Friday, May 5, 2017

Regulating Wall Street: What Needs to Happen Next?

The Wall Street Reform and Consumer Protection Act of 2010--commonly known as the Dodd-Frank act--was a peculiar piece of legislation. It did not directly change financial rules or regulations; instead, it told financial regulators to write new rules in nearly 400 areas. Given that writing a regulation involves a legislatively-mandated process that includes rounds of mandatory feedback and cost-benefit calculations, it's eyebrow-raising but not especially shocking that six years after passage of the bill: "Of the 390 total rulemaking requirements, 274 (70.3%) have been met with finalized rules and rules have been proposed that would meet 36 (9.2%) more. Rules have not yet been proposed to meet 80 (20.5%) rulemaking requirements."

As these hundreds of new regulations began to take effect, and to interact with each other and the real world, there was inevitably going to be a need for follow-up legislation. A Republican-backed bill called the Financial CHOICE Act passed through the House Financial Services Committee earlier this week. A group of faculty members at the New York University Stern School of Business and the School of Law have combined to publish an e-book called Regulating Wall Street: CHOICE Act vs. Dodd-Frank, which offers a bunch of readable short essays on these topics.

My overall take is that although Dodd-Frank had some useful steps, it was most usefully interpreted as a cry by Democrats for "more regulation." Conversely, the Financial CHOICE act is essentially pushback by Republicans for "less regulation." Dodd-Frank is full of problems and missed opportunities, but the Financial CHOICE act, even if it is turns out to be amended in sensible ways, would leave behind additional problems while managing miss many of the same opportunities. US financial reform legislation doesn't offer much inspiration for ability of US legislators to see the bigger picture.

The "Introduction" by Thomas Cooley gives a useful overall perspective on the NYU volume:
The Dodd-Frank Act was not a fully formed set of rules or even a coherent new regulatory architecture for the United States. Rather it was an attempt to create some common mechanisms forcommunication and collaboration within the existing regulatory system through a newly created multi-agency organization—the Financial Stability Oversight Council (FSOC)—and a roadmap for rulemaking to address the obvious flaws in the system. It outlined a path for addressing the flaws in the existing regulatory architecture. The scope of Dodd-Frank is vast, covering everything from consumer financial protection to executive compensation in the financial sector, to the origins of “conflict minerals.” It outlined 390 rulemaking requirements, of which roughly 80% have been met. The resulting increase in regulatory complexity, compliance costs for financial institutions and coordination costs for the regulators has, not surprisingly, led to a backlash against the excesses of the Dodd-Frank regulations. ...
Our early assessments of Dodd-Frank found much to criticize in the legislation, but we viewed it as an important step in the direction of making the financial system less risky. It was important because it correctly identified the overarching threat to financial stability and the root cause of the 2008 crisis as the accumulation of systemic risk—risk of collapse because of the interconnected financial risks— in the financial system. An objective of Dodd-Frank was to identify sources of systemic risk, identify systemically risky institutions, establish ways of monitoring systemic risk in the financial system, limit excessive risk-taking by financial institutions, and provide a roadmap for resolving insolvent institutions. To achieve these goals, Dodd-Frank created the FSOC to monitor systemic risk and identify “systemically important financial institutions” (SIFIs). ...

With nearly seven years of additional perspective, the weaknesses are clearer. Dodd-Frank missed a golden opportunity to simplify and rationalize the very balkanized U.S. regulatory architecture, where responsibility is spread across many institutions, some with overlapping authority. Dodd-Frank did not sufficiently address the issue of the capital adequacy of financial institutions. Its proposals for the orderly liquidation of insolvent institutions were questionable. The proposed Volcker Rule was complicated and difficult to implement, and it became clear that proprietary trading and investing activities were not at the root of the financial crisis. Dodd-Frank did not address the problems of the Government-Sponsored Enterprises (GSEs) or housing finance. It did not address the problem of pricing government guarantees (deposit insurance, lender of last resort access, too-big-to-fail guarantees). It limited the lender of last resort (LOLR) authority of the Fed, constraining its ability to respond in a crisis. The result of the regulatory reform process that Dodd-Frank initiated, to date, has been a vastly more complicated regulatory structure that many doubt is adequate to forestall the next crisis and that some blame for the demise of many small community banks (institutions that are not viewed as part of the systemic problem) and a decline in bank lending.
The CHOICE act has an attractive conceptual hook: the idea is that if a financial institution shows that it is healthy by having sufficient capital, then it should be exempt from a lot of the Dodd-Frank regulatory apparatus. After all, why micro-regulate a healthy firm? But Cooley argues that the level of capital that the CHOICE act treats as "healthy" is far too low and that the CHOICE act goes too far in seeking to eliminate even the idea of "systemically important financial institutions" from the law. Cooley writes: 

The CHOICE Act begins with a premise that we endorse: Financial institutions that are well capitalized relative to their risk exposure pose less risk to the financial system and make the possibility of a systemic crisis much smaller. It is widely agreed that the financial system was undercapitalized prior to 2008. But Dodd-Frank did not directly address the idea of ensuring financial stability directly through capital requirements, or at least it did not do it very well.  The CHOICE Act offers a very enticing prospect: Financial institutions that are “well managed and well capitalized—those with a simple leverage ratio of greater than 10%” would be offered an “off-ramp” from the Dodd-Frank regulations.
The CHOICE Act offers an extensive argument in favor of a simple leverage ratio as a measure of capital adequacy and a critique of the Basel risk-based capital approach. We generally support these arguments. The Act also offers a defense of the estimate of 10% as an adequate “safe” level. The essays in this White Paper address this issue in detail. The relevant empirical and quantitative evidence suggest that 10% is at the very low end of what might be an adequate level of capital to forestall a crisis. An indicator of how far off it may be is the “Minneapolis Plan.” This alternative proposal for ending Too-Big-To-Fail—based largely on higher capital cushions—envisions leverage ratios more than twice the CHOICE Act’s 10%.
There is also an issue with how the CHOICE Act measures the leverage ratio. It uses Generally Accepted Accounting Principles (GAAP). Under GAAP, the average leverage ratio of the U.S. globally systemically important banks (G-SIBs) already is 8.24%. But, under International Financial Reporting Standards (IFRS), which do not net out derivative positions but use gross derivatives positions, their average leverage ratio is 5.75%. For systemic risk, the latter measurement system is more appropriate, because netting of offsetting derivatives positions may not be feasible in a crisis.
There is a deeper problem than just having the level of capital wrong. The CHOICE Act does not address the critical issue of what happens to the value of that capital when the economy and capital markets are in distress. It simply fails to recognize the nature and importance of systemic risk. ... The CHOICE Act is completely misguided in wanting to eliminate the oversight of systemic risk and the use of stress tests to understand
how capital holds up in a crisis. ...
Dodd-Frank responded by limiting the ability of the Fed to use its 13(3) authority, for example by prohibiting loans to individual nonbanks outside of a pre-approved program of broad access. In our earlier books, we expressed concern that this limited the ability of the Fed to respond in a crisis. The CHOICE Act seeks to limit the Fed’s role even further by restricting how the Fed conducts its monetary policy, how it functions as the LOLR [lender of last resort], and how it exercises its regulatory
Finally, many of the important issues that were largely ignored by Dodd-Frank continue to be ignored by the CHOICE act. Cooley writes:

The CHOICE Act is notable for the issues it did not touch. Like Dodd-Frank, it does not address the problems of the GSEs—Fannie Mae and Freddie Mac—that remain at the heart of the U.S. mortgage market. ...

Another important gap is the neglect of the “shadow banking” sector. Neither Dodd-Frank nor the CHOICE Act addresses the systemic risks arising from de facto banking activities per se. But this sector was hugely important in the crisis. The growth of the “shadow banking” system permitted financial institutions to engage in maturity transformation with too little transparency, capital, or oversight. Large, short-term funded, substantially interconnected financial firms came to dominate key credit markets. Huge amounts of risk moved outside the more regulated parts of the banking
system to where it was easier to increase leverage. Legal loopholes allowed large parts of the financial industry to operate without oversight or transparency. Entities that perform the same market functions as banks escaped meaningful regulation solely because of
their corporate form. ... The CHOICE Act has nothing to say about this important sector of the financial system.

In an essay later in the book, Kermit L. Schoenholtz spells out the issue of "Streamlining the Regulatory Apparatus" in more detail:

The U.S. regulatory system has been characterized as a “Rube Goldberg regulatory framework that is (fortunately) unique to the United States” ... At the federal
level, we have three bank regulators (the Federal Deposit Insurance Corporation, the Federal Reserve, and the Office of the Comptroller of the Currency) and two financial market regulators (the Commodity Futures Trading Commission and the Securities and
Exchange Commission), as well as specialized regulators for a range of institutions and activities (including the National Credit Union Administration and the Federal Housing Finance Agency). We also have a college of regulators, the Financial System Oversight Council (FSOC), along with a Federal Insurance Office (FIO) that monitors that sector, and the Consumer Financial Protection Bureau (CFPB). 
But this is only the tip of the regulatory iceberg. Each state has its own banking regulator. The states also have sole authority for the regulation and supervision of insurance and have their own state guarantee funds to backstop insurance contracts. State attorneys
general also occasionally use state laws to impose structural changes in the financial industry (as in New York’s numerous conflict-of-interest suits against securities firms). Finally, on top of the federal and state regulators, there also are the officially authorized self-regulatory organizations, such as the Financial Industry Regulatory Authority and the Municipal Securities Rulemaking Board, along with the numerous finance and real estate industry associations that intensively lobby regulators and legislators alike. ...
Yet, despite the biggest financial crisis since the 1930s, the Dodd- Frank Act did almost nothing to simplify the U.S. regulatory structure. ... Like Dodd-Frank, the Financial CHOICE Act also fails utterly to simplify this regulatory framework.
Could U.S. regulatory arrangements be radically streamlined, making the system more effective and less wasteful? Undoubtedly. The challenge of doing so is not conceptual, but political. Regardless of which party has majority control, Congress has shown no
inclination over time to simplify the system. A Volcker Alliance background report (Elizabeth F. Brown, “Prior Proposals to Consolidate Federal Financial Regulators”) details more than a dozen proposals since 1960 for consolidating the U.S. regulatory
system.  ...

By contrast to the United States, most advanced economies have regulatory systems that are quite simple (see, for example, Elizabeth F. Brown, “Consolidated Financial Regulation: Six National Case Studies and the European Union Experience,” the
Volcker Alliance). As the economy with one of the world’s most competitive financial centers, and one of the world’s largest banking sectors relative to its national income, the United Kingdom provides an important and useful regulatory benchmark for the
United States. The U.K. regulatory system is composed of only three institutions: the Financial Policy Committee (FPC), the Prudential Regulatory Authority (PRA), and the Financial Conduct Authority (FCA). The FPC and the PRA are housed within the Bank of England (BoE). The FPC is responsible for macroprudential policy, while the PRA implements microprudential oversight over depositories, insurers and major investment firms. The FCA, organized outside of the Bank, sets conduct rules for more than 50,000 financial services firms and acts as the prudential regulator for firms not supervised
by the PRA.