Three years ago this July, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act to reign in the bulls that supply-side lawmaking set loose in the 1980s. Ideally Dodd-Frank reorganized the oft-overlapping oversight authority of federal agencies, created new divisions to protect the interests of investors and depositors, and provided Uncle Sam with new tools for his systemic risk utility belt. In reality the law fired vague directives at the wrong problems, and despite being left largely unscathed the Street drowned the legislation in lawsuits that stalled many of its hallmark provisions.
Issues like Too Big To Fail and corporate debt-shelters have worsened largely because Dodd-Frank didn’t let federal regulators address them, and with the Federal Reserve flushing balance sheets with billions in low-interest cash America’s banking behemoths pose a greater risk than they did during the mortgage crisis. All, however, is not lost. Should Congress take a few cues from post-Depression era reforms, and retain several of Dodd-Frank’s better ideas, Washington could finally reel in runaway risk-takers on Wall Street.
Good Idea, Bad Idea
Good Idea: Creating the Financial Stability Oversight Council to keep a weather eye on the financial system for investment practices that pose a systemic risk to the health of the overall economy.
Bad Idea: Doing nearly nothing about the institutions and products that already pose that risk.
- The six largest financial institutions in the country, by assets, are: JPMorganChase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley. Together these firms hold approximately $9,645,151,000.00 in assets, roughly 60.26% of first-quarter 2013 GDP. Last year when I made mention of this same problem, that figure was closer to 56%.
Good Idea: Developing the “residential mortgage originator” concept to allow regulators to trace a mortgage-backed or other asset-backed security to its original underwriter. This, combined with the new definitions for various types of asset-backed financial products and rules for how they’re accounted for, should result in greater transparency for much of the credit derivatives market.
Bad Idea: Leaving artificial corporate structures untouched
- During the financial crisis, federal regulators struggled to untangle OTC derivatives because the path between bankers and borrowers was obscured by a spider’s web of subsidiary issuers, securitizers and lenders. Many of these structures existed purely to act as repositories for toxic debt that hid from investors until financiers on Wall Street secured a federal backstop on their risk. Special Purpose Vehicles are leverage-laden time bombs that enable inordinate risk-taking while simultaneously eroding the foundation of the financial system with credit-sourced speculation, and Congress would be wise to outlaw them entirely.
Good Idea: Creating new regulators for insurance companies, creating investment products from existing policies, and reorganizing oversight authority between agencies to reduce overlap
Bad Idea: Marshaling both old and new regulators to deal with specific operations within the financial system without first separating the firms they’d regulate
- Since 1980, deregulation hastened the merger-and-acquisition trend within the financial industry, producing firms of immense size and effectively blurring the line that laws like Glass-Steagall drew between commercial banks, investment banking, and securities underwriting. Without restoring these firewalls, and adding new ones for players securitizing residential and insurance products, federal regulators will stumble over each other drafting rules for each component of Wall Street’s banking conglomerates.
So What’s Uncle Sam to Do About This?
While there are plenty of things Congress could do to improve the Dodd-Frank law, here are a few teeth the legislation really needs:
- Dodd-Frank needs to sever commercial banking, investment banking, residential/commercial mortgage lending, and securities underwriting from one another. Distancing commercial and investment banking would force the investment bankers to more stringently manage risk, since they’d lack access to consumer deposits as collateral for issuing securities and protections like federal deposit insurance. Without investment banking arms, commercial banks get to de-leverage balance sheets and concentrate on maintaining capitalization through deposits. Mortgage lending operators would be easier to monitor if divested from commercial banks and put in position to draw quality contracts to attract financing for issuing loans instead of relying on the implied safety of insured deposits. Insurance agents should be kept away from the securities industry entirely to restore the integrity of premium costs, and to prevent underwriters from creating investment products that enable price inflation in policies.
- The bill should be amended to deal with Special Purpose Vehicles and other artificial structures in one of two ways: either outlawing their use, or requiring that the subsidiary vehicle’s assets appear on the parent company’s balance sheet. This way financial institutions will have to place liquid, investment-grade assets into these companies, or deal with the market reaction to mounting liabilities on their balance sheet. Fortunately, if the abovementioned severing were to occur, these firms could be small enough to allow the OLA to gracefully see them out the door.
- To support the regulators in their contests against the institutions that violate securities laws, Dodd-Frank should include provisions that increase funding levels for the legal terms of each agency, as well as for suits brought by the Justice and Treasury Departments.
- Last, Dodd-Frank should include higher capital requirements for commercial banks, investment banks, insurance companies, and securities underwriters. Limits on leverage ratios would give banks less room to accumulate liabilities by using speculative lending practices or by issuing new debt to cover outstanding debt. In particular, leverage ratio restrictions should be higher for investment banks, as a greater share of their working capital comes from private investors.