Dismantling Dodd-Frank -- And More

Dismantling Dodd-Frank -- And More

Candidate Trump promised to take on Wall Street. As deregulator-in-chief, he will be Wall Street’s best friend.

February 6, 2017

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This article appears in the Winter 2017 issue of The American Prospect magazine. Subscribe here

History teaches us that financial regulations die from a thousand cuts rather than a signifying event. As Cornell University law professor Saule Omarova puts it, “Financial reform is like a big onion. The more layers you peel off, the harder you cry.”

For example, by the time the Gramm-Leach-Bliley law removed the Glass-Steagall firewall between commercial and investment banks in 1999, that separation was already effectively wiped out—by administrative waivers granted by regulators. The 1994 Riegle-Neal Act that formally allowed banks to open branches across state lines came after a decade of states altering rules to undermine local control of finance. Deregulation of mortgage rules that led to the housing bubble rolled out over a 20-year period, spanning Carter, Reagan, Bush, and Clinton. And even then, it took the George W. Bush administration’s laissez-faire supervision to really supercharge predatory lending.

So while Donald Trump, populist rhetoric notwithstanding, promised on the campaign trail and on his transition website to “dismantle” Dodd-Frank financial reform, he probably won’t do it in one shot. He won’t even have to do it through Congress. Here’s the likely blueprint.

The Dodd-Frank Act did not structurally alter the financial system, either by breaking up the big banks, or by restoring the Glass-Steagall wall between commercial and investment banking. But it did attempt to stabilize what failed in 2008 by using stronger oversight and adding stronger regulatory tools. It created the Consumer Financial Protection Bureau (CFPB), the first independent federal agency primarily focused on preventing consumer rip-offs. It instituted the Volcker Rule, a miniature version of Glass-Steagall that restricts depository banks from making many types of trades on their own accounts. It sent derivatives through central clearinghouses to increase transparency. It empowered regulators to more strongly supervise systemically significant financial institutions, and created an “orderly liquidation authority” for insolvent firms. Combined with international rules that increased various equity requirements, Dodd-Frank patched several weak points in the current system.

However, because reformers lacked the votes to lock clear rules into the legislation, much of the detailed rulemaking was left to the executive agencies. That provided the industry a second bite at the apple, on much more promising territory behind closed doors. Indeed, even under a sympathetic Democratic administration, Dodd-Frank has been at risk, and that was magnified by the election.

 

MANY OF THE DODD-FRANK rules remain incomplete. According to Davis Polk’s most recent progress report in July, over one-quarter of Dodd-Frank’s rulemaking requirements have not been finalized, and about one in five have not even been proposed. These include an important multi-agency rule on executive compensation, which would discourage excessive risk-taking and allow for more clawbacks of bonuses in the event of corporate misconduct.

The easiest way for Trump to wipe out a big chunk of Dodd-Frank, then, is to direct agencies to never finish those unfinished rules. Trump promised a moratorium on new regulations at the outset of his presidency, so this would align with his vow to voters.

While regulators are scrambling to finalize the executive compensation rule and others before Obama’s term ends, Trump can take advantage of a tool the GOP Congress has used to express their dissent the past several years, known as the Congressional Review Act. Within 60 legislative days of a finalized executive branch rule, Congress can introduce a resolution to formally disapprove of it, and if the president signs the disapproval, the regulation is invalidated. That means any last-minute Dodd-Frank rulemaking not completed by this past May would be subject to Trump wiping them out with a stroke of a pen. This tactic can be used even if the regulation has already taken effect.

Brookings Institution

At Risk: Consumer Financial Protection Bureau Chair Richard Cordray, one of the right's prime targets. 

Trump can also rely on personnel changes to nullify the practical effect of Dodd-Frank. Independent agencies like the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, and the Commodity Futures Trading Commission (CFTC) get new majorities on their five-member boards based on the party of the president. Obama’s SEC Chair, Mary Jo White, resigned the week after the election, but Trump is entitled to fill two vacancies on the five-member panel regardless of White’s decision, enabling him to remake the agency.

On consumer protection, Trump could try to cripple the CFPB by having Congress pass a law returning its budget to the congressional appropriations process (currently it derives funds from the Federal Reserve), or changing the leadership structure from a single director to a five-member bipartisan commission. But it’s much easier for him to just replace current Director Richard Cordray. A ruling this October from the D.C. Appeals Court allows a president to remove the director for any reason; the CFPB has appealed, but even if that’s taken up, Trump could fire Cordray for some imagined cause or wait until Cordray’s term expires in July 2018. With a loyalist installed, the Trump administration could render the CFPB ineffective.

The president-elect can also make a direct impact with cabinet appointments. For treasury secretary, he selected billionaire Steve Mnuchin, who was deeply implicated in foreclosure abuses in the aftermath of the subprime collapse that took down the economy. Mnuchin ran OneWest Bank, one of the more egregious practitioners of robo-signing and improper foreclosures, disproportionately in minority communities. Billionaire investor Wilbur Ross, Trump’s nominee for commerce secretary, owned the notorious American Home Mortgage Servicing Inc., which multiple state attorneys general sued for deceptive practices. Ross later served on the board of Ocwen, which paid billions in fines to the CFPB for abusive activities. These are not choices homeowners should welcome.

Perhaps the most important personnel change is the vacant position of vice chair for supervision at the Federal Reserve, created by Dodd-Frank but never filled. The vice chair develops regulatory policy recommendations, oversees the supervision of banks, and reports to Congress on its progress. Daniel Tarullo has held the de facto role but was never formally put into the position. With two vacancies on the Board of Governors, Trump could immediately slide someone into the vice chair position, strip Tarullo (who may leave the Fed anyway) of authority, and pursue a deregulatory agenda at the most important financial regulator. The Fed staff, mostly holdovers from the laissez-faire Alan Greenspan days, would be all too happy to help.

When leadership changes at the top, the direction of regulatory enforcement usually follows suit. Regulators get slower to recognize unlawful activities, more trusting of financial lobbyists, and slightly more attuned to arguments about slowing down the economy if they uphold their mission. Furthermore, all of the new pro-bank leaders will sit on the same board: the Dodd-Frank–created Financial Stability Oversight Council, which monitors financial institutions for systemic risk and can impose more stringent regulations on the most dangerous firms. Overnight, this extra line of defense against systemic collapse would turn into a knitting circle.

This matches a dynamic that has periodically derailed aggressive regulation, regardless of the party in power. University of Colorado law professor Erik Gerding calls it the “Regulatory Instability Hypothesis.” When markets are booming, banks and investors pressure agencies to deregulate, so more firms can participate in the success. A crisis sometimes shifts the pendulum back toward stronger supervision. “The cycle continues once memories of the crisis start to fade,” Gerding says, leading to compliance rot.

In other words, with eight years behind us since the last financial crisis, regulators can be expected to take their eyes off the ball, even without the added prod of the Trump nominees. The Trump administration’s likely priorities on backing off Wall Street will act as a force multiplier for a familiar cycle of regulatory drift.

But when your deregulatory strategy is based on agency interpretation and selective enforcement, it also gives you flexibility to jump back in with a regulatory hammer at your discretion. With Trump’s appetite for vindictiveness, this strategy could be used not to obliterate financial regulation, but to weaponize it.

For example, Trump owes $364 million in commercial loans to Deutsche Bank, his biggest private lender. Deutsche Bank is simultaneously negotiating a fine with the Justice Department over bubble-era abuses in the mortgage-backed securities market. Trump’s Justice Department could pursue a bigger fine and more punitive treatment of executives unless Deutsche Bank renegotiates the president-elect’s debt. And Trump could unleash this kind of regulation-by-threat on any financial institution that crosses swords with him, through any agency, from the Fed to the SEC to the CFPB.

Another way to weaponize regulation is through federal preemption. Section 1041 of Dodd-Frank states that the CFPB cannot preempt stronger consumer protection laws in the states. If Congress eliminates that section—or if the agency just decides that certain state laws are inconsistent with their work—they can use the CFPB to nullify state efforts to boldly protect citizens. There’s a history of this under conservative governments: In 2002, Georgia passed a strong anti–predatory lending law, but the Office of the Comptroller of the Currency, the national bank regulator, told its institutions that they were exempt, citing federal preemption. The CFPB has even stronger consumer protection authority, extending to all sorts of financial products where they could water down state law, or even create a chilling effect by threatening to do so.

 

AP Photo/Susan Walsh

Public Conscience: Senate Banking Committee member Elizabeth Warren grills Wells Fargo Chief Executive Officer John Stumpf (foreground) during a committee hearing on Capitol Hill in Washington, September 20, 2016. 

OF COURSE, REPUBLICANS will likely also try to chip away at Dodd-Frank legislatively, piece by piece. The biggest effort to date comes from House Financial Services Committee Chair Jeb Hensarling, an early rumored choice for Treasury secretary. Hensarling has loudly complained that Dodd-Frank has destroyed consumer and small-business access to credit (it hasn’t, according to the small businesses themselves) and created an impenetrable jumble of complicated rules (there he has a point).

Hensarling’s Financial CHOICE Act offers financial institutions a bargain. If they maintain a ratio of liquid assets to overall debt—known as the leverage ratio—of 10 percent, they can shed many other Dodd-Frank capital requirements and enhanced regulations. The idea is that if banks have a sufficient leverage ratio, they can cover their own losses, negating the need for a heavy hand of supervision. And to get to this level of leverage, banks may have to shed some business lines, initiating the downsizing themselves rather than because of a government mandate.

It’s interesting that a conservative like Hensarling would support higher leverage requirements, part of an intellectual sea change on the right that believes increased capital can counteract “too big to fail.” And Hensarling is seizing on a complaint from the reform-minded left, that current regulation is too needlessly complex and easy to circumvent, and that simpler, easier-to-enforce rules should be the goal. “One benefit to doing something more structural is you can loosen some aspect of regulations today,” says Gaurav Vasisht of the Volcker Alliance, a nonpartisan public policy organization.

The problem is that a 10 percent leverage ratio, while higher than the current 6 percent standard, is not worthy to the task. Anat Admati, a professor at Stanford and the leading commentator on the need for higher leverage requirements, wrote in a paper in May that it’s rare for any healthy corporation to fund more than 70 percent of its assets with borrowing. That would equal a 30 percent leverage ratio, three times what Hensarling wants. Leverage is also not simple to calculate and can be gamed by stashing items off the balance sheet, especially if, as in Hensarling’s approach, there’s no actual penalty for violators. Banks would have a year to rewrite their capital plan if they fall out of compliance, an invitation to yo-yo in and out as it suits them.

But there’s more to the CHOICE Act than leverage, and its smaller pieces could comprise a legislative à la carte menu to weaken financial regulation. Most of them have already passed the GOP-led House in some form.

Republicans want to repeal the “orderly liquidation authority” mechanism to unwind banks in a crisis, making enhanced bankruptcy the only available method. They would limit authority for the Federal Reserve and the FDIC to bail out financial institutions absent direct threats to overall stability. They would eliminate designations of “systemically important financial institutions” that confer heightened regulatory supervision on the riskiest firms, and weaken the independent judgment of members of the Financial Stability Oversight Council, the risk monitor that approves the designations. (For example, all members, who chair banking regulators, would need approval from their bipartisan boards before a vote.) They would impose regulatory relief for community banks and credit unions, exempting them from most Dodd-Frank rules and reporting requirements. They would prevent SEC registration for private equity firms and hedge funds, disband the Office of Financial Research, and force regulators to publicly disclose the frameworks of its stress tests, allowing banks to prepare for them in advance.

Some rules would be repealed, like the Volcker rule, which banned proprietary trading by deposit-taking banks, and the Department of Labor’s fiduciary rule, which forces investment advisers to act in the best interest of their clients. Republicans support a cost-benefit analysis for all new financial regulations, a subjective standard that could easily be interpreted to find any rule too costly. They would pass the REINS Act, a radical piece of legislation that would give Congress a final vote on all major regulations from federal agencies, creating a bottleneck for rulemaking and essentially freezing the administrative state. They would overrule the Supreme Court’s deference to federal agency interpretation of rules, giving industry even more of an upper hand in litigation. They would even kill the Franken amendment to remove conflicts of interest in the credit-rating agencies, which the SEC never even bothered to act upon.

 

DEMOCRATS HAVE 48 SENATORS and can use the filibuster to block these changes, and Republicans appear wary at this time of eliminating the 60-vote threshold for legislation. However, Democrats are unlikely to filibuster everything, and some of Trump’s deregulatory ideas have bipartisan support. Five Senate Democrats up for re-election in 2018 come from states that gave Donald Trump double-digit victories (West Virginia, Missouri, Montana, Indiana, and North Dakota), and five others Trump carried by lesser margins (Florida, Ohio, Pennsylvania, Wisconsin, and Michigan); they’ll be eager to compromise on some issues. A combination of them and a handful of business-friendly members of the caucus could support things like small-bank regulatory relief, which has been on the brink of passing for years.

Other planks of the GOP regulatory plan might get buy-in from even reform-minded Democrats, like a Government Accountability Office audit of the Federal Reserve’s balance sheet. Some Republicans have vowed to increase SEC penalties on securities law violators, which could certainly get Democratic support, perhaps in a trade for accepting something more distasteful.

Furthermore, Republicans’ traditional practice has been to stick items Democrats wouldn’t support on their own into must-pass legislative vehicles like budget bills. This is how the Commodity Futures Modernization Act, which restricted derivatives regulation, passed in 2000, and it’s how a Democratic Senate and President Obama signed into law the only major repeal of a provision of Dodd-Frank, the “swaps push-out” rule that would have forced derivatives trading desks to be separately capitalized from their parent company, protecting customer deposits. Citigroup lobbyists wrote that repeal provision. Placing deregulatory measures into must-pass bills makes them much more difficult for Senate Democrats to stop.

Pete Souza/The White House

Then-President Barack Obama meets with Representative Barney Frank, Senator Dick Durbin, and Senator Chris Dodd, in the Green Room of the White House prior to a financial regulatory reform announcement June 17, 2009.

Finally, Republicans have plans to enrich Wall Street executives in all sorts of ways unrelated to financial regulation. They could reinstate the bank middlemen on federal student loans (a program recently converted to direct loans by the Obama administration), returning a lucrative profit center to lenders. They could weaken or lay off antitrust enforcement of mergers and acquisitions, an extremely profitable outlet for the banks that advise those deals. They could cut the corporate income tax, as well as the tax on pass-through income in corporate partnerships, a huge benefit for traders like hedge fund and private equity managers. They could recapitalize and release mortgage giants Fannie Mae and Freddie Mac, a top priority of hedge fund manager (and Trump adviser) John Paulson and other investors who bought up Fannie and Freddie stock cheaply, hoping for a financial windfall if they were spun back out to the private sector. They could allow banks to get rich from financing Trump’s $1 trillion infrastructure program, which essentially sells off public assets in a privatization fire sale.

That bonanza, combined with the reduction of costs from lighter regulation, explains why the financial industry views the next four years with all the anticipation of a child on Christmas morning.

 

DEMOCRATS DO HAVE TOOLS to prevent the onslaught. The first is that the public still really dislikes the banking industry. And every time Wall Street hopes memories will fade and they can return to a deregulatory agenda, something like the 2016 Wells Fargo scandal drags the industry’s culture of deceit back into the spotlight.

The Wells Fargo case, where the bank was found to have systemically created millions of customer accounts without authorization in a bid to show retail sales growth, was arguably the most damaging incident since the financial crisis, if only because it was so easily understood. “The American people got it hands down,” says Senator Elizabeth Warren, Washington’s biggest champion of consumer protection. “They understood the game is rigged, and no amount of fancy footwork by Republicans could dance back that this bank built a profit model out of cheating its own customers.”

Even Republicans had harsh words in congressional testimony for Wells Fargo CEO John Stumpf, who stepped down from his position, a fairly unprecedented moment of accountability in the past eight years of scandals. The whole affair cemented the reform position that banks, left to their own devices, will take advantage of customers and shareholders. Even if you believe that these were 5,300 rogue operators issuing accounts on their own volition, “that indicates that these institutions are too big, too complex, too sprawling,” says Robert Hockett, a law professor at Cornell University.

There are ways to apply the Wells case more broadly, too. The real villainy was using sales metrics to promote corporate growth. So investors were buying stock based on false numbers ginned up by low-level employees out of fear of termination. That indicates a short-term mind-set, a grab for profits at all costs. “The executives view themselves as working for the shareholders,” says Hockett. This could spur interest in the credit union model, where the depositors are the owners. The National Credit Union Administration has been refining its requirements that could allow for significant expansion, which could trigger a large exodus away from the commercial banking industry. Wells Fargo account openings plummeted 30 percent just in the first month after the scandal was made public.

Any attempt to mess with the CFPB, for example, will be met with an invocation of Wells Fargo. More broadly, the preponderance of hedge fund moguls and bank lobbyists inside the Trump transition team is already being used to highlight the contradiction between Trump’s “for the little guy” campaign rhetoric and the reality of his likely governing decisions. Like the Democrats, the GOP included a restoration of the Glass-Steagall firewall in their official 2016 platform. And Trump repeatedly attacked Hillary Clinton for her Wall Street ties, proclaiming himself beholden to nobody, least of all financial industry executives. That could be useful in denying Republicans a frontal assault on financial rules.

But those quiet backrooms where regulators and industry representatives congregate will provide refuge from the anti-bank rabble. The average Trump base voters, while still concerned that the financial industry is too big and too complex, will likely pay no attention to a rule interpretation at the CFTC, or an enforcement decision at the SEC. “It’s too easy to get lost in the weeds around it,” says Warren. “We win the fight when it’s about basic principles. Once the principles are lost and you’re down to fighting technical language, lobbyists and lawyers have the upper hand.”

The imminent pummeling of Dodd-Frank should also raise questions about the future. Many experts believe that Dodd-Frank didn’t go far enough to truly make the public safe from the financial system. It maintained the basic business model and structure of the industry, and assumed that alert regulators could tweak the system into compliance. There are compelling doubts that tools like orderly liquidation authority would even work in a crisis. And even structural prohibitions like the Volcker rule rely on whether regulators can figure out what represents proprietary trading and not market-making or hedging, two carve-outs in the rule.

“I used to work for Tim Geithner; he was a smart guy who knew a lot about the financial sector,” says Morgan Ricks, former Treasury Department official and author of The Money Problem. “To think that he can turn the dials on the machines, there’s no way anyone can do that. There’s a technocratic conceit built into the way a lot of people think.”

An endless race between more complex financial institutions and more complex rules to target them guarantees that regulators will always remain behind as financial firms construct more esoteric instruments to conceal risk, or use complexity as a cloak to get their way. Taking a step back, we could instead question whether expansive trading activity actually contributes anything productive to society. And if it doesn’t, we could ask why we allow it to exist. “We can control the system much better but we need to gather up the will to do it,” says Anat Admati, part of a team of thinkers who have worked separately on detailed structural reforms, which would be easier to police and more likely to return finance to its role as the facilitator of economic output, rather than the center of it.

Admati has focused on higher capital requirements, so financial institutions have their own funds at risk rather than the taxpayer’s. Arthur Wilmarth of George Washington University believes in rigorously narrow banking, similar to the “ring-fencing” proposals put forward in Great Britain and the European Union. This eliminates subsidies that banks receive to fund trading activities, both from access to cheap deposits and expectations of bailouts. “You can take deposits inside a narrow bank that invests only in safe government securities,” Wilmarth says. “Add a no-transfer rule, not one dollar transferred out to capital market affiliates. If you had that, rigorously implemented, these guys would break up quickly.”

Bill Clark/CQ Roll Call via AP Images

Swamp, Personified: Hedge fund billionaire, Goldman Sachs veteran, Trump finance chair, and Treasury Secretary-designate Steve Mnuchin meets with Senate Majority Leader Mitch McConnell in the Capitol. 

Wallace Turbeville of the think tank Demos believes over-reliance on trading as a profit center is responsible for sclerotic economic growth. He would ban derivatives entirely. “There’s a giant misconception that derivatives are a risk management tool,” Turbeville says. “I was the CEO of a derivatives risk management company. It’s not like I’m making this stuff up.” Tossing out derivatives is part of a broader project of Turbeville’s, to root out complexity and short-term thinking from the financial system, so that corporate profitability and growth are complementary rather than distinct.

Hockett and his Cornell associate Saule Omarova believe that money is a public resource, not a privately supplied product. The banks are just franchisees to the Federal Reserve’s franchise generation of credit. “When you take that view, everything looks different,” Hockett says. “If the federal government takes a more active role in allocating credit, that no longer looks like intervention or meddling, it looks like the sensible management of distribution of resources.” This opens the door for a much more direct public role in who gets credit, along the lines of a public bank. “The public has a fundamental right to have a say in how the financial system works,” says Omarova.

Morgan Ricks’s contribution concerns the creation of money-like instruments in the short-term debt markets. The Federal Reserve and private banks are supposed to have a monopoly on money creation. But money markets or overnight repurchases (repo) are considered as safe as money for accounting purposes, despite being inherently unstable and prone to runs.

Under Ricks’s plan, all short-term debt instruments (renewable in less than a year) would have to be issued by a chartered bank. So-called shadow banks like hedge funds or private equity firms could not generate short-term debt to fund their activities. They would lose a cheap funding tool and have to take on real risk. “We’ve defined deposits the wrong way. All these other entities create deposits,” says Ricks. “They should be off limits.”

All of these are pretty radical ideas, but they have a simple elegance to them. Separating bank business lines by activities, and banning harmful products, changes the system we have from a complex, interconnected agglomeration, where a failure in one area can cascade everywhere, to a more independent system where firms can fail without causing catastrophe. Combining these ideas would reduce trading volumes and channel capital toward only necessary activity.

Moreover, the very existence of a new set of ideas puts us well ahead of the curve relative to 2008. Liberals had no solutions to take off the shelf then, inevitably leading to a technocratic path of tweaks and dials. Instead of the parallel of the Great Depression, after which Roosevelt truly redesigned the financial system, the more apt parallel to the 2008 crisis may be the Panic of 1907, when we added a couple of important parts—most notably the Federal Reserve—but didn’t truly upend the practice of banking. “As bad as it was, the Panic of 1907 was not enough for fundamental reform,” says Arthur Wilmarth. “Until 1933, the public was mad but they didn’t know what to be mad about.”

Even though we’re approaching a Dark Ages for reformers, Saule Omarova sees a ray of hope. She uses the example of regulatory relief for smaller banks. “That is actually a structural reform step. You’re formally establishing two separate regulatory reform regimes,” Omarova says. “After that, a bunch of regionals that may be just above $250 billion [in assets] but are engaged in traditional banking business, and don’t deal with prop trading or derivatives—they might want relief. Once community banks are taken out of regulatory provisions, the next question will be activities. It’s one way structural reform is already on the agenda.”

The Republican reign of deregulation will likely hasten another crisis, though it’s unclear where or when (though we are already seeing problems with commercial real estate, which contains a lot of exposure for banks). At that time, there will be renewed calls for wholesale reform, and renewed resistance from the industry to upsetting their business model. Having a demonstrable understanding of what to do when catastrophe strikes will be invaluable. Paradoxically, chipping away at the present jury-rigged system of financial reform keeps the issues alive for much bigger interventions down the road.

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