The simpler half of financial reform will be completed shortly with the passage of the Dodd-Frank financial reform bill. Hard as it may be to conceive, the complexity embedded in its over 2,000 pages of text is likely to be exceeded by the complications involved in the regulatory implementation of financial reform. This isn't just a technical question of working through the multiple thousands of pages of rule-writing, the creation of operating procedures, and the writing of supervisory guidelines. Critical choices will be made -- regulatory decisions are likely to be as important as the law itself in determining the success or failure of the effort to bring needed stability to our financial system.
What will be the key decisions for regulators to make?
Consumer protection. Dodd-Frank establishes a new Consumer Financial Protection Bureau (CFPB). Regulators will decide almost everything about how this works. Congress laid out a broad mandate, a set of criteria to be considered when balancing decisions, and a few limitations. The rest will be up to the regulators. These initial structural and substantive decisions will matter considerably, since precedents, once established, create very substantial political and bureaucratic inertia.
Derivatives. Congress directed the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) to take a number of crucial steps to reduce the risk of the derivatives markets and to make them more transparent. In particular, they are to ensure that standardized derivatives are traded on exchanges and cleared through central clearinghouses and that appropriate collateral and capital requirements are set for those derivatives that continue to be traded over the counter (OTC). Banking regulators will also be heavily involved, since the major derivatives dealers are all affiliated with commercial banks at this point.
Regulators will determine the rules for when a derivative is standardized enough that it must be traded on an exchange. Indeed they may even be called on to make decisions on specific derivatives at times, especially until the rules are clear to everyone. They will also set the rules determining the collateral that derivatives counterparties must put up on over the counter (OTC) trades, as well as the capital required by banks and their affiliates. These choices will significantly affect the cost and attractiveness of derivatives, which matters a great deal given the importance of these instruments in our financial system.
Beyond that, the law will make derivatives clearinghouses far more critical than they have been. In practice, these will be institutions that are "Too Big to Fail", increasing the priority of careful regulation, since the taxpayer could be on the hook in an emergency.
There may also be significant decisions to be made about how to implement the provisions backed by Senator Lincoln that force certain types of derivatives transactions out of commercial banks and into their affiliates, if they are still to be done within the banking group.
Securitization and rating agencies. Congress mandated a number of changes to securitizations and to how the rating agencies that are central to that market must operate. A considerable number of decisions are left up to the regulators. For example, the SEC is mandated to study whether there is a better approach than Senator Franken's provision that has the federal government determine who the first rating agency is for any new securitization. (Others could be hired as well, but this would guarantee that a rating would be available from at least one agency not chosen by the issuer or their investment bank.) There will also be questions about how to implement the "skin in the game" requirement that issuers of many securitizations keep 5% of the risk.
The Volcker Rule. Congress ordered the banks, after a transition period, to shed their "proprietary" activities. However, there is no satisfactory definition of what this means. Nor are there clear definitions of the several exemptions to the proprietary trading rules, such as the maintenance of securities inventories to facilitate customer transactions. The regulators will be faced with the need to find a way to operationalize the limitations they are required to impose. If they err on the side of toughness, it may limit legitimate bank activities and increase customer costs, whereas if they err in the other direction it could effectively gut what Congress intended.
Oversight of the financial system as a whole. There is broad agreement that one of the failings of the prior regulatory system was that no one was clearly responsible for monitoring the system as a whole, such as watching out for developing bubbles in the housing market or elsewhere. Congress therefore established the Financial Stability Oversight Council, which is to delegate much of its efforts to the Fed. This council is new, as is the Fed's role in working as its agent. As with the CFPB, this means that regulators will be making critical decisions about how it will all work, as they build the structure.
"Too Big to Fail". The media, public, and politicians have devoted a great deal of attention to the question of how to deal with systemically important financial institutions, ones where the government might be forced to intervene if they ran into trouble in a future financial crisis. In the end, virtually all of this will be left to regulatory discretion. The Financial Stability Oversight Council can determine that any financial institution is systemically important. Under those circumstances, the council acquires a great deal of discretionary authority to force divestiture of certain activities, the raising of additional capital, or other steps, as the regulators deem necessary. Further, it is likely that additional burdens will be placed on the big banks and other systemically important institutions, such as the imposition of higher capital requirements than those existing for smaller banks. It is already clear that any additional taxes or insurance premiums on banks will be tilted to make the larger institutions pay higher percentages.
Why will regulatory decisions matter?
Congress often specifically ordered the regulators to decide how to handle an important issue. There are at least 40 instances in the legislation where Congress required the regulators to conduct a formal study and then choose how to address a specific issue.
New legislative mandates will require a large number of critical implementation decisions. There are a number of new aspects of regulation that are created under Dodd-Frank which will require regulators to make key policy decisions that will set precedents for many years to come.
The need for global harmonization of financial reform adds complexity and increases the importance of regulatory choices. The most critical examples of this come in the areas of minimum capital and liquidity requirements. The legislation encourages the regulators to raise these requirements significantly, but leaves up to them how high the requirements should go and how the tests should be calculated. There is already an international coordinating process for these two crucial areas, known as Basel III, run by the Basel Committee on Banking Supervision. The final international agreement will have a major effect on the financial sector and, potentially, on the economy as a whole. The Institute of International Finance (IIF), an industry group, has preliminarily calculated that the economies of the US and Europe could be 3% smaller after five years than they would be without the Basel III rules. My own analyses suggest this figure is quite considerably overstated, but there clearly will be a significant impact which will almost certainly take the form of a trade-off of reduced economic growth in most years in exchange for the mitigation of damage to the economy during financial crises.
Many policy decisions must be made by experts in order to have a chance of being effective, given the complexity of the financial sector. Congress is sometimes accused of micro-management, but the complexity of the financial sector and the vast scope of the reforms would have defeated any effort by Congress to make all the important decisions.
Why is global coordination critical?
Global coordination of public policy in any complex area is difficult, time-consuming, and requires the U.S. to compromise on some of our preferred approaches. Why then should the U.S. regulators put a major effort into global coordination of financial reform? There are at least four reasons why we should often compromise in order to ensure global standards that meet acceptable minimums:
Regulatory arbitrage can create a dangerous race to lower standards. If one jurisdiction chooses to set rules that are too lenient, there would be a strong tendency for finance business to move there. Sound regulation is in almost everyone's long-term interest because of the damage to the financial industry and the economy that is caused by financial crises. However, business can be substantially cheaper to do during the non-crisis years if regulation is lax.
The competitiveness of U.S. financial institutions is affected by international rules. The financial sector is a major part of the U.S. economy. Financial activities constitute over a tenth of GDP, our financial institutions employ millions of people, and the leading global position of many of these institutions makes them a significant exporter in an American economy that could use more exports. If international rules are laxer than American ones, then our institutions are likely to lose business.
Financial crises have a habit of spreading around the world. Financial crises do not respect international borders. This is partly due to direct financial ties between institutions in different countries, partly due to international capital flows set off by crises, and partly due to changes in sentiment that can spread around the world, including the onset of outright panic. It is in our interest to encourage other nations to avoid lax regulation that could trigger such crises.
Economic pain in other countries affects us as well. A foreign recession would hurt us through trade flows and currency movements. Major financial crises generally create or exacerbate recessions, as we saw very clearly two years ago.
Conclusions
Regulators here and around the world will be critical to the success of financial reform. It behooves us to pay careful attention and to encourage decisions that appropriately balance increased safety with the regulatory burden imposed by new rules. Equally importantly, global harmonization will matter a great deal and should be encouraged, difficult and frustrating though the process can often be.
The greatest opportunities in this area stem from the expertise and dedication of financial regulators. The greatest dangers come from the complexity of financial markets, which means mistakes are easy to make, and from the lack of attention paid by the media, the public, and even Congress to the regulatory processes. Bureaucratic self-interest, ignorance of financial concepts, and excessively close ties to vested interests have more room to do damage when external attention is absent.
The crisis is entirely the fault of monetary manipulation. The SBA should hand out loans without the funds going through the Fed, and the IRS can do so with the taxpayers; we need dollars in circulation, the banks are effectively reducing the cash supply, and if the administration doesn't get more in circulation soon, we will have inflation. The only thing important about money is who controls the supply, the Constitution gave that power to the Congress; find out what Jefferson, Jackson and Lincoln knew about central bankers and the money supply:
webofdebt.com, moneymasters.com, secretofoz.org, ineteconomics.org, newdeal20.org
We are screwed!
The Executive Branch (the President and company) implements those laws.
This is a great article for HuffPosters to learn how our government works. Many obviously don't.
Those who blame Obama for what happens in Congress.
The President doesn't make law, but it's up to him to implement it.
Financial reform depends on a President who enforces it.
Congress created the EPA, but Bush crippled it. The same can happen with financial reform.
No one in their right minds should let Dodd and Frank write anything. Watch for Dodd to get a high level, highly paid job as a reward. No one with any integrity should vote for a 2500 page bill with who knows what hidden inside, particularly one written by those two crooks. The original Glass-Steagall was 53 pages. Please do not try to tell me Dodd and Frank are just more careful.
A legion of lawyers are smacking their lips in anticipation.
The Financial "Innovators" have the Ways and Means to keep this tied up in court for a decade.
Don't expect any Resolution without court Authority.
These guys have already demonstrated that they are willing to use any tool at hand to defeat reform.
It's not over just because our congress managed to squeeze out another weak piece of Fig Leaf legislation.
Yup, that`ll work just fine.....for the banking elite. Remembe Madoff and all the rest? And Wall Street can still sell worthless derivatives? Goldman Sachs is still going strong even after the blatant fraud they committed? The FED still cannot be audited?!? Lobbying investments are sky-rocketing in Awash-Ing-in-corruption-ton!!
We are all totally screwed folks.... but what else is new?
I am still looking forward to the day I hear a SINGLE corporate chieftain from the financial sector step forward and admit that the self-created complexity has long surpassed the point where the all-admired private sector would be able to produce these 'experts'.
There's only one way out and that reads: CUT the complexity. Stop pretending that there's anybody out there with all the 'smarts' to control this 'sucker'.
It's just ridiculous. Forever blaming lawmakers and regulators that they're micro-managing while firing every single soul that asks the important questions in the auditing and risk-management process - revealing that the masters of the universe don't know shit.