Putting Stronger Limits into the Dodd Bill

Picture if you had a woodshop filled with oily rags, no ventilation, no exits, a woodshop that was always catching on fire. One thing to do is to get a fire extinguisher. That is the resolution authority of the financial reform debate. Another thing to do is to establish new codes and rules to make it less likely that there will be a fire. Current regulators and industry leaders will tell us that the financial capital markets are up to The Swanson Code, the “I’ll know trouble when I see it” system; however we want there to be clear rules regulators won’t mess up to reduce the likelihood that there will be fires.

Ryan Avent and Kevin Drum both look at the Dodd Bill and are left a little worried about financial reform. A few points.

Written Rules

Here’s one thing that is probably worrying them. This is language from the final House Bill, HR 4173 (giant pdf, page 44):

(3) LEVERAGE LIMITATION.—The Board shall require each financial holding company subject to stricter standards to maintain a debt to equity ratio of no more than 15 to 1, and the Board shall issue regulations containing procedures and timelines for how a financial holding company subject to stricter standards with a debt to equity ratio of more than 15 to 1 at the time such company becomes a financial holding company subject to stricter standards shall reduce such ratio.

Here’s the equivalent language from the Dodd Bill (giant pdf, starting page 25):

(2) DUTIES.—The Council shall, in accordance with this title….(H) make recommendations to the Board of Governors concerning the establishment of heightened prudential standards for risk-based capital, leverage, liquidity, contingent capital, resolution plans and credit exposure reports, concentration limits, enhanced public disclosures, and overall risk management for nonbank financial companies and large, interconnected bank holding companies supervised by the Board of Governors

In both bills, regulators have discretion in how to set limits, as determined by internal risk managers. In the House Bill though, there’s a strict limit: no systemically risky firm can have leverage greater than 15-to-1. In the Senate, the FSOC will make recommendations to the Federal Reserve. The Federal Reserve will do like, whatever it wants – it could follow the recommendations. Or it could not.

This solution in the House Bill is a satisficing solution – there are almost certainly firms that could handle being leveraged 16-to-1. However we don’t trust the regulators to be able to detect that firm and also not bend the rules for firms that couldn’t handle that leverage. So we write down a clear rule.

And these clear rules are exactly what the lobbyists are going to go after.

The Volcker Rule

Hey, remember that? Here’s what it looks like in the current Senate Bill (starting on page 960):

1 SEC. 989. GOVERNMENT ACCOUNTABILITY OFFICE STUDY ON PROPRIETARY TRADING….(1) IN GENERAL.—The Comptroller General of the United States shall conduct a study regarding the risks and conflicts associated with proprietary trading by and within covered entities, including an evaluation of (A) whether proprietary trading presents a material systemic risk to the stability of the United States financial system….(c) REPORT TO CONGRESS.—Not later than 15 months after the date of enactment of this Act, the Comptroller General shall submit a report to Congress on the results of the study conducted under subsection (b).

So the GAO will study the Volcker Rule. And 15 months from now, they’ll give a report. Then the FSOC, a very pro-banking group, will decided whether or not to enact it, according to however they feel like voting that day. Will it be a blanket ban? Will it be a ban for some firms, but not for others? Will it be thrown in the garbage? Who is to say? I bet I know how John Dugan is going to vote though.

Imagine the New Deal running like this. That FDR, instead of passing Glass-Steagall, decided to pass a bill appointing a study of Glass-Steagall and then a gathering of banking regulators can decide to do whatever with it.

I’ve waited on writing about this until I’ve gotten a better sense of the issue. Half the people I speak (mostly industry) fear this is an attempt to get the Volcker Rule accepted as law without lawmakers having to vote for it. “What can I do? It’s what the regulators decided.” The other half of people I speak to (mostly not industry) fear this is an attempt to get the Volcker Rule dropped from the public debate without lawmakers having to vote for it. “What can I do? it’s what the regulators decided.”

It’s funny, I know what a good financial reform bill becoming a bad financial reform bill looks like through this process. I’ve seen bribes and more bribes and last-minute giveaway changes. But this feels different. It’s almost like the one rule that’s a clear rule, that would structurally change the industry in some way….it’s like Congress doesn’t want a vote on it. They’d rather kick it to someone else to deal with. I imagine it is hard to go to fundraisers with a “yes I actually tried to structurally change the financial markets in some manner” vote in hand, but harder to kill a financial reform bill going into a tough election over it.

Lobbyists Efforts

Notice that having limits written into the bill, and not leaving it to the FSOC and the Federal Reserve, is the worst thing for the industry from the point of view of lobbying and exploiting various forms of cultural capital. Here’s Shahien Nasiripour with Volcker: Regulators Can’t Be Trusted To Act (my bold):

“In my opinion, it’s very unlikely that the regulators and supervisors would evoke a strict prohibition until a crisis came and then it’s too late,” Volcker said. “That’s why you want it in legislation.”…

For regulators, “there’s a lot of pressure not to do it,” Volcker told reporters during a break in the hearing. That’s why it needs to be in the legislation, specifically directing regulators to take action, he said.

In a mocking tone, Volcker said the banks would tell regulators, “‘Don’t touch us’…’What did we do wrong?’… You know, ‘Leave us alone.'”

Dodd’s bill, to the disappointment of reformers and consumer groups, leaves a lot of discretion in regulatory matters to bank regulators like the Federal Reserve, the Office of the Comptroller of the Currency, and the Treasury Department.

“Look, I’ve been a regulator for 20 years,” Volcker emphasized. “So I know how they are.”

I think that’s a perfect summary of the problems with the Dodd Bill. And note that the lobbyists will fight the hardest to give regulators more discretion: “Scott Talbott, senior vice president of government affairs at the Financial Services Roundtable [said that] when senators meet to debate changes, “our hope is that they change ‘must’ to ‘may.'” Exactly.

Size Caps

I’ll say this about resolution authority – I’d feel a lot more comfortable about regulators doing prompt corrective action style regulatory regime on institutions that weren’t larger than X% of GDP, be it 2, 3 or 4. A lot of early criticism of this approach, like Gary Stern of the Minneapolis Fed, assumed that it would be the end-all and be-all of reform. That link is a good outline of how resolution authority would work:

Thus, the key to addressing TBTF…consists of three pillars: early identification, enhanced prompt corrective action (PCA) and stability-related communication…[or]…If financial institutions raise systemic concerns because of their size, make them smaller…And I would note, in passing, that it is an idea born of desperation since it seems to admit that large, complex organizations cannot be supervised effectively.

Heh. Well, to quote the band X, “We’re desperate. Get used to it.” And it’s not an either-or question. Now would be a good time to evaluate how resolution authority, particularly the “early identification” and “enhanced prompt corrective action” parts of it would work better with capped firms. Here is Baseline bringing you up to speed on the current legislative efforts for size caps. The goal is to get it specifically written into the bill instead of something we hope the FSOC, which Geithner would sit on, votes for a year and a half from now. Now that health care reform is over, you have no excuse!