One year after the passage of Dodd-Frank, I invited some experts and those on the front lines to weigh in on what’s happened so far and what’s to come on financial regulation. Next I checked in with Marcus Stanley, legislative director of Americans for Financial Reform. AFR is a coalition of more than 250 national, state and local consumer, labor, investor, civil rights, community, small business, and senior citizen organizations that have come together to spearhead a campaign for real financial reform and the best possible implementation of Dodd-Frank. Stanley and AFR have been at the front lines of the Dodd-Frank battles over the past year.
Mike Konczal: It’s been one year since the Dodd-Frank Act has passed. There are dozen of articles saying it’s going awful, dozens saying we don’t know, and even a handful saying progress is being made. How has the past year gone for financial reform and Wall Street?
Marcus Stanley: Progress is being made. We can all make a list of things we believe should have been in Dodd-Frank and weren’t. But there are important pieces that are there. Among the two most significant are the new Consumer Financial Protection Bureau and the new framework for derivatives regulation. Both of those efforts have made solid progress over the past year in the face of heavy opposition. The goal of that opposition is to erode the clear gains we did make in Dodd-Frank.
Some regulators are moving ahead in good faith – not perfectly, but in good faith – on writing rules. Examples are the CFTC and SEC on derivatives regulation. Others are resisting the changes they are required by law to make. The OCC yesterday put out a final rule on preemption that essentially defied Dodd-Frank reforms and restated their existing practice of sweeping overrides of state action to deal with abusive lending.
After 30 plus years of relentless deregulation, Dodd Frank’s passage was just the first step in what will be a long fight. Pressing for effective implementation is part of that fight. It took almost a decade after the 1929 crash before all the key pieces of Depression-era financial legislation were passed and implemented. We are still in the middle of the battle.
MK: The first stop on financial reform is dealing with Too Big To Fail financial firms. How is making them less prone to collapse and more manageable to resolve when they do coming along?
MS: This is the area where many of us were most disappointed in the underlying Dodd-Frank statute. The bailouts of 2008 created an overwhelming perception that the largest and most important financial firms had an implicit government guarantee. The Congressional actions in the Dodd-Frank Act were not strong enough to reverse that perception. The financial sector today is even more dominated by the big banks than it was before, and the largest firms still have an unfair advantage in the market due to the belief that government will support them.
That said, over the past year we’re seen some genuine progress in dealing with some of the risks that make failure — and demands for public support in case of failure – more likely. One is the area of controlling excessive bank borrowing through capital regulation. Capital regulation alone won’t be enough to address systemic risk. But there’s no question capital charges get banks’ attention, and there’s no doubt that the new Basel III capital framework approved by regulators this year creates a substantial boost in capital charges for some of the riskiest activities we saw prior to the crisis. The combination of Basel III and the implementation of the Collins Amendment will also create a firm maximum borrowing (leverage) limit for banks. The limits on bank credit exposures to other systemically important institutions – limits that include credit exposures through derivatives and off balance sheet instruments — will also help address the “too interconnected to fail” problem related to excessive borrowing within a small circle of big banks. These limits will work to restrain some of the worst excesses we saw before the crisis involving short-term and off balance sheet borrowing. Derivatives regulation should also make the system safer and more transparent. As far as we can tell regulators are taking steps to enforce these limits, including for example by significantly increasing the number of on-site examiners at major banks.
Regulators are moving unacceptably slowly in other areas. Making sure that all large financial institutions — including non-banks — have regulatory oversight was a key reform goal. (One way that relying on capital charges can go wrong is that banks can arbitrage the system by routing their transactions through unregulated non-banks). But industry players are lobbying mightily to be exempt from designation. The new Financial Stability Oversight Council (FSOC) hasn’t designated even a single non-bank financial entity for oversight yet, even the largest and most obvious ones. Indeed, the FSOC in general has gotten off to a slow start. The Council and its associated research arm (the Office of Financial Research, or OFR) were supposed to be the “central brain” of the regulatory system, and the answer to the fragmentation in financial oversight that contributed to regulatory failures before the crisis. We have not seen much action that matters from the FSOC thus far, and the Office of Financial Research does not yet have a director and has only hired minimal staff so far. It’s hard to see how regulators will stay ahead of a constantly evolving financial system unless they coordinate their efforts and their information centrally. Open engagement with the public on these issues is also crucial.
In general, regulators have not been as aggressive as they could be in using the full powers granted to them under Dodd-Frank in controlling bank behavior. To take just one example that has gotten relatively little attention, Section 956 of the Act instructs regulators to ban pay and bonus practices that lead to excessive risk taking. The rule regulators have proposed to implement this provision took a step in the right direction by requiring the largest banks to defer full payment of executive compensation for up to three years. That’s a valuable step in avoiding the kind of situation we saw with Bear Stearns and Lehmann, whose top executives walked away with $2.4 billion free and clear in the years before their firms collapsed. But the rule mandates that only one sixth of top executive compensation would be deferred for the full three year period. As the AFR comment to the regulators stated, when you consider the massive pay levels on Wall Street, that’s not enough of a disincentive to risk taking. While AFR is asking regulators to do more, even the modest step they did propose is being vociferously opposed by industry. Over 70 percent of industry comments on this rule ask for some or all of their top executives to be exempted from any pay deferral whatsoever!
Beyond pay levels, there are many additional areas where Dodd-Frank gives regulators powers that could make a big difference if they’re implemented boldly. These range from the Volcker Rule ban on proprietary trading to the FSOC authority to break up the largest banks if they pose a systemic risk. Such powers could be major levers for change. It would be a dramatic change from past behavior for regulators to be truly bold in using these powers. We are not expecting it to happen on its own. We do see it as a place to keep working and pushing. What can we do to make these opportunities matter?
MK: Related, bring new types of transparency and accountability to the derivatives market was a major push. How is progress there?
MS: Progress is pretty good, against a lot of pushback from industry. Regulators have actually laid out a comprehensive and fairly good set of rules on derivatives regulations, which should significantly improve the transparency and stability of the market and the financial system more generally.
These rules represent a real and a large improvement compared to the unregulated markets we have today. But there are potential problems and weaknesses. There is reason to be concerned that the few big dealers who currently dominate the derivatives markets would be permitted to have excessive control of key areas of the derivatives infrastructure, like clearinghouses or data repositories. This could permit them to gain unfair advantages over other market participants. The Justice Department’s Antitrust division has weighed in strongly on this issue. Another danger is that if regulators don’t police it carefully, the so-called “end user exemption” could be expanded into a significant loophole. Finally, one of the most obvious issues here is the sweeping exemption from derivatives regulation that the Treasury Department has granted to the multi-trillion foreign exchange swaps market.
It’s true that the derivatives rules will go into effect a little later than the one-year timeline in the Dodd-Frank Act. In retrospect that time line may have been slightly too ambitious. It’s understandable if it takes a few extra months to roll out something as important as the new regulatory framework for several hundred trillion dollars in currently unregulated derivatives trades. Any delay should be limited, though, and we should see the first major rules put into effect starting around the end of this year. One area where we are seeing unacceptable delays, though, is in the enforcement of limits on speculation in our commodities markets. Dodd-Frank mandated that such limits begin to be put in place six months ago. However, the CFTC has not acted, and the rule they have proposed to limit speculation is in any case not strong enough to genuinely restrain commodity market speculation.
The threat we’re most worried about in the derivatives area is the funding for the regulators who will enforce derivatives rules, which is under serious attack in Congress. The House has proposed to fund the Commodity Futures Trading Commission at just $177 million, 12 percent less than its current funding level and over 40 percent below the minimum funding required for the CFTC to implement its new derivatives responsibilities. (The CFTC will expand its oversight to $280 trillion in interest rate swaps, a seven-fold increase in the size of the market it supervises). The House-proposed funding for the Securities and Exchange Commission (SEC) is 20 percent below the level needed to implement Dodd-Frank. By way of comparison, JP Morgan Chase, which is among other things a major derivatives dealer, spends $4.6 billion annually just on information technology. That’s more than three times as much as the proposed funding for both the CFTC and SEC put together.
MK: What’s going to happen with the Consumer Financial Protection Bureau without a confirmed Director this week?
MS: There is a great deal the Bureau can do without a director. And some of the things it can’t do it might take a little longer to get to in any case, so not having a Director may not really hold them back. But not having a Director also limits its authority in ways that matter. The key distinction is between authority that is being transferred from other agencies and under existing laws, and new authority. Without a Director the Bureau cannot supervise non banks – like payday lenders, for example. And it cannot write rules under its new ‘unfair, deceptive, and abusive’ practices authority.
Preventing the appointment of Director is also of course an effort to undermine the Bureau’s authority beyond the specific power it is denied — the 44 Senators who have said they will not consider any director unless the bureaus authority and effectiveness are diminished are presumably trying both to limit its ability to defend consumer interests in the long run by making these changes, and to make it harder for the Bureau to take aggressive action now because it does not have a head, and because it is under constant hostile scrutiny.
Meanwhile, the work of putting the bureau together has been going well. The agency has done a lot of its key hiring and system building, invested in building relationships with the public, consumers, and industry, got a sterling report from the Inspector General on its planning and implementation activities, and has started work on key projects in a thoughtful way that is winning good reviews from both industry and consumer advocates.
Some of the key actions already under way at the Bureau include the design of new transparent mortgage disclosure forms, so unscrupulous brokers won’t be able to conceal the kinds of “tricks and traps” that led consumers into exploitative mortgages in the past. . They are about to start supervising the big banks for compliance with consumer laws. The Bureau also has the first module of a public complaint system — focused on credit cards, with additional products to follow – up and running as of today. They have started the process of defining the larger non-bank financial market actors they will supervise, and they are developing a research capacity that can really look at the consumer financial marketplace to identify and understand emerging problems. The more you think about the details the more you realize what a difference doing all this right can make.
MK: Describe the atmosphere of rule-writing and drafting regulatory rules. It’s a difficult process for outsiders to understand.
MS: We are outsiders ourselves of course. We’re trying to create a public interest voice into a process that is overwhelmingly dominated by industry. From 2008 to 2010, the financial industry spent an incredible $1.4 billion on lobbying to influence the process in Washington. In 2011, the lobbying is just as intense, and the spending is at almost the same pace as it was during the Dodd-Frank fight in 2010. But a lot of it has switched from Congress to the regulatory agencies. More than 90 percent of the groups appearing in agency meeting logs are banks, hedge funds, or other financial industry companies. One of the things industry’s money buys is the advantage of the “revolving door” — over 240 former government insiders are working as financial industry lobbyists now.
At the same time, although we’re outgunned on money and the sheer number of lobbyists and lawyers, it does matter that we represent the public interest. Many regulators know it’s wrong to listen exclusively to financial firms with money at stake, so they do seek out a public interest perspective. And it matters that the public is with us. AFR and other public interest groups commissioned a poll this week that found that huge majorities of voters favored tougher financial regulation — 77 percent wanted tougher rules and enforcement for Wall Street banks. And the support was bipartisan; 70 percent of Republicans supported it too. Over 70 percent of voters supported the Dodd-Frank reforms specifically. The challenge is to take the clear public desire for real reform and mobilize it against the money and influence of Wall Street.
The regulatory process is an interesting mix of extremely open and very closed. It’s open because anyone can read the proposed rules and comment on them, and the regulators have to at least acknowledge your arguments. I should add that “anyone” most definitely includes the readers of this blog. Americans for Financial Reform welcomes input and assistance in our regulatory comments, especially from those readers who have deep knowledge of technical financial issues — please feel free to contact us if you’d like to participate in our work.
But the process is also closed because the regulators have almost complete control over the final rule and it can be very difficult to understand exactly the considerations that drove their decision. There are also two extra complexities in financial regulations that make the process trickier to navigate than in other areas of regulation. The first is that many of the most important rules in Dodd-Frank are joint rules. They can be written jointly by as many as five major financial regulatory agencies (the OCC, FDIC, Federal Reserve, SEC, and CFTC) — for example, the Volcker Rule is written by all five of these agencies plus the Treasury Department. In practice, this ‘rulemaking by committee’ can mean that the most conservative agency exercises a kind of veto power, and it makes it even more difficult to understand the motivations at work from outside. It’s yet another cost of the fragmented financial regulatory system we have.
The second complexity is that financial regulations often leave enormous discretion to the bank examiners and the regulated banks. The complexity of financial institutions is such that regulators often just prescribe very general risk management principles, which are then implemented in countless detailed interactions between examiners and the institutions they oversee. Since these interactions are confidential it’s not easy to tell what actually happens when ideas that sound good are actually implemented. This makes financial regulations more difficult to police and comment on from outside than, for example, an environmental regulation that sets permissible levels of specified pollutant.
MK: High-level, but other have been worried about the relative power of the financial sector in the country. People worry about “financializaton” from the point of view of entrepreneurship, relative focus and power of economic sectors, a focus at the top instead of the bottom, short-term-ism, etc. A decade from now, how will Dodd-Frank have changed the political economy of the country? Is it way too early to tell, or is it just not relevant to how Dodd-Frank is working?
MS: This is an extremely relevant question for the long run. As we said to start, Dodd-Frank is the first step in a long process of reform. And key to that process will be combating the excessive influence of finance in our economy. Even before the financial crisis, the diversion of private sector investment into a speculative housing bubble and the replacement of wage growth by unsustainable debt as a source of family income were obvious economic problems.
If it is implemented well, Dodd Frank has the promise of restricting the worst speculative excesses, lessening the market advantage of systemically significant financial institutions and protecting families from having their income drained by exploitative and abusive financial contracts. These can all address the diversion of money and talent into finance. The greater Dodd-Frank oversight could also bring to light more information that will help us understand better what else we need to do.
But several decades of deregulation have created a vicious cycle in which growth of the financial sector feeds greater profits and power for Wall Street, which in turn creates more political influence. We have been struck by how often non financial businesses who we contact for assistance in our work say that they are afraid to speak out publicly against the influence of their bankers, even when it would be in their interest to do so. The same can be true of small community banks when their interests conflict with the major Wall Street institutions.
Dodd Frank can’t be end of the story. We’ll need more financial reform, and we’ll still need to put financial reform into the context of a much broader economic agenda.