American banks and financial institutions can hardly have expected to have faced no regulatory or enforced structural or behavioral changes after their lead role in causing the worst financial crash since the 1930s.
However there are some who believe that the Dodd-Frank Wall Street Reform and Consumer Protection Act which received Congressional approval on Thursday, July 15th, is deeply flawed and this is largely because of what got left out.
First, some detail on the act itself. Named after its architects, the Democratic senators Chris Dodd and Barney Frank, the new piece of legislation is nothing if not ambitious. It provides for a new Financial Stability Oversight Council, a “resolution authority” for failing banks and financial institutions, and a new Consumer Financial Protection Bureau ensconced within the Washington-based Federal Reserve. It also imposes tougher capital, leverage and liquidity requirements.
The 2,319-page Dodd-Frank Act also creates new requirements for derivatives, hedge funds, private equity funds, credit rating agencies, debit card interchange fees and corporate governance. The act will almost certainly reduce the profitability of US banks, and if other jurisdictions such as the UK impose less draconian measures, could lead to an exodus of banks and financial institutions - or parts of the same - to places where their activities will be less constrained.
The New York Times said the act signaled the ending of a 50 year period in which successive generations of politicians believed that financial deregulation was best for the US economy:-
"That era of hands-off optimism was gaveled to an end on Thursday as the Senate gave final approval to a bill that reasserts the importance of federal supervision of financial transactions."
The act has drawn the sharpest criticism for what was left out. In particular, critics believe it will do little to prevent the next crisis since it skirts around the “too big to fail” issue (it fails to impose size limits on any financial institution), sidesteps reform of America's dysfunctional secondary mortgage players Freddie Mac and Fannie Mae, and fails to reinstate Glass-Steagall’s separation of “utility” and “casino” banking.
In a broadside published earlier in the Wall Street Journal, John B Taylor, a professor of economics at Stanford University, said the act was a dog's breakfast that would do more harm that good. He said the act:
“[The act] does not prevent future financial crises. Rather, it makes them more likely and in the meantime impedes economic growth."
Taylor believes the Dodd-Frank Act’s biggest flaw is that “it is based on a misdiagnosis of the causes of the financial crisis”. In particular he said the act’s authors are wrong to assume that existing regulatory bodies such as the Federal Reserve, New York Fed, Securities and Exchange Commission and Treasury lacked the powers to rein in or deal with the excesses that caused the crisis. He insists they had appropriate powers; they just failed to use them.
“Instead of trying to make implementation of existing government regulations more effective, the bill vastly increases the power of government in ways that are unrelated to the recent crisis and may even encourage future crises.”
In the field of derivatives, Taylor said the new act creates regulatory ambiguity by assigning the new role of regulating over-the-counter derivatives to both the SEC and the Commodities Futures Trading Corporation without clarifying who does what. He said another serious error of omission is reform of the US bankruptcy code. He argues redrafting this to allow large and complex financial firms to go through a predictable, rules-based Chapter 11 process without bailouts would have been far more sensible than the Resolution Authority.
In an article headlined A decent start, the Economist was marginally kinder towards Dodd-Frank, but questioned the contention of US president Barack Obama that it will become a model for other countries worldwide. The magazine said the act is:
"too idiosyncratically American and too incomplete to be a true template for other [countries]."
In a lengthy overview piece the Financial Times, Francesco Guerrera, Tom Braithwaite and Justin Baer said: "if it is to find its place in history, the Dodd-Frank Bill will have to ensure that Wall Street keeps the greater good, not just its own greed, firmly in its sights." But the question of whether ethics can be ever be regulated for is, I'm afraid, a different story entirely.
Further reading on the Dodd-Frank Act and US financial regulation
- If it ain't broke, don't fix it - Angel financing, part two, by Anthony Harrington [blog post]
- Roubini's 10-part prescription for a more stable financial future, by Ian Fraser [blog post]
- Breaking up is the hardest thing to do, by Ian Fraser [blog post]
Tags: banking , capital adequacy , derivatives , Dodd-Frank Act , Glass-Steagall Act , private equity , regulation , US