Where do we go from here? As we mark another milestone in regulatory reform with the fourth anniversary of the enactment of the Dodd-Frank Act, it strikes us that although most studies required to be undertaken by the Act have been released and final rules have been promulgated addressing many of the most important regulatory measures, we are still living with a great deal of regulatory uncertainty and extraordinary regulatory complexity.
Posts Tagged ‘Financial reform’
The fourth anniversary of the passage of the Dodd-Frank Act provides an opportunity to reflect on why the Act was passed, how the SEC has used the Act to promote financial stability and protect American investors, and what remains to be completed. The financial crisis was devastating, resulting in untold losses for American households and demonstrating the need for strong and effective regulatory action to prevent any recurrence.
The financial crisis that began in 2007 prompted a tidal wave of thinking about financial regulation. One major theme that has been pursued by the Financial Crisis Inquiry Commission, journalists, and scholars—most recently in Other People’s Houses, by Jennifer Taub—is the question of what went wrong in the years or decades leading up the crisis. A second strand of research answers the question of what substantive regulations we should have; one important book in this genre is The Banker’s New Clothes, by Anat Admati and Martin Hellwig. But beyond the issue of what regulations are appropriate for today’s complex financial system, a third important area of inquiry is the political and administrative landscape in which financial regulations (whether statutes, rules, administrative guidances, or court opinions) are hammered out. After all, if it were somehow possible to design a perfect regulatory framework, it could only become effective by navigating through the complicated web of interests and incentives that encompasses the legislative and executive (and perhaps judicial) branches.
How should we think about regulating our dynamically changing financial system? Existing regulatory approaches have two temporal flaws. The obvious flaw, driven by politics and human nature, is that financial regulation is overly reactive to past crises. The Dodd-Frank Act, for example, puts much weight on reforming mortgage financing.
There is, however, a less obvious flaw: that financial regulation is normally tethered to the financial architecture, including the distinctive design and structure of financial firms and markets, in place when the regulation is promulgated. This type of grounded regulation can have value as long as it is monitored and updated as needed to adapt to changes in the financial architecture. Yet without that monitoring and updating, it can quickly become outmoded—such as occurred in 2008 when the pre-crisis financial regulatory framework, based on the dominance of bank-intermediated funding, failed to address a collapsing financial system in which the majority of funding had become non-bank intermediated.
The global financial troubles of 2008-09, with whose debt-deflationary macroeconomic consequences  the world continues to struggle,  exposed weaknesses in many financial sector oversight regimes. Most of these had in common their focus on the safety and soundness of individual financial institutions to the exclusion of the stability of financial systems as wholes—wholes whose structural features render them more than mere sums of their institutional parts.
A number of academic, governmental, and other finance-regulatory authorities, myself included,  have accordingly concluded that an appropriately inclusive finance-regulatory oversight regime must concern itself as much with the identification and mitigation of systemic risk as with that of institutional risk. Once primarily ‘microprudential’ finance-regulatory oversight and policy instruments, in other words, are now understood to be in need of supplementation with ‘macroprudential’ finance-regulatory oversight and policy instruments.
Now because finance-regulatory policy in most jurisdictions is implemented through law, all of the weaknesses inherent in exclusively microprudential finance-regulatory regimes are, among other things, legal problems. They are weaknesses in what some non-American lawyers call existing ‘legal frameworks.’ Many countries in consequence are now looking to update their legal frameworks for finance-regulatory oversight, supplementing their traditional microprudential foci and methods with macroprudential counterparts.
There is a growing consensus that new financial reform legislation may be in order. The Dodd-Frank Act of 2010, while well-intended, is now widely viewed to be at best insufficient, at worst a costly misfire. Members of Congress are considering new and different measures. Some have proposed substantially higher capital requirements for the largest financial firms; others favor an updated version of the old Glass-Steagall regime.
In A Simpler Approach to Financial Reform, forthcoming in Regulation, I suggest a different and simpler strategy. This simpler approach would be compatible with other financial stability reforms. However, in the first instance, it is better understood as a substitute for Dodd-Frank and other measures. The simpler approach would require new legislation. It consists of the following specific measures, starting from a pre-Dodd-Frank baseline:
When people think of Tahoe, they may ponder “Tahoe, oh—skiing, the Lake, maybe golf or gambling. Heck, let’s go.” But today, well, let’s switch it up and talk about the Old West and Tahoe aglow, back in the day. This is a fitting place to do just that. The Ponderosa Ranch, from Bonanza, was just over yonder, on the Nevada side of the Lake. Remember the Cartwright’s? There was Ben who survived three wives, but begets a son from each one: Adam, Hoss, and Little Joe. And just a few miles from here, they hold the Genoa Cowboy Festival at the site of the first ranch in Nevada. (Not the Mustang Ranch—that’s 15 minutes east of Reno. Hey, you at the door, where ya going?) The first ranch in Nevada was Trimmer Ranch No. 1. Let’s assume there were others. The oldest saloon in Nevada is also in Genoa. A portion of the original bar from the 1800’s is still in use. And, the local phone book lists at least 25 places to “get your boots on” and get a pair.
Right about now, some of you might be thinking, “Whoa, hold your horses there, long hair.” Isn’t this supposed to be about financial regulation or commodity markets or something?” Yeah, Sundance, it is. We’re just going to kick up the dust a bit as we “tumble along with the tumbling tumbleweeds” and have our cordial conversationalizing. After all, like George Strait sings, “I ain’t here for a long time. I’m here for a good time.” So, let’s get to it and talk some about the Old West and our financial markets today.
Revelations that bank traders attempted to manipulate LIBOR, the London Interbank Offer Rate, on a widespread and routine basis over the course of many years have rocked the global financial community and fueled international calls for reform. In response, the U.K. Government completely overhauled the governance of LIBOR, adopting in full the recommendations of the Wheatley Review, an independent review of LIBOR led by Martin Wheatley, CEO of the new Financial Conduct Authority (FCA) in the UK. Among other reforms, effective April 1, 2013, both “providing information in relation to” LIBOR and administering LIBOR are regulated activities in the United Kingdom. In addition, a new, independent administrator will provide oversight of LIBOR. NYSE Euronext, selected as the first administrator under the new regime, will begin oversight of LIBOR at the beginning of next year.
These reform efforts are an important first step towards restoring the credibility of LIBOR as an interest rate benchmark. The reforms instituted to date, however, do not address more fundamental concerns with LIBOR. In particular, even non-manipulated submissions sometimes bear little relation to actual market transactions because few market transactions occur in certain interbank unsecured lending markets, particularly in times of market stress. As Mervyn King has observed, LIBOR “[i]s in many ways the rate at which banks do not lend to each other…it is not a rate at which anyone is actually borrowing.”
The debate regarding “too big to fail” (“TBTF”) has reemerged as a focus of regulators, legislators and the media. We review the regulatory activity since the Dodd-Frank Act was enacted and show that new proposals intended to address TBTF tend to put the policy cart before the regulatory implementation horse.
By our count, regulators have amassed over 1,650 pages in proposed and final rules that seek to address TBTF, which we roughly define as proposals that seek to limit the size of financial institutions, the scope of their activities or otherwise seek to protect the Federal safety net (which we use as a term to refer to any Federal assistance, including deposit insurance). In addition, there are provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act (“DFA”) which address TBTF that do not require rulemaking.
Despite this volume of regulatory work to implement the DFA’s reforms, which is mostly not yet complete, proposals for new measures are being put forward, including:
On May 3, 2013, Federal Reserve Board Governor Daniel Tarullo delivered a speech outlining potential regulatory initiatives before the Peterson Institute for International Economics in Washington, D.C. In this speech, entitled “Evaluating Progress in Regulatory Reforms to Promote Financial Stability,” Governor Tarullo acknowledged that substantial progress has been made in achieving financial regulatory reform, but he maintains that much more is still needed. 
Even beyond the substantive impact of the reforms proposed by Governor Tarullo, his speech is particularly noteworthy for two reasons. First, Governor Tarullo oversees the Federal Reserve Board’s banking supervision and regulation function and was recently appointed as Chairman of the Financial Stability Board’s Standing Committee on Supervisory and Regulatory Cooperation. Second, in the past, Governor Tarullo has used similar speeches to forecast the Federal Reserve’s upcoming regulatory initiatives.
Governor Tarullo’s speech focuses on three general areas of increased regulatory scrutiny: (1) large financial institutions generally; (2) large financial institutions that rely on short-term wholesale funding; and (3) short-term wholesale funding markets, in particular those for securities financing transactions (SFTs). Governor Tarullo proposes a number of regulatory requirements to address what he perceives as the unfinished business of regulatory reform, including both macro- and micro-prudential requirements at an institution-specific level and market practice level.