Liberals cheered when Elizabeth Warren was appointed interim director of the new Consumer Financial Protection Bureau after a long internal fight. The bureau, which Warren first proposed in 2007, is one of the more expansive innovations of the financial-reform law known as the Dodd-Frank Act.
Consumer protection, Warren argues, could have headed off much of the financial meltdown. For example, if authorities had been able to shut down subprime mortgages as a deceptive retail product, there would have been no market in subprime mortgage-backed securities to crash the financial system. With Warren at the helm, the consumer bureau is likely to issue tough regulations. Yet as Warren acknowledges, even the best consumer protection is only a partial response to other systemic challenges, such as how to assure that no bank is "too big to fail." And the fight over the consumer bureau is only one of many to be resolved within the executive branch and that will determine whether financial reform lives up to expectations.
With its high-profile leader and easily understood mandate, the bureau is also likely to be an exception to the rule that implementing Dodd-Frank will be an arcane and obscure process dominated by insiders. On most fronts, Wall Street's legions of lawyers and lobbyists will have home-court advantage. The stakes could hardly be higher -- they involve not just whether we avert the next financial collapse but whether the banking system can be restored to its proper role of financing the rest of the economy rather than just enriching itself.
To keep the legislation moving and to get it to the president's desk, Congress in many cases compromised by punting on tough choices and leaving them to the executive branch. The Federal Deposit Insurance Corporation alone, for example, must conduct 44 separate rule-making exercises, according to Chair Sheila Bair. In rule-making, regulators solicit comments, draft provisional rules, take more comments, and then issue final rules. Formally, the process is admirably transparent, but transparency doesn't solve the gross asymmetry of influence and expertise. "We've instructed the several agencies to issue rules, and they're overwhelmed," says a senior aide to one of the legislators who wrote the bill. "Every lawyer in town is on the payroll of one bank or another. There is a huge imbalance of resources combined with the capacity of banks to clog the regulatory machinery."
The miracle of Dodd-Frank is that it got stronger as it moved through the process. The question now is whether that forward momentum will be reversed. Because the factions in the executive branch mirror those in Congress, it's worth looking back at the legislative story.
The Senate has been the graveyard of most progressive reforms of the Obama era. In the case of financial regulation, though, the bill reached the Senate just as the economic crisis was worsening and Wall Street had become politically radioactive. A backbench revolt of relatively junior senators like Jeff Merkley of Oregon, Ted Kaufman of Delaware, Jack Reed of Rhode Island, and Blanche Lincoln of Arkansas unexpectedly succeeded with floor amendments that toughened regulation of financial derivatives and conflict-of-interest prohibitions. Meanwhile, President Barack Obama, shocked into action by Scott Brown's January 2010 election to the Senate, embraced what he called the Volcker Rule -- a partial return to the pre-1999 Glass-Steagall separation of federally guaranteed commercial banking from more speculative investment banking and proprietary trading of securities.
Nonetheless, the final bill was an uneasy compromise between two factions of the Democratic Party (Republicans played little role other than blocking). One faction, reflecting about 50 Democratic senators and most of the House Democratic caucus, called for fundamental overhaul and simplification of the financial system that caused the collapse. In their view, no financial enterprise should be too big to fail. Behemoth institutions inherently too big or too interconnected should be broken up. No product or institution should escape surveillance. Conflicts of interest in the trading of derivatives and other complex securities should be outlawed. These principles are intermittently embodied in the final bill, but with details left to regulators.
The other faction, which includes Treasury Secretary Timothy Geithner, Federal Reserve Chair Ben Bernanke, Wall Street Democrats such as New York's Chuck Schumer, and the New Democrat caucus in the House, did not want to fundamentally change the structure of finance. Rather, this group would give regulators broad discretionary powers to head off future disasters. President Obama and Senate Banking Chair Chris Dodd tacked back and forth between the two factions. Rep. Barney Frank sided more often with the progressives but was hemmed in by the large contingent of New Democrats on his Financial Services Committee.
Reformers ultimately prevailed on a few key issues, including tough regulation of financial derivatives, the Volcker Rule, and Warren's consumer protection agency, while the moderates and their Wall Street allies were able to block other proposals outright, such as breaking up the big banks. But time after time, to gain the support of key swing votes, the bill's managers had to punt details to the executive branch.
At the core of the financial collapse were abuses of derivatives -- the creation and trading of securities backed by high-risk loans. Add to those risky creations the shadowy market in insurance of the same securities via credit-default swaps, and the flagrant conflicts of interest and shaky pyramids of debt that developed around them. Dodd-Frank aims to prevent a similar house of cards from being built by requiring that all "standard" derivatives be traded and cleared via clearinghouses, so that prices are transparent. The clearinghouses would not be controlled by the club of big banks, and adequate capital would be put up by traders to protect against losses. There are loopholes, however, and every one of these provisions, along with dozens more, is subject to definition. Wall Street has a lot at stake, since nearly all of the net profits of large banks are trading profits.
Other than civil servants and a few Wall Street renegades, only a few technically savvy advocates for the public's interest in strong regulation of derivatives are actively engaged in the rule-making process. One is University of Maryland law professor Michael Greenberger, formerly a deputy to Commodity Futures Trading Commission (CFTC) Chair Brooksley Born, who fought a losing battle to regulate financial derivatives back in the 1990s. Another is Heather Slavkin, who follows the issue for the AFL-CIO.
In late August, the Securities and Exchange Commission and the CFTC convened public panel discussions to solicit comments. "The first panel was 15 guys from Wall Street and Heather Slavkin," says Lisa Donner, executive director of Americans for Financial Reform (AFR). "And you are pretty sure that behind each of them are another 15 lawyers and researchers writing the comments and doing the legwork."
In fact, there was one other panelist sympathetic to reform -- Michael Greenberger. But according to Greenberger and The Wall Street Journal, one large investment bank, JP Morgan Chase, has about 100 task forces working on different aspects of implementation of derivatives reform. The CFTC, the key agency responsible for implementing derivatives rules, has only about 30 task forces assigned to implementing the entire law. "On some of the dozens of issues," Greenberger says, "I fear that only the financial services industry will have the resources to submit detailed comments."
In the legislative battles over Dodd-Frank, AFR, with a paid staff of about eight, coordinated daily strategy calls of a steering committee representing more than 200 consumer and labor groups. Collaborating organizations were able to field lobbyists and witnesses, work with key legislative staffers, and obtain rapidly evolving drafts so that the reform perspective had a strategic coherence and was represented in all of the major battles. Now, facing a far more complex and ramified implementation process, AFR has a paid staff of just three.
All of this means that in the next phase of financial reform, the main jockeying will occur between a financial industry that's still immensely powerful and the several regulators who couldn't restrain its excesses in the past. The same division between reformers and incrementalists that marked the legislative jousting splits the executive branch, with relative hard-liners at the CFTC, Securities and Exchange Commission, and Federal Deposit Insurance Corporation, while the Treasury and Federal Reserve are closer to the bankers. It's not clear which faction will prevail. "Issues like derivatives, capital requirements, and proprietary trading are profoundly linked to 'too big to fail,'" says Damon Silvers, vice chair of the Congressional Oversight Panel overseeing the Troubled Asset Relief Program (TARP), "and they have yet to be decided."
The Dodd-Frank Act gives the lead role to the Treasury and the Fed. To make sure that no financial institution or product escapes regulation, the law creates a Financial Stability Oversight Council representing the key regulatory agencies. It is housed at the Treasury and chaired by Geithner. Also at Treasury is a new Office of Financial Research intended to enable the government to investigate risky products and collect data before a crisis happens. If used expansively, this new office could finally provide the regulators and the public with detailed knowledge of Wall Street's business model and practices.
In principle, it's logical to assign lead role to the Treasury, the Cabinet department responsible for the nation's financial system. But as the recent economic crisis unfolded, the Treasury, under both Geithner and his Republican predecessor Hank Paulson, was reluctant to crack down on the big banks. In early 2009, when several were effectively insolvent, Geithner, Bernanke, and Larry Summers, the White House's chief economic adviser, decisively rejected the course of breaking up big banks. Instead, they contrived a "stress test" exercise that no bank could flunk, requested the banks to raise additional capital, and used a combination of TARP funds and cheap Federal Reserve advances to keep the banks on life support.
This recipe has proved problematic in three key respects. First, though the banks have returned to profitability -- compensation soared to a record high of $144 billion this year, according to The Wall Street Journal -- bank loans for ordinary businesses remain scarce. Lending by Bank of America, for example, dropped from $192 billion in June 2009 to $166 billion in December, and others booked similar declines. The banks would rather take advances from the Fed and invest them in Treasury securities -- a no-risk strategy that helps the banks but does nothing for the economy.
The reluctance to lend reflects the fact that the banks' balance sheets are still clogged with toxic securities left over from the crash. Fitch Ratings gives Bank of America and Citigroup "stand alone" ratings of C/D when external government support is not included but actual ratings of A-plus when it is. This raises the second problem: Treasury's strategy is to help the banks gradually rebuild their balance sheets -- but the most profitable lines of business, such as derivatives trading, are the very ones that put the banks in jeopardy. So Geithner's concern to bulk up banks' balance sheets often puts him at odds with tough regulation of abuses.
A third problem is the reality that some banks are still considered too big to fail. Dodd-Frank gives the government the authority for the first time to break up large bank-holding companies. As President Obama declared on Jan. 21, with Paul Volcker at his side, "Never again will the American taxpayer be held hostage by a bank that is 'too big to fail.'" Yet few expect Geithner and Bernanke to use that power when it comes to the biggest banks, meaning excessive risk-taking will continue. According to Silvers, an early test of the government's willingness to break up large, failing, "systemically significant" financial institutions will be its posture toward American International Group, which is still on taxpayer life support.
The premise behind the Volcker Rule, like Glass-Steagall before it, is that there is a fundamental difference between commercial banking and investment banking. Commercial banking requires detailed local knowledge and patience. Nobody gets filthy rich lending to ordinary businesses. Investment banking, by contrast, is a trading culture. You don't need to know much about the underlying business if you have a feel for doing deals and reading market trends and can make a quick fortune. In the old days, investment bankers took these risks with their own money. Since the repeal of Glass-Steagall, giant outfits like Citigroup and Bank of America do both kinds of activity, putting their customers at risk and the taxpayer on the hook.
The counterweights to the Treasury and the Fed include not just other regulatory agencies but the legislators who wrote Dodd-Frank. "If we consider our jobs done and walk away on this, it would be over," says Sen. Merkley, who co-authored the Merkley -- Levin amendment drastically limiting proprietary trading by federally insured banks. Without vigilant congressional oversight, Merkley adds, regulators tend to take the easiest course. "The regulators hear from lobbyists every day telling them how and why to weaken the Merkley-Levin protections and many other parts of the Dodd-Frank Act."
The limits on proprietary trading will be meaningful -- or not -- depending on how the regulators define them. One key question: Will the Treasury and the Securities and Exchange Commission require access to real-time trading data, so that the regulators can tell when a big bank is trading for its own account and when it is passively executing customers' orders? "We have to get data on profit margins, trade by trade," says the AFR's Lisa Donner. "If you're just the trade arranger, the margin should be low. If it's high, that suggests it could be proprietary trading."
The New York Times' Andrew Ross Sorkin quotes one banker as saying dismissively, "I can find a way to say that virtually any trade we make is somehow related to serving one of our clients." Only with very explicit rules and expansive data collection can regulators prevent such gaming.
Though Dodd-Frank gives government new powers to protect against flagrant abuses, the core business model that crashed the system is still basically intact. As economists Jane D'Arista and Gerald Epstein observe in a recent paper for the Roosevelt Institute, the biggest banks are still dangerously dependent on short-term borrowing and high leverage to finance the trading activities that account for nearly all of their net profits. This business model explains the fierce industry pushback against tough rules. "Dodd-Frank is a lot better than many of us feared," Damon Silvers says. "The risk is that the most promising aspects of this bill will never be used."
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