest overhaul of American financial regulation since FDR signed the 1933 Securities Act and the 1934 Securities Exchange Act into law in the wake of the 1929 market crash.

Three years later, the law’s not working; indeed, it’s not doing much of anything. But neither the right nor the left is seizing the opportunity to bash the president and the Democratic Congress that passed the bill for its failure—and prospects for Dodd-Frank reform in the near future are dim.

Dodd-Frank was one of Obama’s signature first-term achievements. On July 21, 2010, Obama said that the law, named after Senator Chris Dodd and Rep. Barney Frank, fixed a longstanding deficiency: “For years, our financial sector was governed by antiquated and poorly enforced rules” that endangered the economy and “left taxpayers on the hook if a big bank or financial institution ever failed.”

The Dodd-Frank law, Obama added, would “bring the shadowy deals that caused the crisis into the light of day and … put a stop to taxpayer bailouts once and for all.” He said he was proud of Congress for having passed the law despite “the furious lobbying of an array of powerful interest groups” backed by House Republicans. Standing behind the president were purported victims of bad financial firms, to remind the citizenry that the new law wouldn’t govern only complex transactions such as over-the-counter derivatives but also relatively straightforward markets such as credit cards and payday loans.

Three years later, Dodd-Frank is the law of the land—but not the rule of the land. The law depended on regulators from the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the new Consumer Financial Protection Bureau (CFPB) and other federal bodies to create hundreds of new rules about everything from restricting derivatives trades to approving new mortgages. Each rule, in turn, requires regulators to solicit comments from the public, including financial representatives, review the comments and ensure that the rule doesn’t conflict with an existing rule or law. Dodd-Frank established specific deadlines by which the regulators were supposed to get this work done.

But regulators have missed deadline after deadline as the rule-making process has become mired in chaos. As the Davis Polk law firm reported in July, of the 398 total rules that Dodd Frank law requires, only 155—or 38.9%—have been finalized. A full 31.9% have not even been proposed. Accomplishments so far have been fraught with uncertainty and delays, as well. “Of … 279 passed deadlines,” the lawyers reported, “175 (62.7%) have been missed.”

The delays have spurred one of Dodd-Frank’s champions, former Federal Reserve Chairman Paul Volcker, to speak up. Volcker had a particular stake in the law succeeding after early 2010. In January of that year, the president, responding to criticism that he wasn’t being tough enough on the banks, amended his early regulatory proposal to add something “simple and common-sense,” called the “Volcker Rule.” Upon the economist’s advice, the president would ask Congress to prohibit banks that have access to federal deposit insurance from engaging in proprietary trading or making speculative bets. The idea was that banks shouldn’t use taxpayer money to speculate.

Three years along, though, regulators have had trouble finalizing the details of this seemingly straightforward notion. The dallying prompted Volcker himself to tell interviewer Charlie Rose in May that, even with a complicated law, “it shouldn’t take three years to make a regulation.” Volcker added that the failure to implement Dodd-Frank is emblematic of a “big lack of confidence and lack of trust [in] government” on the part of the public. “Part of this is the feeling that the government isn’t doing as well as it should be in implementing policies,” Volcker said, chalking the problem up to bureaucratic infighting. “We have five or six agencies that have some responsibility for regulating banks,” he added. “They “all have their own mandates, all have their own turf to defend.”

Congress itself has joined in piling on the regulators. In early 2012, when critics pointed out the Volcker Rule might not have prohibited JPMorgan Chase from engaging its “whale” trades in London, Sen. Carl Levin shot back that the problem was not the law but that regulators were too slow: “If this law were in effect … I believe that these trades violated” it, he said. In December, in one of eight hearings the House Financial Services Committee has held on Dodd-Frank in the past year alone, New Jersey Rep. Scott Garrett said that regulators have exhibited “a refusal to follow explicit Congressional intent” in some matters, helping to make derivatives regulation, for one thing, “somewhat of a train wreck.”

Presidential Inaction

Obama himself has stayed quiet. Mired in the IRS Tea Party scandal and messy foreign-policy questions, he hasn’t put forward much of a domestic agenda at all for his second term. Any such agenda certainly won’t include revisiting a topic in which he never showed much interest in the first place (the events of 2008, remember, pushed him into taking on Wall Street as part of his first election).

Moreover, Obama doubtless knows that revisiting Dodd-Frank—and effectively admitting that he didn’t really fix Wall Street—puts him and other Democrats in political peril. One of the points of the Occupy Wall Street protests in 2011, after all, was that Obama didn’t fix Wall Street. Obama may be hoping that Wall Street stays quiet for the next three years and that any blow-ups will be on the next president’s watch.

More worrisome for the nation’s financial markets, though, is the fact that prominent Republicans, too, have been mum. Dodd-Frank’s quagmire is an opportunity for GOP leaders to point out: The problem isn’t the regulators, but the law itself.

After 2008, Congress and the president needed to do two things: put consistent capital requirements across financial institutions and across financial products so that the financial system had the ability to absorb losses without melting down, and, relatedly, repeal the 2000 law that prevented regulators from overseeing over-the-counter derivatives so that the regulators could impose similar rules in that marketplace, preventing a future AIG rescue. Instead, Americans got an 848-page (small-print version) behemoth of a law that did everything but the first thing and added unnecessary complexities to the second.

One of the law’s two fatal flaws was to assume that a complex financial system needs equally complex financial regulations, when the antidote is the opposite. A complex system needs simple rules. On America’s roads, you can go an infinite number of places for an infinite number of reasons, good, bad and indifferent—but you must stop at red lights, no excuses.

The deeper, harder-to-fix flaw, though, was that politicians of both parties never leveled with the American public about what good financial regulation would do: make consumer credit more expensive for practically everyone, dampen house prices further, and permanently cost tens of thousands of well-paying financial jobs. The politicians have taken refuge, then, in the opacity they’ve created.

Blurry Lines

For an example of how Congress, not regulators, created Dodd-Frank’s problems, just look at the Volcker Rule. Despite Levin’s assertion, it is far from clear that the rule would have prevented JPMorgan from making bets with federally insured deposits. Among other things, the Volcker Rule allows banks to engage in securities and derivatives trading to hedge risk, as JPMorgan has claimed its “whale” activity was intended to do.

True, the law itself states that “a banking entity shall not (A) engage in proprietary trading; or (B) acquire or retain any equity, partnership, or other ownership interest in or sponsor a hedge fund or a private equity fund.” But it also states that banks can conduct “risk-mitigating hedging activities in connection with and related to individual or aggregated positions.”

The line between speculating and hedging, though, can be a blurry one—and the reason it’s taken three years to implement the rule is that no one can figure out the difference between partially hedging an “aggregated” position and speculating. Moreover, even straightforward hedging activity carries significant risk. Banks attempting complicated hedges can find themselves vulnerable to the risk that the institutions with which they have hedged are unable to make their payments when the hedge is most needed.

It’s hard, too, to tell the difference between market-making and speculation. A bank may underwrite or purchase bond securities, for example, because it thinks its clients will want to purchase such securities at a higher price in the near future. Is this good customer service, or is it near-term speculation? Regulators from the SEC, CFTC and other agencies have been mired in these questions for 36 months. Moreover, no one has mentioned that in a world of zero percent interest rates, a “conservative” investment in a 30-year municipal bond or residential mortgage security is itself speculation; the institution purchasing the security is speculating, more or less, that average annual interest rates won’t exceed 4.5% or so for three decades.

These small-ball concerns have kept the Volcker Rule from, well, ruling. But the bigger problem is that if the Volcker Rule were competently enacted, it still wouldn’t fix what went wrong in 2008. Back then, firms such as Bear Stearns and Lehman Brothers had no recourse to FDIC-insured deposits. Even if they had had such recourse, however, nothing would have stopped the government from protecting only small depositors up to $100,000 (the limit back then for deposit insurance) and letting all other bondholders and shareholders take their losses. Volcker himself has not cleared up a misperception; deposit insurance doesn’t protect banks, but only protects their small depositors so that the banks can fail.

Similar problems abound with Dodd-Frank’s other rules. Congress directed the CFTC to regulate derivatives, for example. Sure, it’s easy to poke fun at the CFTC for its silly rule-making process; in April, it proposed a rule to “clarify certain responsibilities of a swap dealer … regarding its employees who solicit, accept or effect swaps in a clerical or ministerial capacity”—that is, rules for derivatives-dealing priests and rabbis. But the bigger problem is that Dodd-Frank contained exemptions for custom derivatives and other ways for clever Wall Streeters to get around overly specific restraints to the broader market.

On mortgages, credit cards, student loans and payday lending—all the purview of the new CFPB—no one in either party has wanted to admit that better rules, in many cases, would mean higher interest rates. A meaty “qualified mortgage” rule, for example, would have required hefty down payments and good credit—but the CFPB required neither in the rule it recently finalized, for fear of upsetting cheap-lending interest groups. Instead, people can borrow up to 43% of their income—ensuring that home prices will remain artificially high as people spend way too much of their money on government-approved loans.

Credit cards and payday lending? The CFPB has held lots of hearings to commiserate with gouged customers. But no one ever points out that, for lots of people, the choice is between high-interest credit and no credit at all. (If politicians believe it should be the latter, they should say so.) The sleight of hand is not that different from that of the politicians who pushed Obamacare. Nobody ever pointed out that real health care reform would require middle-class Americans to pay more for their everyday health care, from prescription drugs to diagnostic tests, saving insurance only for catastrophes. Why? Because people wouldn’t like it.

A national Republican—or Democrat—who points out that Dodd-Frank is exactly what’s wrong with America—politicians failing to level with the public and instead hiding behind complexity—could gain attention. That’s especially true as time passes, and the public naturally begins to blame Obama for not fixing Wall Street more than they blame George W. Bush for letting it get so out of control in the first place.

Unfortunately, potential contenders are scarce. Louisiana Republican Sen. David Vitter has teamed up with Ohio Democrat Sen. Sherrod Brown to push a bill to end Too Big To Fail by breaking up the big banks—but breaking up the big banks won’t end Too Big To Fail if all it does is result in a lot of little banks investing in the same things, thanks to government capital rules that continue to favor some investments (like residential mortgages) over others.

Kentucky Sen. Rand Paul, a libertarian-leaning Republican, talks more about “auditing the Fed” and other red-meat issues than he does about the boring nuts and bolts of what rules we need to get rid of the rules we don’t need. On the left, new Democratic Senator Elizabeth Warren has happily pounded Federal Reserve Chairman Bernanke and other regulators over the persistence of Too Big To Fail—but she hasn’t yet said that the problem is the law, not the law’s rule-writers and enforcers.

Moreover, candidates looking for money on Wall Street aren’t going to say anything to upset Wall Street, which seems happy enough, now, with a law that has enshrined Too Big To Fail by being too complex to work.


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