Tag Archives: Dodd-Frank

Let the US Fiduciary Rule Go Ahead

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The quantity of financial regulation is not quite as important as the quality.  One must get the details right.  The case of the US “fiduciary rule” strongly suggests that President Trump will not get the details right.

Could Dodd-Frank be improved?

Earlier this month, amid the flurry of tweets and other executive orders, the new occupant of the White House issued an executive order directing a comprehensive rethinking of the Dodd-Frank financial reform of 2010.

One can imagine various ways to improve the current legislation.   The most straightforward would be to restore many of the worthwhile features of the original plan that Republicans have undermined or negated over the last seven years.  (Most recently, the House this month voted to repeal a Dodd-Frank provision called “Publish What You Pay,” designed to discourage oil and mining companies from paying bribes abroad.  Score one for the natural resource curse.)

In theory, one might also attempt the difficult and delicate task of modifying, for example, the Volcker Rule, so as to improve the efficiency tradeoff between compliance costs for banks and other financial institutions, on the one hand, and the danger of instability in the system, on the other hand.  Some in the business community are acting as if they believe that Trump will get this tradeoff right.  I see no grounds whatsoever for thinking so.

In particular, the financial system has been strengthened substantially by such features of Dodd-Frank as higher capital requirements for banks, the establishment of the Consumer Financial Protection Bureau, the designation of Systemically Important Financial Institutions, tough stress tests on banks, and enhanced transparency for derivatives.  If these features were undermined or reversed, it would raise the odds of a damaging repeat of the 2007-08 financial crisis down the road.

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Looking Back on Barack

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At the end of his time in office Barack Obama merits an enumeration of some of his many accomplishments.   The recollection should start as he started, on January 20, 2009: the pilot taking the cockpit just when the plane was in an uncontrolled dive.

The circumstances were the most adverse faced by any new president in many decades.  Two ill-conceived and ill-executed foreign wars were underway, which had done nothing to bring to justice the mastermind of September 11, 2001.  He inherited an economy that was in free-fall, whether measured by the seizing up of finance markets, the fall in GDP, or the hemorrhaging of employment.  (The rate of job loss was running ran at 800,000 per month.)  True, Franklin Roosevelt inherited the Great Depression and Abraham Lincoln took office just as the Civil War broke out.   But what other president has come in facing both an economic crisis and a national security crisis?

The rapid policy response to the economic crisis included — in addition to aggressive and innovative monetary easing by the Federal Reserve — the Obama fiscal stimulus (the American Recovery and Reinvestment Act, passed by the Democratic Congress in February 2009) and rescue programs for the financial system and the auto industry.  Republicans were near unanimous in opposing the stimulus. And almost everybody was critical of the rescue programs – either urging nationalization of the banks and auto firms, on the one hand, or urging letting them go out of existence on the other.  There was and is insufficient recognition of how the Obama Administration succeeded, against all odds, at making the middle path work:  jobs were saved, while shareholders and managers suffered consequences of their mistakes  and the government got its money back after the recovery.

Most importantly, the free-fall ended promptly.  The timing and clarity of the turnaround is much more visible than one would think by listening to debates on what was the right counterfactual to evaluate the effect of Administration policies.  Economic output in the last quarter of 2008 had suffered a shattering 8.2 % p.a. rate of decline and job loss had been running at more than 600,000 per month.  Output and employment began to level out almost immediately after the February stimulus program.  The bottom of the recession came in June 2009; output growth turned positive in the next quarter.  Job creation turned positive early in 2010 and employment growth subsequently went on to set records all the way through the end of Obama’s time in office, adding more than 15 million jobs.

By the last half of Obama’s second term, the unemployment had fallen by half, to below 5% (2015 and 2016), wages were rising (by 2.9% nominal over the 12 months to Dec. 2016); and real median family income was finally growing too (by a record 5.2% in the most recently reported year, with lower-income groups advancing even more).

It is certainly true that the recovery was frustratingly long and slow.  Reasons include the depth and financial nature of the 2007-08 crash and the early reversal of the fiscal stimulus after the Republicans took back the Congress in the 2010 election and blocked Obama’s further efforts.   2011-14 are the years when the economy really could have used infrastructure spending and (the right) tax cuts.  But it would seem that Republicans only support fiscal stimulus when they are the ones in the White House — including when the economy is no longer in recession.

Obama’s other two biggest accomplishments in those first two years before the Congress starting blocking everything he tried were the Dodd-Frank financial reform bill and the Affordable Care Act (Obamacare).  In both cases, the reforms would have been better without a succession of steps by the opposition party to weaken them, both at the stage of passing the legislation and subsequently.

But each of those important reforms nonetheless succeeded in moving the country more clearly in the right direction than most people realize.  Dodd-Frank in a variety of ways helped make less likely a repeat of the 2007-08 financial crisis. Among other things, it increased transparency for derivatives, raised capital requirements for banks, imposed additional regulations on “systemically important” institutions, and, per the suggestion of Senator Elizabeth Warren, established the Consumer Financial Protection Bureau (CFPB).  Obamacare has succeeded in giving health insurance to 20-million-plus Americans who lacked it (for example, due to pre-existing conditions) and the cost of health care contrary to most predictions and perceptions slowed noticeably.

In the area of foreign policy, the wars in Afghanistan and Iraq were  intractable.   But the President made the tricky decisions that resulted in the elimination of Osama bin Laden (a goal in which George W. Bush had lost interest, in his eagerness to invade Iraq).  In 2015, just as the press was saying Obama was a lame duck, he achieved a string of foreign policy successes: a much-needed nuclear agreement with Iran, normalization of relations with Cuba, agreement on the Trans-Pacific Partnership (TPP), and important progress to address global climate change via a breakthrough with China.

Needless to say, the man who assumes the Presidency this month has said he will reverse most of these initiatives, if not all.  In some cases, he will do exactly that. TPP is certainly dead, at least for the time being.  (And four years from now will probably be too late to revive it, as East Asian countries may by then have responded to America’s withdrawal from the region by joining China’s trade grouping instead.)

In other cases, real-world constraints will make it harder for Mr. Trump to translate crowd-pleasing sound-bites into reality.  Repealing Obamacare is apparently top of the list.  But the Republicans are likely to be stymied by the absence of an alternative that does not take health insurance away from those 20 million Americans nor raise the net cost.  Some important innovations, such as the switch to electronic patient record-keeping and more emphasis on preventative care, are bound to survive in any case.  Perhaps the eventual outcome will be relatively minor changes in the substance of the Affordable Care Act, together with a new name – the analog of building a big beautiful wall on a quarter-mile of the Mexican border as a sort of stage set suitable for photo opportunities.

Similarly, it is hard to see how pushing harder on China would produce desirable results.  To take the most ironic example of ill-informed policy positions, if the Chinese authorities were to acquiesce to Mr. Trump’s demands that it stop manipulating its exchange rate, its currency would depreciate and its competitiveness would improve.

Similarly, if the Administration tries to carry out its promise to tear up the nuclear agreement with Iran, it will quickly find that US sanctions are ineffective without the participation of our allies.  Iran could rapidly renew and accelerate its nuclear program.  That is what happened with North Korea when George W. Bush essentially tore up the “agreed framework” upon taking office in January 2001.

Do the voters hold presidents accountable?   Bush made other serious mistakes in economic and foreign policy as well in those early years, of course, with the predictable consequences for the economy, budget, and national security.  Yet his poll numbers soared in his first term.

Conversely President Obama’s popularity sagged during much of his eight years.  Yet he leaves office with substantially higher poll ratings than most presidents at this stage and – unusually – with much higher ratings than his successor, let alone his predecessor at the end.  So apparently the person who occupies the White House does eventually receive the credit he is due for the intelligence of his policies and the content of his character.  It just takes longer than it should.

[A shorter version of this column appeared at Project Syndicate.  Comments can be posted there.]

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Who is right on US financial reform? Sanders, Clinton, or the Republicans?

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Eight years after the financial crisis broke out in the United States, there is as much confusion as ever regarding what reforms are appropriate in order to minimize the recurrence of such crises in the future.

There continue to be some good Hollywood movies concerning the crisis, including one nominated for multiple Oscars at the February 28 Academy Awards.  The Big Short has been justly praised for making such concepts as derivatives easy for anyone to understand.  As has been true since the first of the movies about the crisis, they are good at reflecting and crystalizing the audience’s anger.  But they are not as good at giving clues to those walking out of the theater as to the implications.  What policy changes would help?  Who are the politicians that support the desirable reforms?  Who opposes them?

If an American citizen is “mad as hell” at banks, should he or she respond by voting for the far left?  By voting for the far right?   (Or by refusing to vote at all?)   Each of these paths has been chosen by many voters.  But each is misguided.

There is a place in political campaigns for short slogans that fit on cars’ bumper stickers.  (“Wall Street regulates Congress.”)   And there is a place for ambitious goals.  (“Shrink the financial sector.”)  But the danger is that those who are attracted to inspirational rallying cries and sweeping proposals will lack the patience required to identify which is the right side to support in the numerous smaller battles over financial regulation that take place every year and that ultimately determine whether our financial system is becoming structurally safer or weaker.

Breaking up banks

Senator Bernie Sanders has proposed breaking up the banks into little pieces.  It is the centerpiece of his campaign for the Democratic presidential nomination.   The goal is to make sure that no bank is too big to fail without endangering the rest of the financial system.   That would require quite a sledge hammer.  The American banking system historically featured thousands of small banks.   But having thousands of small banks did not prevent runs on depositary institutions in the United States 1930s.

Continental Illinois was the original case of a bank that was deemed “too big to fail” in 1984, when it was bailed out by the Reagan Administration.   So banks would have to be broken into smaller pieces than that.  Merely turning the deregulatory clock back 30 years would not be enough to do it.

I am not sure whether or not, if one were designing a system from scratch, it would be useful to make sure that no bank was above a particular cap in size chosen so that any of them could later be allowed to fail with no further government involvement.   I do know that having a financial system dominated by just five large banks did not prevent Canada from sailing through the Global Financial Crisis of 2008-09 in better shape than almost any other country.

Attacking banks is emotionally satisfying, for understandable reasons.  But it won’t prevent financial crises.

Reforms proposed by Hillary Clinton

Hillary Clinton is correct in pointing out that the most worrisome problems lie elsewhere:  hedge funds, investment banks, and the other so-called non-banks or shadow banks.  These are financial institutions that are not commercial banks and that therefore have not been subject to the same regulatory oversight and the same restrictions on capital standards, leverage, and so on.  Recall that Lehman Brothers was not a commercial bank and AIG was an insurance company.

Secretary Clinton has done her homework and proposes specific measures to address specific problems with the non-banks.     Four examples:

  • She puts priority on closing the “carried interest” loophole that currently allows hedge fund managers to pay lower tax rates on their incomes than the rest of us pay.  This is a more practical step than most proposals to address the very high compensation levels in the financial sector that cause so much resentment.  It would help moderate inequality, reduce distortion, and raise some tax revenue to help reduce the budget deficit.
  • She proposes a small tax targeting certain high-frequency trading prone to abuse. (Sanders proposes a tax on all financial transactions.)
  • She also supports higher capital requirements on financial institutions, including non-banks, if necessary, beyond those increases already enacted.
  • She proposes a “risk fee” on big financial institutions that would rise as they get bigger.  This is reminiscent of a fee on the largest banks that the Obama Administration proposed in 2010, to discourage risky activity while at the same time helping recoup some revenue from bailouts.  It was going to be part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, but in the end three Republican senators demanded that it be dropped as their price for supporting it.

The Dodd-Frank reforms

The Dodd-Frank law was a big step in the direction of needed financial reform.  It included such desirable features as increasing transparency for derivatives, requiring financial institutions to hold more capital, imposing further regulation on those designated “systemically important,” and adopting Elizabeth Warren’s idea of establishing the CFPB, the Consumer Financial Protection Bureau.

It goes without saying that Dodd-Frank did not do everything we need to do.  But the law  would have moved us a lot further in the right direction if many in Congress  had not spent the last six years chipping away at it.  Those who worked to undermine the financial regulatory reform legislation – mostly Republicans – appear to have paid no political price for it, since most of these issues are below the radar for most voters.

Here are a few examples of how Dodd-Frank has been undermined:

  • I mentioned the abandonment of the fee to discourage risk-taking by large banks and of an earlier proposed global bank levy.
  • Auto-dealers, amazingly, lobbied successfully to get themselves exempted from regulation by the CFPB, allowing the resumption of some abusive lending practices that resemble the sub-prime mortgages which played such a big role in the 2008 financial crisis.  There are 17,838 auto dealers.  I guess highly concentrated industries are not the only ones that can buy their way to special-interest carve-outs.
  • The Dodd-Frank law was supposed to require banks and other mortgage originators to retain at least 5% of the housing loans they made, rather than repackaging every last mortgage and reselling it to others.  The reason is that the originators need to have “skin in the game” in order to have an incentive to take care that the borrowers would reasonably be able to repay the loans.  Under heavy pressure from Congress, that requirement was gutted in 2014.   (This one is not especially the fault of the Republicans.  Virtually every American politician in both parties still acts as though the goal should be to get as many people into as much housing debt as possible, even if many will not be able to repay the loans and even after such practices caused the worst financial crisis and recession since the 1930s. Other countries manage to do this better.)
  • The Congress has refused to give regulatory authorities such as the SEC (Securities and Exchange Commission) and CFTC (Commodities Futures Trading Commission) budgets commensurate with their expanded regulatory responsibilities, in a deliberate effort to hamper enforcement.  Many Republicans appear still to believe that these agencies represent excessively aggressive regulation.  This is remarkable in light of the financial crisis.  Remember that Bernie Madoff — who is himself now the subject of new Hollywood portrayals — was able to run his Ponzi scheme right up until 2008 despite repeated tip-offs to the SEC, because it systematically refrained from pursuing investment management cases during this period.

Who can get the job done?

Sanders has indicated that if he were president, nobody with past experience on Wall Street would be allowed to serve in his administration.  A blanket rule like this would be a mistake.  Judging people by such superficial criteria as whether they have ever worked for Goldman Sachs, for example, would have deprived us of the services of Gary Gensler.  As CFTC chairman from 2009-2014 Gensler worked tirelessly to implement Dodd-Frank.  To the consternation of many former Wall Street colleagues, he aggressively pursued regulation of derivatives and, for example, prosecution of a case against five financial institutions who had colluded to manipulate the LIBOR interest rate (London Interbank Offered Rate]. Yet Sanders tried to block his appointment in 2009.

Financial issues are complicated.  Getting the details of regulation right is hard.  (The examples mentioned here are just the tip of the iceberg.)  We need leaders and officials who have the wisdom, experience, patience, and perseverance to figure out the right measures, push for their enactment and then implement them.  If such people are not the ones who receive political support for their efforts, we should not be surprised if the financial sector again escapes effective regulation and crises recur in the future.

[I have given my subjective evaluation of various specific legislative proposals – some in Dodd-Frank, some proposed by Bernie, some proposed by Hillary– on a 1-slide diagram.  A shorter version of this column was published at Project Syndicate.  Comments can be posted there or at the Econbrowser post.]

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