THE DODD-FRANK ACT The Politics of Financial Reform

Paul Ockelmann

5/4/2012

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TABLE OF CONTENTS

Foreword | 4

A History of Missed Opportunities | 5

1933: The Glass-Steagall Act | 5

1975-1999: Missed Changes to Strengthen and Preserve Glass-Steagall | 7

Brooksley Born and Long Term Capital Management | 11

Conclusion | 14

The Inadequacies of Dodd-Frank | 15

Regulatory Shortcomings as Illustrated by Crisis | 15

Independent Perspectives on Fixing the Financial System | 20

What Dodd-Frank Does | 23

Conclusion | 29

Why Dodd-Frank is Inadequate | 33

Presidential Involvement | 33

Congressional Incentives | 37

The Influence of Lobbying on Rulemaking | 41

Conclusion | 45

Final Thoughts | 47

References | 51

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FOREWORD

The recent financial crisis has profoundly affected both the United States and

global economies. Much has been written examining the crisis’s multiple causes,

analyzing its handling, and warning of the next crisis on the horizon. Far less, however,

has been written evaluating the United States government’s legislative attempt to

prevent another financial crisis of this nature and magnitude: the Dodd-Frank Act.

What has been written falls into two distinct categories. Some worry that Dodd-Frank

fails to close loopholes that will allow another crisis of the same nature to occur. Others

despair at the Act’s immense size and complexity and wonder how business will

continue to function. How was a system in clear need of reform left largely the same,

even with a compelling national interest at stake? What steps in the legislative process

led to such an unsatisfactory outcome? Evaluating these questions can help provide a

glimpse into multiple aspects of the modern political process in the United States. These

answers speak volumes about the influence of the financial sector as well as the power of

special interests in representative government. Studying the Dodd-Frank Act’s creation

not only shows how the given result happened, but it also serves as a case study of the

competing interests vying for representation in today’s American democracy.

This thesis is divided into four chapters, each with a different purpose. The first

chapter relates a brief history of financial regulation in the United States and details the

erosion of that system beginning in the 1970s. Rules and regulations did not keep up

with financial innovation, leaving behind a broken system. Chapter Two details the gaps

the 2008 financial crisis exposed in that system. It then looks at suggested methods of

reform and compares them to what the Dodd-Frank Act actually did, concluding that

the causes and fixes do not match up. Chapter Three provides a probable explanation for

why, using political science theory to create an explanatory framework. Special interests

dominate politics, and it is no surprise the financial sector—one of the most powerful

special interests—dominated the formation of the Dodd-Frank Act. Chapter Four

concludes with a discussion of future implications on financial reform and the greater

political system. Studying the legislative response to the financial crisis is vital to

understanding how this country works and what lies ahead in its financial and economic

future.

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CHAPTER ONE: A HISTORY OF MISSED OPPORTUNITIES

The history of modern financial regulation in the United States began as a

response to the Great Depression. While the Federal Reserve had been created twenty-

odd years earlier under President Woodrow Wilson, a sound banking system did not

emerge immediately, as evidenced by the great stock market crash of October 24, 1929.

The creation of the Federal Deposit Insurance Corporation (FDIC), Securities and

Exchange Commission (SEC), and the passage of the Glass-Steagall Act led to reform

that preserved stability, protected against conflicts of interest, and helped lead to

continued economic growth over the next four decades. But many opportunities to

update and strengthen Glass-Steagall were missed as financial innovation began to take

off in the 1970s. Deregulation became seen as the necessary prerequisite to the optimal

allocation of capital, leading to the weakening and eventual repeal of Glass-Steagall in

1999. This chapter illustrates the systematic weakening of regulatory authority over

time; it focuses on Glass-Steagall because of the events that occurred following its

repeal, which showed that financial innovation on its own cannot remove the inevitable

conflict of interest when commercial and investment banking are not kept separate.

§1.1 – 1933: The Glass-Steagall Act

The Glass-Steagall Act of 1933 marked the separation of banking and commerce

for the first time in American history. The purpose of isolating banking from securities

(which are contracts that can be assigned values and traded)1 was threefold: “ to (1)

maintain the integrity of the banking system; (2) prevent self-dealing and other

financial abuses; and (3) limit stock market speculation.”2 As investment banking refers

to the securities business and traditional banking is commonly referred to as

commercial banking, the Glass-Steagall Act effectively separated commercial and

investment banking.

In the decades leading up to the 1929 financial crash, the professions of banker

and broker were difficult to differentiate, causing conflicts of interest within banks that

both held deposits and invested that money in financial markets. Much of the blame for

1 Examples include notes, stocks, preferred shares, bonds, options, futures, swaps, rights, warrants, or virtually any other financial asset. 2 Congressional Research Service. “Glass-Steagall Act: Commercial vs. Investment Banking.” (IB87061). By William D. Jackson. Washington: June 1987, 4.

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the crisis was placed on banks who speculated on the market in the 1920s.

Congressional hearings during the Great Depression showed that fraud and conflicts of

interest took place in many banks’ securities trading. Individual investors were hurt

repeatedly as banks had the primary incentive to promote stocks that would benefit

them rather than the consumer. Following the 1929 banking crash, one in every five

banks in the United States failed. The elegant solution devised in response to this

massive failure was to create a barrier to separate banking from securities trading. The

Banking Act of 1933 made it a felony for any person to take deposits while

simultaneously participating in the securities business. The only exceptions were that

“banks could underwrite and deal in obligations of the United States and many of its

instrumentalities”3 and could act as agents on stock purchases (per a 1935 amendment).

Banks thus had to make the choice between providing traditional lending and

underwriting as a broker.

Several reasons exist for separating the two different types of banking, reasons

that remain as relevant today as at the time of Glass-Steagall’s creation. Any institution

that both grants and uses credit, that both lends and invests, suffers from conflicts of

interest that can lead to abuse and decisions that are in a bank’s best interest rather than

the customer’s. Institutions holding deposits hold great financial power in controlling

other people’s money, and limits on their size must be enforced to maintain a

competitive market for loans or investments. Securities activities inherently contain

risk, leading to the possibility of great losses: “In turn, the Government insures deposits

[through the FDIC since 1934] and could be required to pay large sums if

depository institutions were to collapse as the result of securities losses.” 4

Depository institutions are also at a competitive disadvantage against investment

brokerages because they are not conditioned to manage high levels of risk. Commercial

banks may be prone to unwise speculation if given the opportunity. The logic for the

Glass-Steagall Act becomes apparent when analyzing its purpose: The common-sense

provisions of the Act created to prevent financial crashes such as the one in 1929 remain

sensible and could have helped prevent the 2008 crash had the Act been modified to

account for subsequent financial innovation.

3 “Glass-Steagall Act: Commercial vs. Investment Banking,” 4. 4 Whole section, ibid, 4. (emphasis added)

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The Glass-Steagall Act continued to be enforced by regulators and was applied to

bank holding companies as well as individual banks. Regulation became the province of

the Federal Reserve under the 1956 Bank Holding Company Act and was strengthened

in 1970. Glass-Steagall provided the foundation for financial regulation without limiting

or impinging on economic growth. In the period that regulation was at its strongest

from 1947-1973, real GNP (Gross National Product) grew at an average of almost four

percent,5 providing evidence that more regulation does not automatically hurt economic

growth. But banks began systematically lobbying against the separation of commercial

and investment banking began as soon as the 1960s and 1970s, with brokerage firms

beginning to offer money-market accounts that paid interest, allowed check-writing, and

offered credit or debit cards.6 Instead of Glass-Steagall being used as a foundation for

continued effective regulation, multiple opportunities were missed to preserve the law’s

effectiveness in the face of newer financial instruments.

§1.2 – 1975-1999: Missed Chances to Strengthen and Preserve Glass-Steagall

While Glass-Steagall maintained regulatory continuity for decades, banks began

to chafe at restrictions beginning in the 1970s. While the strict separation between

investment and commercial banking was relatively straightforward to enforce

immediately following the Great Depression, regulation post-1956 rested with the

Federal Reserve. Even though banks began lobbying to be allowed to participate in the

municipal bond market as early as the 1960s, there was no concerted plan within the

financial industry to overthrow regulation throughout the 1970s and 80s. According to

former IMF chief economist Simon Johnson,

This development [deregulatory trend] emerged from a confluence of

factors: exogenous events, such as the high inflation of the 1970s; the

emergence of academic finance; and the broader deregulatory trend begun

in the administration of Jimmy Carter but transformed into a crusade by

Ronald Reagan.7

5 Average real GNP growth rate, 1947-1973: 3.86%. Federal Reserve Bank of St. Louis, Source: U.S. Department of Commerce: Bureau of Economic Analysis, http://wikiposit.org/a?uid=FRED.GNPCA. 6 “The Long Demise of Glass-Steagall,” PBS Frontline: The Wall Street Fix. 7 Simon Johnson and James Kwak. 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (New York: Pantheon Books, 2010), 109.

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The trend of deregulation soon became the dominant intellectual mindset in

government regulatory agencies such as the Securities and Exchange Commission and

the Federal Reserve as well as with politicians. Former Chairman of the Federal Reserve

Alan Greenspan did more than anyone else to champion the self-regulating nature of the

free market, relying on “the idea that market forces would be sufficient to prevent fraud

and excessive risk-taking.”8 The pervasiveness of the deregulatory mindset prevented

the Glass-Steagall Act from being strengthened and updated to preserve the boundaries

between investment and commercial banking.

The consequences of changes in regulation were a changed incentive structure

that encouraged banks to take more and more risk. The first leak in the dam of

regulation sprung on May 1, 1975, when the SEC ordered the elimination of fixed

commissions on the New York Stock Exchange (NYSE). Fixed commissions had existed

since the apocryphal Buttonwood Agreement of 1792, in which 24 brokers decided to

trade on a commission basis and set a minimum threshold for commissions.9 Many

brokers charged that fixed commissions were anti-competitive, creating a cartel-like

NYSE where trading volume was artificially limited. In response to increased pressure

from both Congress and within Wall Street, the SEC ordered an end to fixed

commissions beginning on the day now known as “May Day.” The immediate effects of

unfixing commission rates was not apparent, but over time the dramatic change became

evident. The average commission per share dropped from around 80 cents per share in

the early 1970s to four cents per share in the early 2000s. Full-service brokers lowered

their rates and discount brokers emerged online in the 1990s, spurring a huge increase

in trading volume as well as the percentage of households with exposure to the equities

market. The incentive structure on Wall Street was changed forever, with the most

capitalized firms now able to search for higher margins on commissions. Because

brokers were no longer able to rely on fixed commissions as a steady source of income,

competition increased and banks had to assume more risk to remain profitable.

The first major blow to Glass-Steagall came five years later in 1980, when the

Depository Institutions Deregulation and Monetary Control Act (DIDMCA) phased out

capped interest paid on savings accounts. Regulation Q of the Glass-Steagall capped the

8 Johnson and Kwak, 147. 9 Kenneth Silber, “The Great Unfixing,” Research Magainze, May 2010.

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interest rates that savings accounts could pay at 5.25 percent. This regulation prevented

rate wars between banks competing to entice investors. However, the framework of

capped interest rates hurt banks once inflation rates rose to as high as 10 percent in the

late 1970s. Money fled to money market mutual funds, which paid substantially higher

interest rates to small investors. President Carter signed the DIDMCA in 1980 to help

savings and loans banks (also known as thrifts) compete with these mutual funds; S&L’s

were permitted to expand from mortgages to higher-risk loans and investments.10 The

bill also overruled state laws limiting interest on mortgages, making mortgage interest

rates market bearing for the first time in history. The so-called boring banking model

that had prevented bank failure for the previous forty years was no more, with the

DIDMCA leading to direct competition between mutual funds and savings and loans

banks for deposits. Eliminating Regulation Q was seen as necessary to ensure the S&L

industry’s survival, but the unforeseen consequences of this deregulation would

eventually be widespread and wreak havoc on the financial system and the greater

economy.

The climate of deregulation was firmly established by the 1980s, in no small part

due to the rise of academic finance and the efficient market hypothesis. The hypothesis

consists of two parts: first, because traders look to exploit asset price inefficiencies,

prices are always right. Second, because prices are always fundamentally correct, the

financial sector could be left to itself. The combination of the efficient market hypothesis

and the rightward shift in political climate led to an explosion of deregulation in the

1980s, with each act further eroding the foundations of banking regulation. The 1982

Garn-St. Germain Depository Institutions Act lifted more regulations on the savings and

loans industry (colloquially, thrifts), permitting them to expand into commercial

lending and invest in corporate bonds. Although this legislation was designed to help

thrifts, these banks were now able to enter new territory with new risks. The savings and

loan industry predictably expanded rapidly from 1982 to 1985, with investments shifting

to high-risk commercial real estate loans rather than traditional home mortgage loans.

The Tax Reform Act of 1986 eliminated tax shelters in real estate, causing the thrift

market to crash and eventually need recapitalization under the Bush Administration.

10 Matthew Sherman, “A Short History of Financial Deregulation in the United States,” Center for Economic and Policy Research, 7.

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The crash in the thrift industry foreshadowed future crises in which deregulation

transformed an industry, investors entered markets where they had little experience,

and a shaky industry expanded far past government safeguards. Warning signs and

lessons learned were missed about how truly far-reaching the unintended consequences

of deregulation could be.

Alan Greenspan’s appointment as Chairman of the Federal Reserve in August

1987 marked the beginning of the end for Glass-Steagall. The Fed had changed its

interpretation of Glass-Steagall in December 1986, saying that a commercial bank could

receive up to five percent of gross revenues from investment banking. Seemingly in

conflict with the law’s provisions, the Fed’s ruling was expanded to ten percent under

Greenspan shortly after his confirmation as chairman. The Federal Reserve effectively

neutered Glass-Steagall in 1996, further expanding the ten percent ruling up to 25

percent, as essentially any institution could stay within that 25 percent level.11 The

Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 eliminated

interstate barriers to banking and branching that had been law since the passage of the

Bank Holding Company Act of 1956, permitting mergers and acquisitions between

banks. As more and more banks began to merge, the number of banks decreased by 27

percent from 1990 to 1998. Major commercial banks began to buy investment banks,

creating superbanks that were heavily involved “in underwriting securities,

manufacturing securities (securitization), trading securities, and trading derivatives.”12

As an example, Travelers Insurance Group and Citibank announced plans to merge in

1998. Though they carefully structured the deal to appear to conform to interpretations

of Glass-Steagall, the executives and regulators were so confident that the law was soon

to be repealed as to allow a technically illegal merger that created the world’s largest

financial services company through the largest corporate merger in history. The final act

of deregulation followed shortly in 1999 with the Gramm-Leach-Bliley Act, which

“repealed all restrictions against the combination of banking, securities, and insurance

operations for financial institutions.”13

11 “The Long Demise of Glass-Steagall.” 12 Johnson and Kwak, 140. 13 Sherman, 10.

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§1.3 – Brooksley Born and Long Term Capital Management

Opportunities to update and strengthen regulation were clearly missed in the

1980s and 90s, but it does no good to present a series of events without more closely

identifying the reasons for their occurrence. A close study of the evolution of regulation

of over-the-counter (hereafter OTC) derivatives in the mid-1990s shows both the

powerful deregulatory influence in Washington as well as foreshadows the 2008

financial crash. The story of one woman versus a nexus of influence illustrates the

results of failing to regulate derivatives a full ten years before the most recent crash. The

story of Brooksley Born and Long Term Capital Management occurs at the height of the

deregulatory era.

A derivative is essentially a two-party contract that transfers a given amount of

risk or volatility, which “may relate to the price or performance of a reference asset,

event, a market price or any other economic or natural phenomenon.”14 OTC derivatives

are contracts that are entered outside of any regulated exchange, deriving value from

any conceivable asset, reference rate, or index. They are trades in risk, with either

party’s possession of the reference asset unnecessary. Final-users employ derivatives to

attempt to alleviate risks from volatility and variance “in interest rates, foreign exchange

rates, commodity prices, and equity prices, among other things.”15 OTC derivatives are

also useful in assuming price risks to raise investment yields and to speculate on price

changes (a process known as arbitrage). OTC derivatives can be important financial

management tools to manage risk, and they have led to flourishing American capital

markets over the past thirty years that transfer risk from the risk-averse to those who

have an appetite for it. But the lack of transparency as well as direct counterparty risk

(as opposed to exchange-traded derivatives where a clearinghouse bears the

counterparty risk) makes the possibility of catastrophic loss possible, if not at some

point inevitable.

Derivatives are a relatively new product, and regulation was forced to evolve to

keep pace with newer and increasingly exotic forms of financial instruments. The

capacity to regulate all futures and options was given to the Commodity Futures Trading

14 Vinod Kothari, “Introduction to Credit Derivatives,” In Credit Derivatives and Synthetic Securitisation, (Wiley, 2002), 3. 15 Commodity Futures Trading Commission, Concept Release: Over-the-Counter Derivatives, (Washington: 1998), 3.

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Commission (CFTC) in 1974—this commission was the first to consider regulation of the

OTC derivative market in the 1998. The CFTC’s newly appointed director Brooksley

Born issued a concept release in May 1998 asking for public comment on the future of

OTC regulation for the following reasons:

The explosive growth in the OTC market in recent years has been

accompanied by an increase in the number and size of losses even among

large and sophisticated users which purport to be trying to hedge price risk

in the underlying cash markets. Market losses by end-users may lead to

allegations of fraud or misrepresentation after they enter transactions they

do not fully understand. Moreover, as the use of the market has increased,

entities such as pension funds and school districts have been affected by

derivatives losses in addition to corporate shareholders.16

One of the key assumptions in the argument for unregulated OTC derivatives seemingly

ceased to hold in the mid-1990s: symmetric information. That is, many end-users, such

as pension funds and institutional investors, did not possess the same knowledge of the

contract as the other party with which they entered the deal.17

Though Born only identified a need to reevaluate OTC regulation, seeking

comment without proposing new regulation outright, the backlash from the financial

establishment was both swift and brutal. The President’s working group, consisting of

SEC chairman Arthur Levitt, Treasury Secretary Robert Rubin, and Chairman Alan

Greenspan of the Federal Reserve Board, objected to the concept release, warning that

the release along could “increase the legal uncertainty concerning swaps and other OTC

derivative instruments and, thus, destabilize what has become a significant global

financial market.”18 Even as Born warned that “concerns have also been raised regarding

the potential effect of derivatives losses on the investing public and on the financial

16 ibid, 10. 17 For a full list of abuses in the OTC derivatives market in the mid-1990s See, e.g., Jerry A. Markham, Commodities Regulation: Fraud, Manipulation & Other Claims, Section 27.05 nn. 2-22.1 (1997) (listing 22 examples of significant losses in financial derivatives transactions); 1997 GAO Report (General Accounting Office, GAO/GGD-98-5, OTC Derivatives: Additional Oversight Could Reduce Costly Sales Practice Disputes 3 n.6 (1997) ) at 4 (stating that the GAO identified 360 substantial end-user losses). 18 U.S. Securities and Exchange Commission, “Written Statement Regarding the Regulation of the Over-the-Counter Derivatives Market and Hybrid Instruments,” June 10, 1998.

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system as a whole,”19 her claims were dismissed as crying wolf in what was at the time a

booming economy.

The hedge fund Long-Term Capital Management (LTCM) soon proved Born’s

remarks prophetic. A private investment partnership that managed money for only a

hundred investors and employed fewer than two hundred people, LTCM made the

financial markets hold their collective breath in the fall of 1998. Founded by legendary

bond trade John Meriweather, LTCM was given financing on highly generous terms and

had racked up over 40 percent returns the previous four years. A group of Ph.D.

financial academics formed the core of LTCM, using their collective intellectual power to

create arbitrage formulas that generated massive returns. LTCM had entered thousands

of OTC derivatives contracts with virtually every Wall Street bank, summing to the

mammoth amount of over $1 trillion exposure from only $5 billion in original capital.

When the markets crashed in the fall of 1998, LTCM was at risk of being unable to fulfill

its counterparty obligations. Many major banks would have been left with unsustainable

losses, forcing 14 banks to pay around $400 million each to avert a crisis that could have

affected the entire financial system.20 LTCM’s exposure was not fully known because of

a lack of regulation in the OTC derivative market, enabling them to leverage themselves

at over 200:1.

The shocks of LTCM reverberated throughout Congress, which called hearings to

determine what should be done to strengthen regulatory safeguards on OTCs. Brooksley

Born testified that the “lack of basic information about the positions held by OTC

derivatives users and about the nature and extent of their exposures potentially allows

OTC derivatives market participants to take positions that may threaten our regulated

markets or, indeed, our economy without the knowledge of any federal regulatory

authority.”21 Surely a vindicated Born would spur Congress to establish a regulatory

framework that would prevent such (problems) in the future. However, Alan Greenspan

had other ideas and continued to champion the free market and self-regulation. Shortly

after the LTCM collapse, he equated regulating the OTC derivative market to preventing 19 Brooksley Born, Statement to the U.S. House of Representatives Committee on Banking and Financial Services, Concerning the Over-the-Counter Derivatives Market, Hearing, July 24, 1998. 20Jim Gilmore, The Warning, Written and Directed by Michael Kirk, PBS Frontline. 21 Brooksley Born, “The Lessons of Long-Term Capital Management L.P.” Remarks of Brooksley Born, Chairperson Commodity Futures Trading Commission (Chicago Kent-IIt Commodities Law Institute, Chicago, IL, October 15, 1998).

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people from being stupid, saying, “I know of no set of supervisory action we can take

that would prevent people from making dumb mistakes.”22 The trio of Greenspan,

Treasury Secretary Rubin, and Deputy Secretary of the Treasury Lawrence Summers

then pushed through new regulation that limited the CFTC’s capabilities instead of

regulating OTC derivatives. Congressional legislation mandated that “the Commission

[CFTC] may not propose or issue any rule or regulation, or issue any interpretation or

policy statement, that restricts or regulates activity in a qualifying hybrid instrument or

swap agreement.”23 The CFTC was decimated as an independent regulatory agency, and

OTC derivatives were legally protected as unregulated financial instruments. Born

resigned on June 1, 1999, a casualty of her power struggle with the financial

establishment.

§1.4 – Conclusion

The conflicts of interest that helped lead to the Great Depression were solved

through legislation that produced the FDIC, SEC, and Glass-Steagall. Glass-Steagall’s

firewall between commercial and investment banking created a financial sector that was

not incentivized to take risks. Stable economic growth emerged, characterized by a

noticeable absence of financial crises. But banks began to chip away at regulations, with

some acceleration towards deregulation due to the unintended consequences of

removing barriers to competition. New products such as derivatives challenged

regulators who perhaps did not fully understand the risks they posed. The collapse of

LTCM showed how much of a latent downside risk there was, with a relatively small

firm almost bringing down the entire system. But LTCM and the passionate advocacy of

Brooksley Born occurred at the wrong time—the economy was booming and no end was

in sight. This was the biggest missed opportunity. A chance to bring transparency to the

most opaque of markets was lost, setting the stage less than a decade later for one of the

worst financial crises in American history.

22 Gilmore, The Warning. 23“An Act making omnibus consolidated and emergency appropriations for the fiscal year ending September 30, 1999, and for other purposes.” (PL 105-277, October 21, 1998), 25.

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CHAPTER TWO: THE INADEQUACIES OF DODD-FRANK

The missed opportunities to strengthen and update the Depression-era

regulatory system both portended and foreshadowed the recent financial crisis. The

aftermath of the LTCM bailout resulted in a legislative seal of approval for formalized

unregulated OTC derivatives, setting the stage for a vast increase in the market for these

products over the next seven years. Yet the benefits of economic growth masked the

underlying shaky foundation of the United States’s financial system. It took the largest

crisis since the Great Depression to reveal a complete picture of the regulatory gaps in a

system that was unable to keep up with the increasingly rapid pace of financial

innovation. With the system’s flaws exposed, significant reform was necessary to

prevent another crisis of such magnitude from occurring. Beginning with a March 2009

Senate Committee on Banking, Housing and Urban Affairs hearing titled “Modernizing

Bank Supervision and Regulation,” the reform process culminated one year and three

months later on July 21, 2010 when President Barack Obama signed the Dodd-Frank

Wall Street and Consumer Protection Act into law (referred to here as both “the Act”

and “Dodd-Frank”).

This chapter is divided into three main sections. The first describes the regulatory

gaps exposed by the financial crisis and highlights how large government subsidies to

large, complex financial institutions (LCFIs) posed an interconnected risk to the

financial system and economy as a whole. Section two discusses proposed methods to

create a newly stable financial system and the consensus among experts on the need to

remove the aforementioned government safety net for LCFIs. The third and final section

analyzes the Act’s effect and potential effectiveness in preventing future financial crises.

While Dodd-Frank has produced positive reforms in the form of increased consumer

protection, more transparency in derivatives transactions, and created a system

resolution authority for large, failing banks, the Act ultimately fails to rid the financial

sector of the systemic risk potential posed by too big to fail (TBTF) financial institutions.

§2.1 – Regulatory Shortcomings as Illustrated by Crisis

The 2008 financial crisis was spawned by a complex web of easy credit,

securitized subprime mortgages, banks taking excessive risks, and a level of

interconnectedness between financial institutions. While there is little consensus in

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determining exactly who is to blame for all aspects of the crisis, it is clear that gaps in

the regulatory structure were a powerful factor in creating the conditions for such a

crisis.24 Only in the aftermath of the crisis were the system’s flaws fully exposed.

The financial crisis powerfully attested to the systemic importance of LCFIs and

the risks they pose. The cataclysmic chain of events set off by Lehman Brothers’

bankruptcy on September 15, 2008 taught the costly lesson that institutions of that size

could not be allowed to fail and simply go bankrupt without huge consequences. OTC

derivatives were the unregulated vehicles that led to increasingly swaps coupled with

their false portrayal as risk-free assets. While consumers did purchase subprime

mortgages they could not afford, both shady mortgage brokers and a bipartisan push for

increased homeownership were at fault.

Too Big to Fail and Systemic Risk

The taxpayer-funded bailouts of the financial sector illustrated the systemic risk

posed by firms of a certain size. These bailouts were the first explicit display of a central

implicit government policy of the last thirty years: a government safety net that

subsidized risk-taking. Such an implicit subsidy or guarantee had a pricing effect on

capital markets, giving large banks a distinct advantage. Both before and during the

crisis, “LCFIs operated with much lower capital ratios and benefited from significantly

higher stock prices (adjusted for risk) and much lower funding costs compared to

smaller banks.”25 Lower capital ratios allowed large banks to take on more risk than a

smaller bank had they had the same amount of assets. The biggest players were thus

incentivized to take the most risk, having internalized the benefit of public support in

the event of a crisis. Debt-to-equity (or leverage) ratios substantiate the ability of large

firms to ‘leverage up,’ with the top five investment banks having leverage ratios between

26 and 34 to 1 at the end of 2007, compared to only 13 to 1 for the average commercial

bank.26

24 The history of the regulatory system’s slow erosion is further detailed in the preceding chapter. 25 Arthur E. Wilmarth, Jr, “The Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-to-Fail Problem” (Oregon Law Review Vol. 89 2011), 981. 26 U.S. Government Accountability Office, “Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System” (GAO-09-219, Washington: 2009), 20.

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The 2004 Consolidated Supervised Entities (CSE) program implemented by the

SEC perfectly illustrates the inability of regulators to deal with the risk posed by LCFIs.

A voluntary program that lacked the necessary mechanisms to enforce capital

requirements on big banks, the CSE failed to rein in LCFIs’ risk-taking behavior. In

effect, it actually outsourced control of these minimum capital requirements to the

banks which were being regulated.27 The danger of such high leverage is displayed by

the story of Bear Stearns:

Bear Stearns’s leverage reached a ratio of thirty-three to one, meaning that

if its assets fell by 3 percent the bank would be insolvent; it was the first to

fall in 2008 when rumors that it might be insolvent caused its short-term

funding to dry up in a matter of days.28

In the face of obvious ineffectiveness, the CSE program was suspended following

Lehman Brothers’ bankruptcy and the fire-sale of Merrill Lynch to Bank of America.

Then-SEC chairman Christopher Cox succinctly summed up this episode, saying, “the

last six months have made it abundantly clear that voluntary regulation does not

work.”29

The systemic risk posed by LCFIs was displayed in the taxpayer-funded bailouts

undertaken in response to the financial crisis. Warning signs existed in hindsight, as

financial conglomerates grew larger and more complex in a spate of mergers and

acquisitions. For example, “by 2005, the 10 largest U.S. commercial banks held 55% of

the industry’s assets, more than double the level held in 1990.”30 With no way to seal

securities trading from ordinary, commercial banking following the 1999 repeal of

Glass-Steagall, the FDIC guarantee on deposits was implicitly extended to the

investment banking parts of LCFIs. The government guarantee of debt issued to banks

following the crisis allowed them to raise money from private investors that would

effectively be risk-free because of its government backing. The largely unconditional

27 The five participants in the program: Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley. 28 Johnson and Kwak, 225. 29 U.S. Securities and Exchange Commission, “Chairman Cox Announces End of Consolidated Supervised Entities Program,” (Press Release 2008-230) Washington, DC: September 26, 2008. 30 Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (Washington: Government Printing Office 2011), xvii.

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bailouts of the financial sector reaffirmed the previously implicit government safety net

in the most explicit of manners. As Governor of the Bank of England Mervyn King noted

in 2009, this “massive support extended to the banking sector…, while necessary to

avert economic disaster, has created possibly the biggest moral hazard in history.”31

Derivatives

While the implicit and explicit government subsidy to LCFIs was manifested in

low capital requirements and post-crisis bailouts, the continued existence of these large

institutions does not fully explain what made this crisis so catastrophic for the entire

global economy. The vast expansion of derivatives following their 2000 deregulation

and the level of innovation in these products is largely responsible for creating

previously unseen levels of systemic risk throughout the financial system.

The term derivative itself “is simply a label for a financial product whose value

‘usually depends on the value of an underlying asset price, reference rate, or index.’”32

Over-the-counter derivatives (OTCs) are privately negotiated options or forwards

contracts that are not traded on an exchange, and thus customizable.33 One common

type of derivative that exploded in usage following 2000 was the credit default swap

(CDS), which is an insurance-like agreement where the seller of a CDS covers the

buyer’s loss in case of a credit event (e.g. default) in exchange for a premium.34 The size

of the CDS market in the United States grew from $6 trillion dollar in 2004 to over $58

trillion by 2007, a remarkable 850% increase.35

OTC derivatives do have significant theoretical benefits as tools to disperse and

better allocate risk across the financial system and broader economy. Southwest Airlines

successfully secured low fuel prices for years by negotiating long-term options deals.

Financial institutions can similarly use OTC derivatives to shift credit exposure to other

counterparties, allowing them to initiate more loans and thus generate more income.

31Mervyn King, “Speech to Scottish business organizations, Edinburgh,” October 20, 2009, 4. 32 Lily Tijoe, “Credit Derivatives: Regulatory Challenges in an Exploding Industry” (Boston University Review of Banking and Financial Law, 2007), 388. 33 Options are rights to buy or sell a reference asset at or before a deadline at an agreed-on price. Forwards are similar to options but oblige the delivery of a reference asset at a future date. 34 Usually either monthly, quarterly, or annually. 35 U.S. Government Accountability Office (GAO-09-216), 40.

19

This transfer of risk throughout the system thus theoretically leads to the better

allocation of capital.

The decades-long embrace of financial innovation led to a regulatory climate with

capital requirements as the only protection against risk shifting. Securitization had

falsely created the concept that a reduction in credit risk warranted a reduction in

minimum capital requirements. Derivatives, because of their seemingly low risk and

high return, prompted a shift from usage as a hedging tool to one of outright

speculation.36 As of 2007, ten of the top Wall Street firms held over two-thirds of all

CDSs.37 Combined with a large variety of participants in the OTC derivatives market,38

any credit event posed systemic risk to such an interconnected system.

The financial crisis exposed multiple types of risk posed to the system that were

previously not internalized by firms. Counterparty risk could anecdotally be described as

the ripples generated by the falling rock of a burst asset bubble, most recently the

housing market. AIG (American International Group) built up an egregiously one-sided

portfolio of CDSs and proved unable to pay off CDS buyer counterparties across the

system. An $85 billion government bailout was necessary to pay off these

counterparties, illustrated in the table below taken from in Acharya et al (2011), titled

“AIG Financial Products Counterparty Payments”: 39

36 Viral V. Acharya and others. “Market Failures and Regulatory Failures: Lessons from Past and Present Financial Crises” (Asian Development Bank Institute Working Paper Series No. 264, February 2011), 12. 37 Tijoe, 404. 38 Including commercial banks, investment banks, corporations, money managers, mutual funds, hedge funds, and pension funds) 39 Edmund L. Andrews, “Fed rescues AIG with $85 billion loan for 80% stake,” New York Times, September 17, 2008. Chart from Acharya et al, 19.

20

The AIG bailout also exposed the risk of opacity to financial markets. With most

innovation focused on sharing risk through opaque, off-market transactions, the

bilateral nature of contracts did not create a mechanism to determine concentrations of

counterparty risk. For example, Société Générale or Deutsche Bank, two of Europe’s

biggest banks, had no way of knowing AIG’s huge one-way exposure when purchasing

CDSs from AIG.

The shadow banking system of OTC derivatives, due to lowered capital

requirements, interconnectedness, counterparty risk, and opacity was subject to the

same bank-like runs that the entire United States regulatory system had been intended

to prevent. Together with the implicit government incentives to grow to a too-big-to-fail

size, financial innovation exposed a regulatory system in dire need of fixing and

updating. The financial crisis provided a resounding verdict that deregulation über alles

did not work and that the entire regulatory system was in urgent need of overhaul.

§2.2 – Independent Perspectives on Fixing the Financial System

Much as consensus does not wholly exist on whom to blame for the financial

crisis, expert positions on an ideal response have also varied. However, just as the

failure of deregulation has gained broad credence, so have certain principles necessary

to create effective regulation (notwithstanding the claims of financial lobbyists). Before

21

analyzing what Dodd-Frank did for financial reform, it is important to establish what

effective reform would entail. Broadly, the removal of a government safety net for LCFIs

must eliminate the possibility and expectation of future bailouts. While some argue that

limiting bank size is necessary, others believe that if LCFIs are forced to internalize the

costs of systemic risk and face capital markets, they will be forced to downsize without

the need for government legislation. Combined with increased transparency in

derivatives trading, these reforms would help prevent systemic risk. In addition, this

section will address the case for re-instituting Glass-Steagall’s wall between commercial

and investment banking.

At the most basic level, effective regulation incorporates the overarching goal of

transforming the financial sector, the symbol of Western capitalism, from being the

most heavily subsidized US industry to facing competition on the free market. Acharya

et al (2011) provide a comprehensive framework for reining in the incentives LCFIs have

to take risks. Under this framework, firms should be made to internalize costs by paying

for guarantees they receive implicitly by paying for the sum of expected loss by the firm

on default combined with the firm’s “contribution to a systemic crisis.”40 Substantially

higher capital requirements for riskier exposures could even create a returned

separation of banking activities by market-driven forces rather than legislation. The

need for transparency in derivatives would cause CDSs to be traded in the open on

central clearinghouses and exchanges to mitigate the counterparty risks seen in the

previous section with AIG. This combination of solutions proposed by Acharya et al

would reform the financial sector by eliminating the risk-taking incentives that create

systemic risk.

Many agree that the “primary objective of regulatory reforms must be to

eliminate (or at least greatly reduce) TBTF subsidies, thereby forcing LCFIs to

internalize the risks and costs of their activities.”41 However, the methods for

permanently removing that subsidy vary and generally split into two camps: one that

argues market forces will break up large banks on their own once subsidy and implicit

support are removed. The second reasoning proposes a hard cap on bank size as a

percentage of GDP as an elegant solution. Both agree and demonstrate that the

40 Acharya et al, 11. 41 Wilmarth, 954.

22

supposed economies of scale for large financial conglomerates simply do not exist. In

fact, without the TBTF subsidy, large banks have failed to prove more efficient than

midsize banks.42 Regardless of these differences, though, widespread agreement exists

that the continued subsidized existence of “big banks” poses a systemic risk to the

financial system and economy as a whole.

The need to reform derivatives trading has also been widely seen as necessary to

prevent an opaque market with the potential for systemic contagion. In accordance with

the Modigliani-Miller Theorem of capital allocation, “choosing investments should be

based solely on whether the return on the project’s assets exceeds its cost of capital for

those assets.”43 This school of thought proposes an accurate accounting and

internalization of long-term downside risk to ensure banks have an incentive to make

such calculations. A mechanism of contingent capital is also seen as extremely

important in forcing LCFIs to act in their clients’ best interest by knowingly maintaining

a share of a transaction’s risk. Economist Raghuram Rajan emphasizes the need to

account for tail-end, low-probability events in order to prevent short-term speculators

from creating a possible asset bubble. The logical method to implement such a

suggestion would be a type of escrow, where key members of a firm would have to

maintain certain amounts of capital during and after employment, giving those in

charge the incentive to pursue long-term sound policy rather than short-term

profiteering.44

The issue of protecting consumers and investors springs directly out of the

opacity of structured financial products such as OTC derivatives. Financial innovation

created products barely understood by those within the finance world, leaving

institutional investors such as pension funds little chance to comprehend a product’s

underlying components. Requiring clarity in end products such as mortgages is a

42 Stephen A. Rhoades, “A Summary of Merger Performance Studies in Banking, 1980–93, and an Assessment of the ‘Operating Performance’ and ‘Event Study’ Methodologies,” Federal Reserve Board Staff Studies 167, summarized in Federal Reserve Bulletin, July 1994, available at http://www.federalreserve.gov/Pubs/staffstudies/1990–99/ss167.pdf: “In general, despite substantial diversity among the nineteen operating performance studies, the findings point strongly to a lack of improvement in efficiency or profitability as a result of bank mergers, and these findings are robust both within and across studies and over time.” 43 Acharya et al, 24 44 See both Raghuram Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton: Princeton University Press, 2010), 114 and Wilmarth, 1009.

23

complementary but important reform needed to prevent duplicity and deception.

Similar transparency within credit rating agencies would ensure that an often-used

proxy to determine an investment’s level of risk is accurate and honestly produced.

An effective response to the financial crisis would have the primary goals of

eliminating implicit government support for large firms and preventing the myriad risks

posed by opaque, two-party transactions. In addition, effective reform would eliminate

the information asymmetry between creators of financial products and end-use

consumers, along with ensuring accountability among credit rating agencies. The FDIC

guarantee on commercial deposits was transferred to financial conglomerates with the

repeal of Glass-Steagall in 1999. Many across the political spectrum have argued that a

renewed wall between commercial and investment banking is necessary to eliminate the

same conflict of interest within banks that helped cause the Great Depression. Having

established what ‘good’ regulatory reform would look like in this section, the next

section evaluates the Dodd-Frank Act’s success in plugging the holes in the United

States’s regulatory system.

§2.3 – What Dodd-Frank Does

Signed into law on July 21, 2010, the Dodd-Frank Wall Street Reform and

Consumer Protection Act purports to prevent the possibility of another financial crisis.

President Barack Obama declared the bill a momentous blow to crony capitalism in the

financial sector, saying,

Our financial system only works – our market is only free – when there are

clear rules and basic safeguards that prevent abuse, that check excess, that

ensure that it is more profitable to play by the rules than to game the

system. And that’s what these reforms are designed to achieve -- no more,

no less.45

Yet over a year and a half following the bill’s passage, it is unclear how much progress

has truly been made. While regulation of large banks has strengthened, the systemic

importance of large firms has not been reduced to the point where future government

rescue is unlikely. Multiple amendments have sought to limit speculative activity with

45 Barack Obama, “Remarks by the President at the Signing of Dodd-Frank Wall Street Reform and Consumer Protection Act,” Ronald Reagan Building, Washington, DC, July 21, 2010.

24

federal safety net subsidies but have subsequently become loophole-laden. Bright spots

include a consumer protection agency with significant potential to reduce end-user

fraud as well as increased transparency to derivatives transactions. Above all, however,

the Dodd-Frank Act emerged as the longest, most complex financial reform bill in U.S.

history by an order of magnitude. This section highlights the most important positive

and negatives associated with the Act, using the previous section as a guide to effective

regulation.

Ending Too Big To Fail?

The Dodd-Frank Act addresses the previously-explained too big to fail problem in

two ways – by creating a new category of systemically important financial institutions

subject to more stringent regulation and through the new Financial Stability Oversight

Council (FSOC), composed of the heads of certain federal regulatory bodies and chaired

by the Secretary of Treasury. The intention of this two-pronged approach is to increase

large banks’ capital requirements and reduce risk of a bailout while centralizing the

crisis prevention facilities within one body, that is, the FSOC. Under Dodd-Frank, the

regulatory authority for the Federal Reserve Board (hereafter referred to as the “Board”

or the “Fed”) has expanded significantly. It is now exclusively responsible for bank

holding companies and savings and loan holding companies with total consolidated

assets of $50 billion, as well as Board-supervised nonbank financial companies.46 The

powers granted to the Board are broad and discretionary. Should any bank holding

company be deemed “a grave threat to U.S. financial stability,” the Board is required to

take action, choosing from options such as restricting a company’s ability to offer

specific products for forcing asset transfers to other unaffiliated entities.47

But the rulemaking for this special category of banks does not apply only in

situations of crisis: the Act prescribes a special set of new rules for these large financial

institutions. These rules are laid out in broad strokes—prudential standards must be

more stringent than those for banks that pose less risk and have the possibility of

increasing stringency under certain circumstances. Banks must periodically submit

“their plans for rapid and orderly dissolution in the event of material financial distress

46 “Dodd-Frank Wall Street Reform and Consumer Protection Act,” (PL 111-203, July 21, 2010), §318. 47 Dodd-Frank, §121.

25

or failure,”48 colloquially known as living wills. This provision serves the theoretical

purpose of forcing banks to acknowledge their credit exposure and reduce opaque, off-

balance sheet risk. This section of the Act also requires annual stress tests to determine

a bank’s soundness in the face of a crisis such as a further drop in housing prices or a

breakup of the Eurozone. The section even requires a 15:1 cap on debt to equity ratio in

LCFIs, but only if the FSOC determines “that the company poses a grave threat to the

U.S. financial stability and that this requirement is necessary to mitigate that risk.”

The Act creates the Financial Stability Oversight Council and tasks it with the

Herculean agenda of identifying risks to U.S. financial stability, promoting market

discipline by eliminating expectations of future bailouts, and responding to emerging

threats to the system.49 Specific duties of the FSOC include identifying regulatory gaps,

making recommendations on LCFI requirements to the Board, and identifying

systemically important financial market utilities and activities. A tall order for the

Justice League, let alone a council that meets only sporadically!

While a dual approach to TBTF regulation appears effective on the surface, the

Act fails to address the core problem posed by a continued government safety net.

Creating a separate regulatory category for LCFIs entrenches the implicit guarantee of

systemic importance, confirming in a roundabout fashion that these firms will not be

allowed to disappear from existence. In order to understand why this perception is

shared by LCFIs, one must look no further than basic statistics: the largest firms are

even bigger than before the crisis.50 It is difficult to take a parent seriously who yells “no

more ice cream!” to a child scraping the bottom of a half-gallon carton of Ben and

Jerry’s. Is it beyond the realm of expectation to think a bank having just received

billions might not be convinced the bailout spigot has gone forever dry? And only

because of new, more “stringent” capital requirements and a special categorization?

Viewing the Act’s approach of LCFIs in the context of past bailouts shows an

unwillingness on the part of legislators to take the bold steps necessary to remove the

expectation of government bailouts. In this specific instance, the status quo has barely

shifted, putting lipstick on the pig that is the policy of too big to fail.

48 Dodd-Frank, §165c. 49 Dodd-Frank, §112. 50 See Simon Johnson, “Too Big to Fail Not Fixed, Despite Dodd-Frank.” Bloomberg, October 9, 2011.

26

Perhaps the most important product of the Act relating to LCFIs is the

establishment of an orderly liquidation (OLA) “that should provide a superior

alternative to the choice of ‘bailout or bankruptcy’ that federal regulators confronted

when they dealt with failing SIFIs [systemically important financial institutions] during

the financial crisis.”51 This title of the Act appoints the FDIC as the receiver for

distressed financial companies52 once the President or Secretary of Treasury has

deemed a financial company in danger of default or of posing systemic risk to the U.S.

financial system.53 In addition, the Act requires that all companies placed into

receivership must be liquidated. Use of taxpayer funds is specifically prohibited from

preventing liquidation. The FDIC is a logical place to have this liquidation authority—it

has had success winding down smaller banks in its receivership in the past.

However, this authority also lacks teeth in several major respects. The first

problem is posed by the definition of LCFIs: They are complex, often global institutions.

As economist Simon Johnson notes, “The resolution authority under Dodd-Frank is

purely domestic—there is no cross-border dimension. This presents a major problem if

large financial institutions, which typically have extensive international operations, need

to be shut down in an orderly way.”54 Without a level of international coordination

currently not in place, a complex wind-down of an international financial company with

a large U.S. presence would be next-to-impossible. It is also not apparent that an OLA in

place prior to the 2008 financial crisis would have had much effect. The OLA process

requires FSOC approval, placing even more decisionmaking power in the Treasury

Secretary’s hands, who happens to be the least independent actor possible as a direct

appointment by the President! The OLA provides a reassuring framework and a

powerful dissuasive tool, if only through its sheer existence. It remains to be seen how

effective a mechanism it would be in the case of another financial crisis.

Derivatives and Systemic Risk

The second key component to financial reform, laid bare by the crisis and

affirmed by various experts, was the need to update the regulatory regime to deal with

51 Wilmarth, 955. 52 Dodd-Frank, §202. 53 Dodd-Frank, §203. 54 Johnson, “Too Big to Fail Not Fixed, Despite Dodd-Frank.”

27

innovative financial produces (described here mainly as derivatives). Title VII of the Act

deals with derivatives in the form of the Wall Street Transparency and Accountability

Act of 2010. Major steps are taken to increase transparency by prohibiting federal

assistance to a “swaps entity” in case of crisis if certain types of swaps are cleared by

derivatives clearing organizations (DCOs).55 Clearing organizations will significantly

help in the standardization of swaps. Other parts of the Act require maintenance of

adequate capital levels as collateral for swaps transactions to be cleared.56 Particularly

important is the amendment to the Commodity Exchange Act (CEA) that requires

“segregation of a counterparty’s assets to be held as collateral in over-the-counter swaps

transactions not submitted for clearing to a DCO.”57 The Act even repeals the Gramm-

Leach-Bliley Act’s prohibition on the regulation of swaps-related agreements. From

these key changes above, derivatives legislation clearly has improved under the Dodd-

Frank Act.

Yet the Act undermines its own effectiveness with the loopholes it grants to the

banks. The section immediately following the repeal of Gramm-Leach-Bliley provides

the perfect example. Not only does it grant counterparties the voluntary choice to

enforce an exception for hedging and mitigating risk, but it also “authorizes such a

counterparty to any security-related swap that is not subject to the mandatory clearing

requirement to elect to require clearing of the swap.”58 The decision whether or not to

submit to necessary but time-consuming, paper-filled clearing of a swap is sheer error—

one does not elect to carry a driver’s license, one must (even if it often requires three-

plus hours at the DMV). Similarly, the second-to-last section of Title VII entrusts great

power to the same regulators who failed to protect or warn of the recent financial crisis.

The SEC is given “general exemptive authority” on security-related swaps and the

granting of exemptions for certain activities such as hedging.59 The exemptions to

derivatives legislation thus mostly render new increases in transparency moot and in a

way return the regulation of derivatives to the pre-crisis status quo.

55 Dodd-Frank, §716. 56 Dodd-Frank, §723. 57 Dodd-Frank, §742. 58 Dodd-Frank, §763 (emphasis added). 59 Dodd-Frank, §772.

28

The Act does make one other attempt to prevent systemic risk to the financial

system with the “Volcker Rule”—named after its most vigorous advocate, former

Chairman of the Federal Reserve Paul Volcker. The rule institutes a ban on proprietary

trading, barring institutions that receive federal subsidies from speculating with

taxpayer and government funds. Volcker served as the point man for the rule, arguing

that such inherent conflicts of interest create undue hazard and must be prevented. In

its idealized conception, the rule could serve as an elegant reinstatement of Glass-

Steagall, forcing banks that wish to maintain FDIC-insured status to spin off or

discontinue their proprietary trading activities. But the final product of the rule as

embedded in Dodd-Frank tells a different story than that conjured by the rule’s

namesake. Full of loopholes and exemptions for “hedging” and “market-making

activities,” the first version of the proposed rule ran over 500 pages long and incredibly

complex. At the time of writing, an extended comment period for the rule is still open,

yet much of its elegance and simplicity has been destroyed. A promising rule that had

teeth for those in the banking industry has been worn down to a nub and is unlikely to

perform its assigned task of wholly preventing proprietary trading. As stated earlier, in

order to remove regulatory gaps, incentive structures for financial institutions had to be

significantly modified. The process of the Volcker Rule’s dilution illustrates how difficult

it is to alter those incentives.

The most interesting subplot regarding what the Dodd-Frank Act actually does

revolves around the creation of an agency dedicated to protecting consumers from

fraud, the Consumer Finance Protection Bureau (CFPB). Inspired by former Harvard

professor Elizabeth Warren, the CFPB’s job is to protect end-users (e.g. consumers or

the apocryphal average American) from fraud in mortgage lending, credit card

agreements, and student loans. Warren originally laid out the case for increased

consumer protection in 2007, writing that “credit products…are regulated by a tattered

patchwork of federal and state laws that have failed to adapt to changing markets.”60

Consumers needed one agency to clarify loans and their contents, ending the predatory

practices that helped sell so many subprime loans to people who could not afford them.

Warren’s views soon gained traction among powerful allies. Former Chairman of the

60 Elizabeth Warren, “Unsafe at Any Rate,” Democracyjournal.org, (Summer 2007), 9.

29

Senate Committee on Banking, Housing, and Urban Affairs Christopher Dodd’s initial

remarks on financial reform even put consumer protection on the same level of

importance as systemic risk prevention, saying, “Systemic risk is important – but no

more so than the risk to consumers and depositors, the engine behind our banking

system.”61 Dodd went a step further in remarks to the [committee name] the next week,

placing the primary cause of the financial crisis the lack of consumer protection: “In a

crisis created first and foremost by a failure to protect consumers, we cannot afford to

consider a so-called ‘systemic risk regulator’ without also considering how we can better

protect the consumer.”62 The CFPB emerged from Dodd-Frank as a powerful new

agency with a clear mission, a bright spot in an otherwise complex and often

contradictory bill. The following chapter evaluates why such emphasis was placed on

consumer protection in response to a crisis whose causes were both myriad and largely

private sector-driven.

§2.4 – Conclusion

The aims of this chapter were threefold: To describe the flaws in the regulatory

structure exposed by the financial crisis, to review independent opinion on optimal

regulatory solutions, and to evaluate the Dodd-Frank Act’s potential effectiveness in

preventing another financial crisis. The primary conclusion can be plainly stated: This

bill is inadequate. A silver lining does exist; the Act improves regulation in a few

concrete ways. The OLA will give regulators more options than the choice between

bailout and bankruptcy they faced during the crisis. Exchange-traded derivatives offer

more transparency, and there is a “likelihood that the CFPB will act decisively to prevent

further lending abuses from threatening the stability of our financial system.”63

But the core government safety net remains, as do TBTF institutions. Historian

George Santayana once made the famous statement, “Those who cannot remember the

past are condemned to repeat it.” The Act’s continued reliance on the same capital

61 Christopher Dodd, Statement to the U.S. Senate Committee on Banking, Housing, and Urban Affairs. Opening Statement of Chairman Christopher J. Dodd: “Modernizing Bank Supervision and Regulation,” Hearing, March 19, 2009. 62 Christopher Dodd, Statement to the U.S. Senate Committee on Banking, Housing, and Urban Affairs. Opening Statement of Chairman Christopher J. Dodd: “Modernizing Bank Supervision and Regulation, Part II,” Hearing, March 24, 2009. 63 Wilmarth, 1053.

30

requirement-based regulation and the same federal agencies that failed to prevent the

previous crisis fit Santayana’s aphorism with uncanny accuracy. David Skeel picks up on

this trend, specifically on the fact that failed regulators have been given more power

without changing the regulatory status quo: “Dodd-Frank enshrines a system of ad hoc

interventions by regulators that are divorced from basic rule-of-law constraints. The

unconstrained regulatory discretion reaches its zenith with the new resolution rules for

financial institutions in distress.”64 By granting regulators the power to pick and choose

whom to take over, as well as picking and choosing among creditors, the Act ensures

that decisionmaking authority rests with politicians and their appointees rather than

specified, legislated process.

Much criticism of the Act focuses on its failure to address adequately the causes

of the financial crisis. Remarkably, the Act has also inspired criticism that it over-

regulates: Compliance with its 400-odd rules will entail high costs. The big risk,

according to the Economist, is that “the Dodd-Frank apparatus will smother financial

institutions in so much red tape that innovation is stifled and America’s economy

suffers.”65 One example from Dodd-Frank is sections 404 and 406. These two sections,

totaling a few pages, resulted in a form for hedge funds 192 pages long that will cost an

estimated $100 to 150 thousand to fill out initially and a subsequent $40 thousand each

subsequent year. Bankers have largely opposed the Act, and while they do not hold the

moral high ground concerning the moral high ground, some points address legitimate

concerns. JPMorgan Chase CEO Jamie Dimon elaborated on the problem of the politics

of overregulation in his annual letter to shareholders:

As a result of Dodd-Frank, we now have multiple regulatory agencies with

overlapping rules and oversight responsibilities. Although the FSOC was

created, it is proving to be too weak to effectively manage the overlap and

complexity. We have hundreds of rules, many of which are uncoordinated

and inconsistent with each other. While legislation obviously is political,

64 David A. Skeel, Jr, “The New Financial Deal: Understanding the Dodd-Frank Act and its (Unintended) Consequences” (University of Pennsylvania Law School: Institute for Law and Economics Research Paper No. 10-21, 2010), 8. 65 “The Dodd-Frank Act: Too Big Not to Fail,” The Economist (February 18, 2012).

31

we now have allowed regulation to become politicized, which we believe

will likely lead to some bad outcomes.66

Uncoordinated and overlapping rules will be an inevitable byproduct of any large-scale

piece of reform legislation. It is possible that the Act’s complexity will over-regulate and

create the possibility of more systemic risk over time through loopholes and exceptions.

Dimon’s argument must be taken with a grain of salt, however, as financial industry

lobbyists are largely responsible for the myriad loopholes and incredible complicated

nature of Dodd-Frank.

Nevertheless, it is true that the formidable size and complexity of the Act presents

another barrier to effective reform. It requires visual demonstration to compare the Act

to previous financial reforms:

Even more shocking, an act that runs over 2,000 pages and took 15 months to craft

prescribes many rules to be written rather than writing them into the Act itself. Stacy

Kaper (2010) calculates that federal regulators’ workload is to complete 243 rules, 67

one-time reports and studies, and 22 periodic reports.67 At the time of writing, only

30.2% of deadlines for the rulemaking process have been met with finalized rules.68 This

process also leaves the door open for significant post-Act lobbying, with the possibility

that “decisionmakers will be opportunistically lobbied to scale back taxpayer and

66 Julia La Roche, “Here’s the Massive Chart Jamie Dimon Used to Explain Why More Regulations are Going to Screw Up Wall Street,” Business Insider, April 5, 2012. 67 Stacey Kaper, “Now For the Hard Part: Writing All the Rules,” American Banker (July 22, 2010), 35. 68 Dodd-Frank Progress Report: April 2012, Davis Polk & Wardwell LLP (Manhattan, New York).

0

500

1000

1500

2000

2500

Dodd-Frank Act (2010): 2,319 pages

Gramm Leach Bliley Act (1999): 145 pages

Sarbanes-Oxley Act (2002): 66 pages

Riegle-Neale Act (1994): 61 pages

Glass-Steagall (1933): 37 pages

Federal Reserve Act (1913): 31 pages

32

consumer protections to sustain opportunities for extracting safety-net subsidies.”69

What is left is a bill that itself seems Too Big to Fail.

Having established both the historical deregulatory trend of the past 30-plus

years as well as the Dodd-Frank Act’s failure to produce clear, comprehensive, and

enforceable reform, the big question that bears answering is why the outcome of the Act

was the one that happened. What forces shaped the Act’s formation? How did a need for

reform endorsed by those across the political spectrum get so badly mangled? Why is a

clear national interest in preventing future bailouts to LCFIs not explicitly written into

law? The next chapter seeks to answer these questions by turning to a long and large

political science literature to analyze the legislative process, the actors involved, and

determine if the Dodd-Frank Act conforms to the theories advanced by this literature.

69 Edward J. Kane, “Missing Elements in US Financial Reform: A Kübler-Ross Interpretation of the Inadequacy of the Dodd-Frank Act” (Journal of Banking and Finance, May 2011), 7.

33

CHAPTER THREE: WHY DODD-FRANK IS INADEQUATE

The shortcomings of the Dodd-Frank Act being established in the previous

chapter, the question begs asking of what makes this act inadequate. In the rare case of

a bipartisan national interest in creating a more effective regulatory system, why was

reform so ineffective yet complex? To evaluate this problem properly, one must look at

the political actors involved and their motivations. The field of political science has a

large literature devoted to studying the incentives facing politicians and legislators. This

chapter uses that literature to generate a constituency-driven framework to better

analyze the Dodd-Frank Act. This simple hypothesis contrasts the president as a leader

with a national constituency against a congressman representing a specific district or

state. For coherent regulatory reform to occur, this theory requires significant

presidential involvement in the legislative process, for multiple reasons. This chapter

analyzes the extent of presidential involvement across areas of financial reform. It does

not attempt to explain all aspects in the long, winding process of reform, but rather

provide a framework for analysis and explanation that allows conclusions to be drawn

about this specific Act and, more broadly, the process of legislative reform in the 21st-

century United States.

This chapter is divided into three main sections, focusing in turn on the

presidency, the Congress, and the post-Act rulemaking process. Section one provides the

theory behind the president representing the national interest and the presidential

ability to influence the legislative process. It then analyzes the extent of President

Obama’s involvement in the legislative process and the subsequent effectiveness in the

areas of his activity. The second section discusses the localized constituencies of

congressmen and the unique reelection pressures they face. The influence of organized

interests creates incentives that make cohesive reform unlikely to ever emerge directly

from Congress. The final section demonstrates how post-Act rulemaking procedures

favor business interests in general and explain the effectiveness of lobbying efforts

following the passage of Dodd-Frank.

§3.1 – Presidential Involvement

The President of the United States is the only representative elected by the

country’s entire population – the tribune of the people. Much literature is devoted to the

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aphorism that all politicians are reelection-driven, beginning with David Mayhew’s

seminal work Congress: The Electoral Connection. This should hold as true for

presidents as it does for other elected officials. As the only nationally-elected politician,

the president is the most powerful advocate for the national interest, for what is

objectively best for the country. But presidents have term limits: What explains their

actions when they do not face reelection? Much can be attributed to the presidential

obsession with legacy. No president wishes for the blame for a crisis to rest on his

shoulders for posterity, hence the Bush Administration’s frantic effort to provide

emergency relief to the financial sector late in 2008. Whether motivated more by legacy

or reelection, presidents are the most likely out of all politicians to act on behalf of the

nation. Keeping these likely motivations for presidential decisionmaking in mind, it

follows to assess how a president can influence the legislative process to produce clear,

enforceable laws that benefit the national interest.

While the president cannot determine legislative outcomes on his own (the

separation of powers enshrined in the Constitution prevents this), he has the ability to

dictate much of the process. The agenda-setting power of the president is well

documented, both anecdotally and empirically. Even though scholars such as

Rudalevige make the point that presidents do not always dominate legislative outcomes,

active presidents have both the will and the ability to dominate the legislative agenda.70

A president must actively involve himself early in the legislative process by setting the

agenda, or influence is inevitably lost. Matthew Beckmann notes many of the corollaries

to this concept: The prerequisite to presidential influence is presidential involvement,

success in key votes for presidents is plainly rooted in the ‘early game,’ and the key

finding that presidential lobbying is necessary to increase the prospects of legislative

success.71 In order for a president to influence a legislative process in his favor, he must

actively set the agenda while subsequently convincing key players to follow his vision

early on, long before a vote is taken on the final version of a bill. To what extent did

President Obama actively set the agenda for financial reform, and how much political

capital did he expend lobbying for votes?

70 Andrew Rudalevige, “The Executive Branch and the Legislative Process,” In The Executive Branch, edited by Joel D. Aberbach and Mark A. Peterson (New York: Oxford University Press, 2005), 445. 71 Matthew N. Beckmann, Pushing the Agenda: Presidential Leadership in U.S. Lawmaking, 1953-2004 (Cambridge University Press: New York, 2010), 21-22.

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It is quite difficult to interpret presidential intentions and determine where so-

called political capital is intended to be spent. Without interview access, one can rely

only on public source data such as speeches and secondary sources. However, in the

case of President Obama, a detailed economic policy memo from economic adviser

Larry Summers to the president-elect in December 2008 was recently made available.

As a blueprint for the president’s first-term economic policies, it provides a revealing

glimpse of priorities as well as political realities. Crafting a financial stimulus package

was the economic team’s first priority; it was necessary to jumpstart the economy with a

combination of government infrastructure projects and tax cuts. But the memo also

reveals an integral part of financial reform: the timing. “The new Administration has an

opportunity to lead forcefully on this issue right away, and we will have to move quickly

to shape…a credible reform agenda.”72 The crisis clearly illustrated the need for an

update to the financial regulatory system, and Larry Summers and Obama’s economic

team recognized the need to move quickly. Summers argues, “We want to be in a

position where, within thirty to forty-five days of taking office, the new Administration

can present the broad outlines of a reform plan that would offer the prospect of a more

stable financial system.”73

But President Obama did not turn to financial reform immediately after the

stimulus. Health care reform soon became the Administration’s primary goal, and

Obama’s first major speech on financial reform did not occur until September 15, 2009

on the one-year anniversary of Lehman Brothers’ bankruptcy, a full nine months after

he took office. While the concept of political momentum is not evidenced in any

scholarly literature, common sense indicates that the greatest chance for meaningful

reform comes directly after a crisis occurs. For one, the crisis is fresh in the minds of

voters and thus the politicians they elect. And secondly, there was even significant

bipartisan consensus that reform was needed, with ranking Republican on the Senate

Banking Committee Richard Shelby saying in March 2009, “I believe that we have to

72 Lawrence Summers, “Update on Economic Policy Work,” Larry Summers to President-Elect Barack Obama, December 15, 2008, 42-3. 73 “Update on Economic Policy Work,” 43.

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have a new regulatory regime for our financial system.” He even added that “sweeping

legislation” would be needed.74

When President Obama did pivot to financial reform, his immediate commitment

focused more on keeping campaign promises than on comprehensive reform, a stance

evident in the aforementioned memo. Among the early steps advocated:

…are campaign promises such as the Credit Cardholder bill of rights,

which bans certain practices, some of which have already been banned by

the Federal Reserve, and the STOP FRAUD Act, which, among other

things, creates a federal definition of mortgage fraud and allocates

additional law enforcement resources to combat fraud and increase

consumer protection.75

Consumer protection had been a clear priority for the Obama administration from the

campaign onward. The president forcibly deployed his agenda-setting power in this

arena, irrespective of the centrality of consumer protection to preventing another crisis.

Consumer champion Elizabeth Warren provided testimony to the House Financial

Services Committee in June 2009, making an impassioned case that consumer

protection would reduce systemic risk and permit increased financial innovation.76

President Obama’s sustained advocacy made the final version of a consumer protection

agency, the Consumer Financial Protection Bureau (CFPB), an agency with a chance to

succeed in its assigned task. Yet his unwillingness or inability to throw similar weight

behind other aspects of financial reform meant the task would be delegated to Congress.

Why did Congress fail to produce clear and comprehensive reform? Was it sheer

ineptitude, or was the task given to Congress simply impossible without further

executive involvement?

Out of the president’s goals for financial reform, consumer protection was clearly

given priority and political capital, in line with all of the agenda-setting tools available to

the one who occupies the bully pulpit. Other financial reform was left to Congress to sort

out, conforming to the pattern of delegating major legislation that has become a

74 Robert G. Kaiser, “Republican Sen. Richard Shelby fights for financial reform,” The Washington Post. December 17, 2009, Sec. C01. 75 “Update on Economic Policy Work,” 45 (emphasis added). 76 Elizabeth Warren. Statement to the House Financial Services Committee. “Regulatory Restructuring: Enhancing Consumer Financial Products Regulation,” Hearing, June 24, 2009.

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hallmark of Obama’s presidency. Perhaps Obama learned from President Clinton’s

failed attempt at line-by-line health care reform, but the pendulum steeply swung in the

other direction on financial reform. Aside from Obama’s forceful support for consumer

protection, little attempt was made to advocate consistently and passionately for clear,

effective reform. What are the implications of delegating such an assignment to

Congress? What processes created the final product seen by many as un-navigable, and

were any of these steps avoidable?

§3.2 – Congressional Incentives

Congress, made up of the House of Representatives and the Senate, is a

constituent-driven body, elected by the people of their respective districts and states.

Similar to the president, members of Congress are responsive to those whom they

represent. However, the similarities stop there because of the nature of their

constituencies. Members of Congress do not represent national constituencies. Instead,

they advocate for particularized local interests, seeking to gain the approval of those

who elect them to office. A congressman from Nebraska surely cares far more about

agricultural law than the Israel-Palestine peace process, as support for farmers in his

district will ensure his reelection to Congress every two years. The constituency-driven

nature of elective democracy creates a system where reelection is the primary goal for

many representatives and senators. The summary of views of members of the Congress

thus truly represents an aggregation of specific, localized interests rather than a

cohesive vision of the national interest. The original vision of the United States’s

founders, given voice by James Madison in Federalist 10, argues that these myriad

interests (named factions) will balance each other out in a large republic such as the

United States, preventing any one interest or group from dominating.77

However, Madison’s logic breaks down when applied to Congress and the

legislative agenda, a place where favors are traded and the nation’s well-being is often

trumped by that of individual districts. Organized interest groups punch far above their

weight because of their organizational capacity. As political scientist E.E.

Schattschneider observes, “The representation of latent interests is not automatic

77 James Madison, “The Federalist No. 10: The Utility of the Union as a Safeguard Against Domestic Faction and Insurrection (continued)” (Daily Advertiser. Published November 22, 1787).

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because the interests of the broader public are likely to remain unorganized.”78 Interest

groups gain influence through two different mechanisms—money and information. The

money argument is one of relative simplicity. Congressmen need funding for reelection

campaigns, and interest groups can supply that money in exchange for continued

support. As constituents who are relied on for support, interest groups can then exert

their influence in policy.

New York Congressional Democrats provide one of the best examples of this

phenomenon in Dodd-Frank’s creation process, where a small group of representatives

“mounted a furious rear-guard effort to reduce the impact of the bill on U.S.-based

derivatives trading.”79 Not only did the money of the financial sector play a role here,

but it was also explicitly cited for doing so. Giving voice to the theory is Democrat

Michael McMahon, “who Thursday had threatened to vote against the bill, on Friday

called it a ‘much more reasonable package.’ His district includes 70,000 people who

work in New York’s financial industry. Though he knew the banking industry was

unpopular, said Mr. McMahon, ‘I came to fight for it.’”80 A clearer case cannot be made

for a congressman placing the organized interests of his district higher than the

unorganized social interest in reining in too-big-to-fail institutions.

The story of Senate Amendment 3733 (SA 3733) to the Dodd-Frank Act provides

another stunning example of interests’ power within the Democratic Party. Senators

Sherrod Brown (D-OH) and Ted Kaufman (D-DE) introduced the amendment with the

intention “to promote the financial stability of the United States by improving

accountability and transparency in the financial system, to end ‘too big to fail’, [and] to

protect the American taxpayer by ending bailouts.”81 This amendment attempted to do

exactly what was proposed by many independent experts: Break up the big banks.

Limits included a concentration limit of ten percent—preventing any bank holding

company from holding more that portion of the nation’s insured deposits—and a limit

on non-deposit liabilities of two and three percent, respectively, for bank holding and

78 Quoted in Nolan McCarty, Keith T. Poole, and Howard Rosenthal. Polarized America: The Dance of Ideology and Unequal Races. (The MIT Press: Cambridge, 2006), 130. 79 Devlin Barrett and Damian Paletta, “A Fight to the Wire as Pro-Business Democrats Dig In on Derivatives,” The Wall Street Journal, June 26, 2010. 80 “A Fight to the Wire as Pro-Business Democrats Dig In on Derivatives,” The Wall Street Journal. 81 111 Cong. Rec. S2,765-6 (Text of Amendments – April 28, 2010).

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financial companies. 82,83 In addition, the amendment set a six percent leverage limit for

bank holding and financial companies. Senator Brown argued that the combination of

size limits and adequate resources to cover losses were necessary “to prevent big banks

from putting our entire economy at risk.”84 Senator Kaufman echoed these sentiments,

citing the primary requirement in financial reform as the need to end too big to fail:

Only by capping the size and leverage of banks at manageable limits can

we end ‘too big to fail’ for good. In the 1930s Congress passed laws that

gave our nation a foundation for financial stability for almost 50 years.

Why gamble this time around by trusting the regulators to do what they

failed to do in the first place?85

SA 3733 proposed a straightforward method to end TBTF, seemingly the goal of

financial reform. Surely such a powerful amendment would gain the simple majority

required to amend the Dodd-Frank Act.

But things are not as simple as they seem. The amendment was soundly defeated

by a vote of 66-31. Only 29 Democrats supported the amendment compared to 27 who

opposed. Unsurprisingly, those with a large number of financial constituents rejected

the bill, including both Senators from New York and New Jersey, Senator John Kerry

from Massachusetts, and the author of financial reform himself, Senator Christopher

Dodd of Connecticut.86 Dodd made the argument that capping bank size “would be

cutting our nose of to spite our face” and equated fighting with Wall Street to “taking on

the heartland.”87 Far more likely is that taking on Wall Street would have alienated the

influential donors responsible for funding the campaigns of Dodd and other pro-

business Democrats. Additionally, opposition from within the Obama administration to

a cap on bank size left SA 3733 dead in the water. The large number of administration

connections to the financial industry provides the plausible explanation of intellectual

82 Non-deposit liabilities are defined in the amendment as total assets minus the sum of Tier 1-capital and deposits for bank holding companies. For financial companies, they are defined as total assets minus the sum of Tier 1-capital. Both definitions account for off-balance sheet liabilities. 83 111 Cong. Rec. S2,765-6 (Text of Amendments – April 28, 2010). 84 “Brown, Kaufman File Amendment On Too Big To Fail Legislation.” Press Release, April 29, 2010. 85 ibid 86 “On the Amendment (Brown (OH) Amdt. No. 3733: Roll Call Vote No. 136.” (May 6, 2010). 87 As quoted in Simon Johnson, “Why Do Senators Corker and Dodd Really Think We Need Big Banks?” The Baseline Scenario (blog), May 1, 2010.

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capture, in which many who previously worked on Wall Street simply could not imagine

a financial industry without large, complex financial institutions.

In trusting Congress to produce financial reform, the Obama administration

placed its trust in two representatives famed for their ties to the financial industry.

Senator Christopher Dodd (D-CT) received over $14 million in lifetime campaign

contributions from the finance, insurance, and real estate sector, with $6.4 million

coming specifically from securities and investment industries.88 Representative Barney

Frank (D-MA) received over $4.3 million lifetime from finance, insurance, real estate

and over $1 million from the securities and investment industries.89 For both members,

these sectors and industries provided by far the most funding for their campaigns. On

the surface, it makes little sense to trust two representatives so connected to the

financial industry to reform it. David Skeel even finds the placing of such trust to be

cynical on the part of the Obama administration:

Congress and the President cynically assigned the task of framing the

government’s response to the financial crisis to committee chairmen who

had helped to create it: a Senator [Dodd] who is retiring under a cloud of

favors received from a giant mortgage lender and a Congressman [Frank]

who served as a longtime cheerleader for the dangerous policy of using the

housing-finance system to expand homeownership.90

It is apparent that the organized interests of the financial sector were well-represented

with Frank and Dodd as the leaders of financial reform. Yet the relatively simple ‘money

equals influence’ theory of interest groups does not tell the entire story, actually selling

their influence short.

The second pathway for interest group influence can be called an information

mechanism. John Wright makes the argument that “interest groups achieve influence

through the acquisition and strategic transmission of information that legislators need

to make good public policy and get reelected.”91 This theory criticizes influence buying

as cynical and simplistic, instead presenting an alternative explanation the centers on

88 Center for Responsive Politics. “Senator Chris Dodd: Career Profile.” 89 Center for Responsive Politics, “Representative Barney Frank: Career Profile.” 90 Skeel, 8. 91John R. Wright, Interest Group and Congress: Lobbying, Contributions, and Influence. (Boston: Allyn and Baenn, 1996), 2.

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the strategic sharing of expertise. A representative with little to no knowledge of finance

would seem to benefit greatly from a briefing provided by a large bank. The

representative is better informed while viewing the issue through the lens of the

information provider. The information mechanism satisfies the question of “with

common interest, why do democratic societies have such a hard time ridding themselves

of special interest politics?”92 Not only are special interests better organized as noted by

Schattschneider, but they are also better informed. Susanne Lohmann argues that the

implication of this information asymmetry between special interests and the general

public is that an incumbent can achieve a net gain in political support by redistributing

resources toward the special interest at the expense of the general public.93

It is easy to see how the information mechanism works with the financial sector.

Knowledge of derivatives, systemic risk, and liquidation authorities does not naturally

exist in the general population. It takes someone trained in the subject, and those

trained in the subject are likely to come from the financial sector. In a world of

organized interests, there is no interest opposing the financial sector. Unlike the fight

within Dodd-Frank between retailers and banks over debit card fees, no cohesive

opposition exists against the financial industry. Well-intentioned regulators can propose

needed reforms (with especially effective individuals such as Gary Gensler achieving

significant reform in derivatives), but legislators are the ones who draft laws.

Unfortunately, under the influence of interest groups and organized opposition, the

Dodd-Frank Act came into being as a loophole-ridden, contradictory mess that fails to

rein in the financial sector. In a reelection-driven world dominated by special interests,

it is no surprise to see such a result. Rather than ineptitude, rational incentives drive

congressmen to act the way they do and produce a bill such as the Dodd-Frank Act.

§3.3 – The Influence of Lobbying on Rulemaking

Not only does the structure of Congress make the likelihood of self-generated

reform legislation virtually impossible to emerge successfully; the way rules are written

by regulatory bodies tends generally to favor business interests. Most specific

92 Susanne Lohmann, “Representative Government and Special Interest Politics: We Have Met the Enemy and He is Us,” (Journal of Theoretical Politics 2003, 15), 299. 93 Lohmann, 311.

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government regulations are ultimately written by the agencies enforcing them rather

than written completely at the legislative level. Dodd-Frank prescribes over 400 rules to

be written, leaving regulators with the final task of creating a set of rules that flesh out

the Act’s intent into actionable steps. This outsourcing can be accurately described as

business as usual, relying on the same incentive structure that originally led to crisis.

The central process of rulemaking is that of public commenting, which allows for input

from those affected by forthcoming regulations. One view is that the comment process is

a victory for democracy: such rulemaking is a “refreshingly democratic” way to create

and implement public policy that is “vastly superior to the unstructured and chaotic

procedures of legislatures.”94 By giving everyone a voice, the theory is that final rules

will be balanced and unable to be captured by special interest groups. Unfortunately,

this is not the case.

Opening comments to the public has created an environment where regulatory

agencies fall under strong pressure to alter rules that could cause certain sectors or

industries harm. Business interests have proven extremely effective in influencing the

final form of many rules. The study “A Bias Towards Business” by Jason and Susan

Webb Yackee clearly demonstrates the influence of business commenters. The authors

find that “when business commenters are united in their desire to see less regulation in

a final rule…they will receive less regulation over 90% of the time.”95 In the case of

public commenting, it is not the higher quality of information provided by business

groups but the consistency of message and volume of comments. Not having an

organized interest in opposition to the industries of finance and business creates a

powerful asymmetry. Yackee’s empirical findings “indicate that as the proportion of

business commenters increases, agency outputs become increasingly skewed toward

providing less government in final rules.”96 The old adage strength in numbers has

never rung truer. Dodd-Frank does nothing to dispel the Yackee study but rather

reinforces it, with the Volcker Rule setting the most egregious example.

94 Michael Asimow, “On pressing McNollgast to the Limits: the Problem of Regulatory Costs” (Law and Contemporary Problems 57 (1), 1994), 129. 95 Jason Webb Yackee and Susan Webb Yackee. “A Bias Towards Business? Assessing Interest Group Influence on the U.S. Bureaucracy” (The Journal of Politics Vol. 68, No. 1, February 2006), 135. 96 Yackee, 136.

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The Volcker Rule’s purpose is to limit federal support to commercial banking

activities that provide needed financial services. The rule’s intention was simple: ban the

proprietary trading of financial products by banks that receive support from the

government. Paul Volcker’s testimony summarizes the need to ban proprietary trading:

Proprietary trading of financial instruments – essentially speculative in

nature – engaged in primarily for the benefit of limited groups of highly

paid employees and of stockholders does not justify the taxpayer subsidy

implicit in routine access to Federal Reserve credit, deposit insurance or

emergency support.97

This modern version of Glass-Steagall seeks to remove the central conflict of interest in

speculating with government, and by extension, taxpayer money for a firm’s own

benefit. But as seen earlier, this simple rule has morphed into a convoluted mess. The

framework provided by Yackee helps explain this process. Of the substantive public

comments submitted on the Volcker Rule, 13 were pro-reform compared to 300 from

the financial industry.98 The organizational force of the financial sector helped lead to a

first draft that was unwieldy and so loophole-ridden as to be ineffective at best.

One draft provision of the Volcker Rule merits particular scrutiny for the

revealing light it shines on lobbyists’ techniques. JPMorgan Chase and Morgan Stanley

had earlier both lobbied the Fed to apply regulation more broadly to foreign firms, citing

concerns about keeping competitive balance. One such section of the proposed rule that

assuages those concerns exempts U.S. government bonds from the ban on proprietary

trading, as Treasuries are considered a safe asset. But lobbyists for U.S. banks were not

done yet. “Banks and their lobbyists later sent position papers to the Washington

embassies of foreign governments and met with officials to warn that sovereign-debt

prices would suffer if U.S. banks are barred under the Volcker rule from buying other

nations’ bonds for their trading accounts.”99 U.S. banks thus argued for increased

restrictions on foreign firms before warning them of the effects, perhaps hoping to find

97 Paul Volcker, “Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships with, Hedge Funds and Private Equity Funds,” (letter, February 13, 2012, to multiple federal agencies), 4. 98 Jesse Eisinger, Dealb%k (blog). The New York Times. “The Volcker Rule, Made Bloated and Weak”, (according to Daniel Kelleher of Better Markets). 99 Yalman Onaran, “Bank Lobby Widened Volcker Rule, Inciting Foreign Outrage,” Bloomberg, February 23, 2012.

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an ally in the industry’s fight against the rule. The world’s largest banks soon picked up

the argument, saying that the rule’s language “would increase risk, raise investor costs,

hurt U.S. competitiveness and be vulnerable to court review.”100 Disingenuous lobbying

cannot overshadow the dangerous nature of proprietary trading in foreign government

bonds as evidenced recently by MF Global’s bankruptcy:

[T]he outsize bet that MF Global took on foreign government bonds is a

memorable cautionary lesson in why the rule should exist in the first place.

Jon Corzine, MF Global’s chief executive, made a highly leveraged bet-the-

firm gamble on European bonds. Counterparties were so concerned about

that exposure that they effectively closed the firm by no longer trading

with it.101

This incident displays the lengths to which the financial industry in the United States

will go to lobby against regulations it dislikes, pushing regulators to increase restrictions

and then encouraging those potentially affected to complain against those restrictions.

With the Volcker Rule and many other rules created by Dodd-Frank, it is

apparent that the coordinated and concerted efforts of the financial industry will

continue to limit the effectiveness of reform far into the future. Most incredible is the

continued permissive acquiescence to the influence of lobbying:

Financial-sector lobbyists’ ability to influence regulatory and supervisory

decisions remains strong because the legislative framework Congress has

asked regulators to implement gives a free pass to the dysfunctional ethical

culture of lobbying that helped both to generate the crisis and to dictate

the extravagant cost of the diverse ways that the financial sector was bailed

out. Framers of the Act ignored mountains of evidence that, thanks in

large part to industry lobbying, incentive-conflicted officials have almost

never detected and resolved widespread financial-institution insolvencies

in a fair, timely, or efficient fashion.102

100 Mahmoud Kassem and Arif Sahrif, “Volcker Says Rule Won’t Apply to Foreign Banks’ Non-US Units,” Bloomberg, February 29, 2012. 101 Andrew Ross Sorkin, Dealb%k (blog). The New York Times, “Volcker Rule Stirs Up Opposition Overseas,” January 30, 2012. 102 Skeel, 7.

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Dodd-Frank delegated rulemaking authority and left the process of public commenting

unchanged. A saying is often heard that insanity can be defined repeating something

and hoping for a different result. Dodd-Frank does exactly that by relying on the same

failed regulators to create rules to prevent the next crisis.

§ 3.4 – Conclusion

This chapter attempts to provide a framework for analyzing the process of the

Dodd-Frank Act’s creation. By drawing on a diverse social science literature, it is

possible to make logical assertions that based on something more than common sense.

The hope is that in bringing accumulated knowledge to a single case study it is possible

to draw conclusions systematically. Doing so has the benefit of wider applicability—the

explanations of Dodd-Frank’s inadequacies do not lie only in the specific circumstances

of this bill but on a level applicable across the legislative system. This section briefly

summarizes the main points made in the chapter and connects multiple arguments in

more accessible fashion.

The key insight underlying the entire argument presented here is the centrality of

presidential engagement to producing reform. President Obama’s level of continued

involvement in different areas of financial reform correlates very closely with the level of

the reforms’ effectiveness. The CFPB has been granted vast powers and seems intent on

carrying out its given duties as vigorously as possible. President Obama’s recess

appointment of Richard Cordray as head of the bureau signaled strong continued

support for the agency from the executive branch; no way would the president let his

campaign promise to protect consumers not to come true.103 Even though the president

broadly argued at times for the need to create an orderly resolution authority, reduce

systemic risk, and end too-big-to-fail, those tasks were delegated to Congress. The

incentive structure of both Congress and the post-Act rulemaking process systemically

favor special and business interests respectively. This chapter showed through example

how those processes were happening with the Dodd-Frank Act. The final piece of the

puzzle is the unequal balance of interests specific to financial reform, which pits an

103 Barack Obama, “Speech on Financial Reform,” (Federal Hall, New York, NY, September 15, 2009.) Obama’s September 2009 Federal Hall speech is another example of the continued primacy of consumer protection to the Administration’s financial reform.

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organized and influential financial industry against an unorganized latent social

interest. The suboptimal reform does not look like a random outcome, but seems the

only probable outcome given the lack of continued presidential involvement.

This result still leads to one set of puzzling questions. Simply put, why did

President Obama not lead more? As the only representative of the national interest, it

was up to the president to throw his large weight behind financial reform that worked.

Dodd-Frank did not require large amounts of Republican votes, allowing Democrats to

shape the form and direction of the bill’s contents. What barriers existed to the

president lobbying both in public and behind the scenes with members of his own

party to pass a law with enough simplicity and sense of purpose to rein in an out-of-

control industry? Presidents are motivated by the legacy they leave behind; surely,

President Obama does not want the lasting image of serving as a stooge to the big banks.

His legacy in financial reform will be that of someone unable and unwilling to overcome

the special interest influence within his own party. Reform has been proposed, passed,

and enacted, but as the graphic below shows, the big banks remain stronger than ever:

Source: http://blog.american.com/2012/04/even-bankers-dont-believe-dodd-frank-ended-too-big-to-fail/

This chapter has attempted to use the discipline of political science as a way of looking

at a specific case study. The final chapter uses this analysis of Dodd-Frank to draw

broader conclusions and propose possible topics for future research.

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CHAPTER FOUR: FINAL THOUGHTS

Dodd-Frank was the most significant reform of the nation’s financial system in

over 70 years. As a response to the recent financial crisis, it attempts to prevent another

crisis of similar magnitude by addressing a vast array of areas. Chapter One illustrated

the long-term path toward deregulation in the United States and the forces that led to

such a mindset becoming dominant across the political spectrum. Chapter Two analyzed

regulatory gaps exposed by the crisis and possible ways to fix them; special emphasis

was placed on the need to end too-big-to-fail. The Dodd-Frank Act fails to do this, and

has left the largest banks intact and even bigger than before. Chapter Three provides an

explanatory framework for why this happened. A lack of presidential involvement

helped ensure a loophole-ridden bill that will be further eroded during the post-Act

rulemaking process led by armies of lobbyists and lawyers. Paul Volcker sums up the Act

best when he says it “went from what is best to what could be passed.”104 This chapter

addresses two more general questions to see what lessons can be learned: What are the

broader implications for financial reform and the democratic process in America?

Financial reform throughout the United States’s history has always come in

response to crises. The creation of the Federal Reserve under Woodrow Wilson and the

creation of the SEC, FDIC, and Glass-Steagall following the Great Depression both

illustrate this trend. The key takeaway: There is one shot at legislative reform post-

crisis, after which more reform is not likely to occur until another financial crisis hits.

There is no reason to expect anything different with the Dodd-Frank Act. Passed under a

unified Democratic government, the Act has already come under siege from Republicans

following their seizure of the majority in the House of Representatives in 2010. Budgets

for regulatory agencies have remained small or in some cases shrunk, leading regulators

to complain that they simply do not have enough manpower to meet the deadlines

imposed by Dodd-Frank. In 2011, House Republicans sought to cut the Commodities

Futures Trading Commission’s budget by one-third, causing Democratic commissioner

Michael Dunn to warn, “There would essentially be no cop on the beat.”105 Intense

104 Wilmarth, 1035. 105 Ben Protess. Dealb%k (blog). The New York Times. “Regulators Decry Proposed CFTC Budget Cuts,” February 24, 2011.

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Republican opposition through funding cuts will make enforcement and rulewriting

even more difficult long into the future.

It is also unlikely that the enshrined system of ad hoc intervention will enable

regulators to keep pace with future financial innovation. Much of that future innovation

will be defined by the myriad complexities of Dodd-Frank, especially with new

regulation of swaps and derivatives still to be written. The nature of regulation as

conceived in Dodd-Frank—namely a mosaic of specific rules lacking a clear, overarching

framework—forces it to be a reactive process rather than a proactive one. Given a set of

don’ts to enforce, they must wait for violations in order to sanction, protect, or wall off

banks from the greater financial system. The rules-based system also permits regulators

to make ad hoc changes in response to concerns from the financial industry. The

Financial Times reported on this phenomenon recently:

US regulators are exploring ways to give large foreign banks and overseas

subsidiaries of US lenders a reprieve from stringent new derivatives rules,

potentially alleviating one of the biggest concerns facing global financial

institutions. The US Commodity Futures Trading Commission is looking

to grant a temporary exemption to swap dealers that may fall under the

jurisdiction of foreign financial authorities from complying with a host of

post-financial crisis regulations governing derivatives transactions, people

familiar with the matter said.106

The regulatory future seems to hold much of the same, with agencies responsive to the

wishes of the big banks rather than putting sound principles in place to prevent future

crises.

Financial reform reached its short-term high water mark immediately following

the passage of Dodd-Frank. The intensity of regulatory supervision will only decrease

over time as the economy improves, financial sector profits return, and the crisis fades

from the memory of the mass public and regulators. Congress failed to strip LCFIs of the

implicit and explicit government support they expect to receive, and the big banks have

neither been broken up nor forced to deal with the same pressures of capital markets

106 Tom Braithwaite and Shahien Nasiripour, “US regulators look to ease swap rules,” The Financial Times, April 22, 2012 (subscription required).

49

that other industries face. The Dodd-Frank process shows the interconnectedness

between financial reform and politics, both special interest and partisan.

When asking the question of why the administration chose to focus on consumer

protection, update the same rules, and rely on the same regulators, one must examine

closely the ongoing ties between the nation’s financial and political elite. The continued

relationship between special interests and politicians stretches beyond the influence of

money and access to information. The revolving door between Wall Street and

Washington continues to spin, with as many former Wall Street-ers in positions of

power as ever. A partial list, with former Wall Street connections in parentheses:

former National Economic Council director Lawrence Summers (Lehman

Brothers, JPMorgan Chase, Citigroup); deputy assistant to the president

and deputy national-security adviser for international economic affairs

Michael Froman (Citigroup, managing director); deputy Treasury

secretary Neal Wolin (Hartford Financial); chief of staff William Daley

(JPMorgan); former chief of staff Rahm Emanuel (Wasserstein Perella,

managing director); national-security adviser Tom Donlion (Fannie Mae);

and economic-transition team leader Robert Rubin (Goldman Sachs,

Citigroup).107

Treasury secretary Timothy Geithner does not make this list, but his work as Chairman

of the New York Fed did earn him an offer to be the CEO of Citigroup. His favorable

views to Citigroup were made public in the substantial government intervention the firm

received following the financial crisis. But why should prior work experience influence

future decision-making? What is to say that these advisers did not bring their expertise

and leave previous loyalties at the door upon joining the Obama administration?

Unfortunately, the concept of intellectual capture prevents the above hypothetical

from coming true. It is near impossible to dissociate the financial expertise gained from

working at a large bank from the industry’s assumptions and outlook. Should the

Kaufman-Brown amendment (SA 3733) have passed, Secretary Geithner would be the

one in charge of enforcing the banks’ breakups. One’s beliefs and experiences naturally

limit the realm of what one sees as possible; for Geithner and others, presiding over the

107 Kevin D. Williamson, “Repo Men,” National Review Online, December 28, 2011.

50

demise of the industry which they served and regulated for so long presumably fell

outside of those ideological boundaries to their conception of the possible. Intellectual

capture makes sense because it explains the actions of key administration members not

occurring out of malice, but rather stemming from a belief in the world working a

certain way. Without considering the deeply-held beliefs of those involved in reform, a

complete picture of motivations is incomplete. Combined with the influence of special

interest lobbying in Congress, the intellectual capture of many administration members

has created a climate that makes further deregulation likely far into the future.

The creation of Dodd-Frank proves that one simply cannot have expected

Congress to regulate the economy in ways well-suited to promote the public interest.

The executive leadership needed to counteract, or at least dilute, special-interest

influence did not materialize. Its absence demonstrates the imperative of its presence.

Dodd-Frank provides another example reinforcing that the designers of our

Constitution created a system with “unanticipated opportunities for minority factions to

be influential.”108 What Dodd-Frank lays bare is a crisis in representation. The core

tenet of representative government is that it reflects the will of the people, but time and

again this will is not accurately transmitted. Society as a whole has an interest in

preventing future financial crises, even if the largest five banks in the country are forced

to take less risk in order for that to happen. But no one is out there representing that

best interest. Congress’s choices are constituency- and thus interest-driven; these

representatives are not inept or stupid. They desire re-election and pursue the optimal

path to achieve that goal. Unfortunately, that incentive structure has persuasively been

shown to be in something other than the public interest. There are regulatory steps that

are undoubtedly in the interest of all of society. Congress is obviously not the place to

generate such reform. In its current conception it is safe to say that it never will be.

108 Lohmann, 303.

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