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The Politics of Financial Reform

Paul Ockelmann 5/4/2012

3 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

4 FOREWORD The recent financial crisis has profoundly affected both the United States and global economies. Much has been written examining the crisiss multiple causes, analyzing its handling, and warning of the next crisis on the horizon. Far less, however, has been written evaluating the United States governments 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 Acts 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 Acts 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 todays 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 sectorone of the most powerful special interestsdominated 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.

5 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 twentyodd 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
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.

6 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 instrumentalities3 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-Steagalls 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 banks best interest rather than the customers. Institutions holding deposits hold great financial power in controlling other peoples 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.
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Glass-Steagall Act: Commercial vs. Investment Banking, 4. Whole section, ibid, 4. (emphasis added)

7 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 laws 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
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, 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.

8 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 9

Johnson and Kwak, 147. Kenneth Silber, The Great Unfixing, Research Magainze, May 2010.

9 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&Ls 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 industrys 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.
Matthew Sherman, A Short History of Financial Deregulation in the United States, Center for Economic and Policy Research, 7.

10 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 Greenspans 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 laws provisions, the Feds 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 worlds 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

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

12 Commission (CFTC) in 1974this commission was the first to consider regulation of the OTC derivative market in the 1998. The CFTCs 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 Presidents 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

ibid, 10. 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 Overthe-Counter Derivatives Market and Hybrid Instruments, June 10, 1998.
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13 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 Borns 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 LTCMs 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
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).

14 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 CFTCs 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-Steagalls 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 timethe 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.

Gilmore, The Warning. 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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15 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 Statess 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 systems 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 Acts 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

16 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 systems 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

The history of the regulatory systems slow erosion is further detailed in the preceding chapter. Arthur E. Wilmarth, Jr, The Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-toFail 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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17 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 Stearnss 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 industrys 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

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.

18 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 buyers 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 32

King, Speech to Scottish business organizations, Edinburgh, October 20, 2009, 4. 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

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.


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, Socit Gnrale or Deutsche Bank, two of Europes biggest banks, had no way of knowing AIGs 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 ber 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-Steagalls 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 firms 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 41

Acharya et al, 11. 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 projects 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 transactions 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 products underlying components. Requiring clarity in end products such as mortgages is a
Stephen A. Rhoades, A Summary of Merger Performance Studies in Banking, 198093, 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 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 investments 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 Acts success in plugging the holes in the United Statess 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 thats what these reforms are designed to achieve -- no more, no less.45 Yet over a year and a half following the bills 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
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 companys 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 strokesprudential 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 47

Dodd-Frank Wall Street Reform and Consumer Protection Act, (PL 111-203, July 21, 2010), 318. 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, offbalance sheet risk. This section of the Act also requires annual stress tests to determine a banks 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 Jerrys. 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 Acts 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.
Dodd-Frank, 165c. Dodd-Frank, 112. 50 See Simon Johnson, Too Big to Fail Not Fixed, Despite Dodd-Frank. Bloomberg, October 9, 2011.
48 49

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 authorityit 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 domesticthere 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 Secretarys 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
Wilmarth, 955. Dodd-Frank, 202. 53 Dodd-Frank, 203. 54 Johnson, Too Big to Fail Not Fixed, Despite Dodd-Frank.
51 52

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 counterpartys 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 GrammLeach-Bliley Acts prohibition on the regulation of swaps-related agreements. From these key changes above, derivatives legislation clearly has improved under the DoddFrank 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 drivers license, one must (even if it often requires threeplus 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.

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

28 The Act does make one other attempt to prevent systemic risk to the financial system with the Volcker Rulenamed 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 GlassSteagall, 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 rules 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 Rules 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 CFPBs 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 productsare 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. Warrens views soon gained traction among powerful allies. Former Chairman of the
Elizabeth Warren, Unsafe at Any Rate,, (Summer 2007), 9.


29 Senate Committee on Banking, Housing, and Urban Affairs Christopher Dodds 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 Acts 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 Acts continued reliance on the same capital
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 Santayanas 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 overregulates: 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 Americas 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,

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 Acts complexity will over-regulate and create the possibility of more systemic risk over time through loopholes and exceptions. Dimons 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:
2500 Dodd-Frank Act (2010): 2,319 pages 2000 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 0




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
Julia La Roche, Heres 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).

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 Acts 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 Acts 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.

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

33 CHAPTER THREE: W HY DODD-FRANK IS I NADEQUATE 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 21 stcentury 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 Obamas 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 countrys entire population the tribune of the people. Much literature is devoted to the

34 aphorism that all politicians are reelection-driven, beginning with David Mayhews 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 Administrations 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?
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.

35 It is quite difficult to interpret presidential intentions and determine where socalled 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 presidents first-term economic policies, it provides a revealing glimpse of priorities as well as political realities. Crafting a financial stimulus package was the economic teams 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 shapea credible reform agenda.72 The crisis clearly illustrated the need for an update to the financial regulatory system, and Larry Summers and Obamas 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 Administrations primary goal, and Obamas 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

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.

36 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 Obamas 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 presidents 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
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.

37 hallmark of Obamas presidency. Perhaps Obama learned from President Clintons failed attempt at line-by-line health care reform, but the pendulum steeply swung in the other direction on financial reform. Aside from Obamas 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 Statess 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, Madisons logic breaks down when applied to Congress and the legislative agenda, a place where favors are traded and the nations 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
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).

38 because the interests of the broader public are likely to remain unorganized. 78 Interest groups gain influence through two different mechanismsmoney 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-Franks 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 Yorks 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 percentpreventing any bank holding company from holding more that portion of the nations insured depositsand a limit on non-deposit liabilities of two and three percent, respectively, for bank holding and

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).

39 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 probusiness 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

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.

40 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 governments 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
Center for Responsive Politics. Senator Chris Dodd: Career Profile. 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.
88 89

41 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
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.

42 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 Acts 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 rulethey 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. Yackees 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.

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.

43 The Volcker Rules purpose is to limit federal support to commercial banking activities that provide needed financial services. The rules intention was simple: ban the proprietary trading of financial products by banks that receive support from the government. Paul Volckers 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 firms 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
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.

44 an ally in the industrys fight against the rule. The worlds largest banks soon picked up the argument, saying that the rules 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 Globals 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 Globals chief executive, made a highly leveraged bet-thefirm 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

Mahmoud Kassem and Arif Sahrif, Volcker Says Rule Wont 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.

45 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 Acts 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 applicabilitythe explanations of Dodd-Franks 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 Obamas 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 Obamas 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
Barack Obama, Speech on Financial Reform, (Federal Hall, New York, NY, September 15, 2009.) Obamas September 2009 Federal Hall speech is another example of the continued primacy of consumer protection to the Administrations financial reform.

46 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 bills 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-ofcontrol 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:


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.

47 CHAPTER FOUR: F INAL THOUGHTS Dodd-Frank was the most significant reform of the nations 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 Statess 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 postcrisis, 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 Commissions budget by one-third, causing Democratic commissioner Michael Dunn to warn, There would essentially be no cop on the beat. 105 Intense

Wilmarth, 1035. Ben Protess. Dealb%k (blog). The New York Times. Regulators Decry Proposed CFTC Budget Cuts, February 24, 2011.
104 105

48 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-Franknamely a mosaic of specific rules lacking a clear, overarching frameworkforces it to be a reactive process rather than a proactive one. Given a set of donts 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

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 nations 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 industrys 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. Ones beliefs and experiences naturally limit the realm of what one sees as possible; for Geithner and others, presiding over the
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. Congresss 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.


Lohmann, 303.

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