Financial Instruments & Institutions – ECON 304 Financial Crisis and the Dodd Frank Act Words: 3510 After the 2007 Financial crisis, confidence in free markets was at an all time low: the public was increasingly skeptical about the ability of governments and regulatory institutions to improve market conditions. In an attempt to restore financial stability and improve investor confidence, the Obama administration enacted the Dodd–Frank Wall Street Reform and Consumer Protection Act.
Easily one of the most controversial pieces of legislation passed by the US government, this act was met with extremely varied reactions from the public, from fierce opposition to straight adulation. While the lack of hindsight prevents us from giving a fair assessment of the act’s outcome and efficiency, a few questions can be formulated: what prompted the US government to pass the Dodd Frank act? What kind of changes did it implement and how did this modify the already existing regulatory architecture? What were the main criticisms?
To answer these questions, we will first examine the background of the financial crisis, how these changed the regulatory architecture and finally expose the differing views on the Dodd Frank act. The 2008 global financial crisis resulted from the creation of massive fictitious financial wealth, which is disconnected from the production of goods and services (Bresser-Pereira, 2013). The financial system in the United States was designed to generate profit as leveraged capital, cycled from homeowners to investors.
Capital began in the hands of homeowners, who borrowed from commercial banks in the form of a mortgage. The commercial banks profited from interest payments on the mortgages. Investment banks raised millions of dollars to buy mortgages then packaged the mortgages to sell them as financial instruments called collateralized debt obligations (CDO). Rating agencies are hired by the investment banks to rank the quality of the CDOs. These ratings take into account the credit risk evaluation of collateral assets based on the probability of default and other modeling assumptions (Fender, 2004).
To compensate for their higher risk, speculative CDOs pay a higher rate of return and safer CDOs pay a lower rate of return. Increasing demand for CDOs caused commercial banks to start lowering their lending standards and approving loans to less credit-worthy homeowners. These subprime mortgages often required payments only on the accrued interest for the first several years. This made monthly payments achievable for low-income borrowers. Subprime mortgages were then sold by commercial banks to investment banks and the heightened default risks associated were transferred as a result.
When investment banks packaged the subprime mortgages into CDOs, many of the CDOs failed to pay their returns because of defaulting subprime homeowners. Prudent investors and cynical speculators took notice, and began to guarantee their investments through insurances companies (Desmond, 08). These insured investments, called credit default swaps, transferred an incredible amount of risk to insurance companies like AIG. With the purchase of a credit default swap, the buyers received credit protection, making the seller of the swap guarantee the credit worthiness of the debt security.
In doing so, the risk of default was transferred from the holder of the fixed income security to the seller of the swap (Investopedia, 2013). When subprime borrowers needed to begin payments on the primary in addition to the accrued interest on their mortgages, the increased monthly payments became impossible to pay. The subprime borrowers consequently began defaulting in large numbers, thereby harming investments higher up the chain. CDOs became worthless to investment banks, who ceased purchasing them from commercial banks.
As a result of the frozen debt security market, the commercial banks stopped lending. The credit default swaps that insurance companies sold were exercised. The flow of investment stopped between homeowners, banks, and insurance companies. As of February 22, 2012 authority for the Troubled Asset Relief Program was originally set at a maximum of $700 billion. However, that total was reduced to $475 billion in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Congressional Budget Office, 2012:2).
The $700 billion bailout plan for the US financial system exacerbated their debt in a desperate attempt to rehabilitate the economy. The crisis highlighted the need to redefine the architecture of the regulatory system. The first issue is to address the relevant externalities. An externality occurs when an economic transaction imposes costs or benefits on individuals who are not party to the transaction. The externality, with regard to the financial crisis, was the build-up of systemic risk in the financial system.
There is no market to appropriately price systemic risk due to asymmetric information and the limited ability to make binding commitments. According to economists, the most efficient solution is to impose a Pigovian tax that would tax financial firms and would rise with their systemic risk contribution. This, however, is not a politically palatable policy. With regulation, the government wants to give regulators the authority and the tools to deal with systemic risk and demystify the organizational structure of complex financial institutions (Acharya et al. 011, 6, 7). There are two proposed ways to give a measure of the financial system’s health and assess whether the Act will have any impact in the future on the level of systemic risk. The Act proposes a classification-based criterion for determining risk in institutions. The problem is that large banks may then choose to break themselves up to avoid being placed in the high risk category that is under more intense scrutiny, all the while retaining their exposure to risky assets.
This approach should then be supplemented with market-based continuous measures of systemic risk which use market data to estimate which firms are exposed to risk and therefore contribute to incurred losses. Such measures are based on stock market data since it is available daily and least affected by bailout expectations. To exemplify, we use the measure called Marginal Expected Shortfall (MES), which predicts how much the stock of a particular financial company will decline in a day if the whole market declines by at least 2 percent.
It determines the capital shortfall a firm would face in a crisis. If the aggregate financial sector falls below prudential levels, there is too little capital to cover liabilities, therefore increasing systemic risk and leading to widespread failure. NYU Stern’s Vlab uses the MES to produce a Systemic Risk Contribution (SRISK%), which equals the percentage contribution of each firm to the aggregate capital shortfall in the event of a crisis and gives a good measure of systemic risk (Acharya et al. 2011, 94-100).
We can plot the SRISK% measure for the United States to view the variation in systemic risk since 2007. The curve shows the rise in systemic risk from 2007 to 2009 with a peak in September 2008 concurrent with, amongst other things, the placement of Fannie Mae and Freddie Mac in government conservatorship and Lehman Brothers filing for bankruptcy (Federal Reserve Bank of St Louis, 2011). Systemic risk has since decreased but has not yet attained the pre-recession levels. This model accurately tracks the variations in systemic risk and enables us to see which firms are the largest contributors.
Additional tools such as these will hopefully enable the new government institutions – which we will talk about in the following section – to effectively keep track of systemic risk and pin-point who is responsible. From an economist’s standpoint, in all financial systems, there are four pillars of effective regulatory architecture: encouraging innovation and efficiency, providing transparency, ensuring safety and soundness, and promoting competitiveness in global markets. Pursuing each of these pillars creates difficult policy trade-offs. So how did the Dodd Frank Act modify the regulatory architecture?
To provide context, following the Great Depression, a more robust regulatory structure was designed in the 1930s. Throughout the 20th century the structure was altered to accommodate new institutions, new financial instruments, financial globalization, and periodic shocks and market failures. It was modified too many times to efficiently accommodate the complexities of financial intermediation and by 2007 the system failed. In 2009 the defects of the dominant institutions remained, which posed a risk to future financial stability and gave the need for a new regulatory architecture (Acharya et al. 011, 35, 36). Regulatory architecture is critical to resource allocation and economic growth. Good financial architecture must be robust to shocks that emanate from the financial system and the real economy both domestically and internationally. From past experience, we can already rule out managerial self-regulation, proper corporate governance, industry self-regulation, and market discipline as effective solutions to containing systemic risk. To deal with systemic risk, the Obama administration adopted a modified laissez-faire approach in 2009.
Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the regulatory structure has undergone many changes but without an overarching and coherent structural design. This maintains the status quo, allowing banks to engage in all forms of financial intermediation and principal investing worldwide subject to certain safeguards. The challenge is to deal with the loss of transparency and the increase in information asymmetry due to the growth of the shadow banking sector. It only partially deals with the dangerous growth of the shadow banking system, that is, the units of financial conglomerates that perform ey functions of banks but fall outside the regulatory system to a certain degree. A modified laissez-faire approach involves: creating an appropriate mandate and tools for a systemic risk regulator, pricing implicit public subsidies to systemic financial firms using capital and liquidity requirements, improving the transparency of the financial system, and creating the bankruptcy tools the financial system needs (Acharya et al. 2011, 39, 40). The success of modified laissez-faire depends heavily on the Fed. Its mandate has extended further from monetary policy as it has become increasingly politicized.
While its regulatory role has been greatly expanded, its powers to intervene have been constrained. Many criticized the Fed’s straying from the normal precincts of monetary policy when it wielded power to avoid a financial meltdown so the government had to rethink the role of the Fed after 2009. The central bank now juggles monetary policy, the supervision and regulation of individual financial institutions, and systemic regulation of the financial concern for the financial sector. The difficulty is in the Fed’s ability to come to aid the shadow banking system, which is a politicized task.
The Treasury and the FDIC also have new roles in preserving financial safety. The SEC has also expanded mandate for rule-making, monitoring, and ensuring transparency, as we will see in the following section. At 848 pages, the Dodd Frank Act is a massive bill. Provided here is a quick overview of some broad objectives of the bill along with measures, contained in the act, which work towards achieving the following goals: – 1) promoting transparency and accountability in the financial system, – 2) eliminating the perception that some institutions are “too big to fail” and – 3) protecting consumers from abusive financial services practices.
To address problems of transparency and accountability, the Act restructured the financial regulatory system. It created new agencies and gave them new regulatory powers, in addition to consolidating existing powers. The Financial Stability Oversight Council oversees the general stability of the financial system; the new Credit Rating Office oversees the consistent and prudent application of credit ratings as well as the overall operations of credit rating agencies. The new Financial Insurance Office oversees the health and stability of the insurance industry in particular.
They fulfill their individual mandates by conducting regular examinations of financial institutions and creating new rules and regulations in each respective jurisdiction. The Financial Insurance Office is also able to designate any insurance company who poses a risk to the stability of the system as a “non-bank financial institution”, which would qualify it for further examination and supervision by the Federal Reserve. These measures work to increase the amount of information available to regulators and consumers, and therefore increase the amount of transparency and accountability in large, complex financial institutions.
The Act also seeks to eliminate the perception that certain institutions within the financial system are so important to its health and stability that they are “too big to fail”. The 2007 crisis demonstrated that the failure of such systemically important financial institutions (SIFIs) can impose costs on the entire system. The anticipation that regulators will bailout SIFIs encourages excessive risk taking, therefore reinforcing systemic risk (Acharya et al. 2011, 87).
To prevent this, the Act has given the Federal Depository Insurance Company (FDIC) the power to take a failing institution and preserve the essential operations by running a “bridge company” while everything else is liquidated. This new measure, called “Orderly Liquidation”, should help federal regulators place the burden of bankruptcy on creditors and shareholders while protecting depositors and taxpayers from losses by eliminating the need for heavy financial government aid. To support this process, new bankruptcy contingency standards have been introduced.
The failure of large institutions, such as Lehman Brothers, was a strain on financial industry stability because there were no bankruptcy contingencies in place and they were unprepared for such situations. These new standards require that all large, complex financial institutions have all the information needed for liquidation readily accessible. These measures increase the likelihood that large financial institutions fail harmoniously, thus reducing the likelihood that financial government aid will be needed and hopefully reduce the perception that those large financial institutions are “too big to fail”.
Another new piece of legislation is the Consumer Financial Protection Act which introduces a number of measures to curb abusive consumer financial services practices and protect consumer-depositors. It created the Bureau of Consumer Financial Protection, designed to oversee and enforce protections on consumer financial services such as mortgages, credit cards, and student loans. Its powers encompass those of various other now-redundant agencies, including the ability to regularly examine and conduct studies on financial institutions, markets, and services in its jurisdiction, and to make recommendations and new regulations accordingly.
The Act also gave much power to the Securities and Exchange Commission (SEC) that can now impose a fiduciary duty on the broker-dealer to their clients. A fiduciary duty is an obligation to act carefully and with due diligence, like the duty lawyers have to their clients. Among other things, this means that mortgage lenders must fully explain subprime or other risky loans and give recommendations based on what’s in “the client’s best interests” as opposed to what is just “suitable”.
This also means that contracts will be easier to understand as banks eliminate hidden fees and information that used to be contained in the fine print. A more abstract protection of consumer-depositor funds was introduced with the partial separation of commercial banks and hedge funds contained in the Act and embodied by the Volcker Rule. The Volcker Rule touches upon multiple issues, and protects consumers by preventing banks from owning or operating hedge funds unless they invest less than 3% of their core tier one capital in them.
This is because hedge funds often engage in speculative trading, a risky activity which is believed to have contributed to the financial crisis. By increasing the separation between the commercial bank and hedge funds, it’s hoped that the banks and their customers, will face less risk from those separated entities and risky behaviours. Some argue that, had the act been passed before 2008, the crisis would not have occurred. Indeed, one positive aspect of the DFA is its attempt to bring more transparency, end “too big to fail” and protect consumers as well as investors. The DFA aims to regulate financial disintermediation.
As a matter of fact, non-banking institutions that had been unregulated over the last 20 years were competing with banks, whereas they had a significant advantage over the latter, thanks to fewer capital requirements and regulations. In addition, codifying into law capital requirements should bring stability and restore confidence in the markets. However, the DFA is criticized on several points. First of all, while some praised the reactivity of Congress, critics argued that it was a rapid, clumsy and aggressive overreaction to the 2008 financial crisis (Koba, 2010). The U.
S was one of the first countries to take a step towards stricter regulation in the financial sector, which according to its advocates, puts the country well ahead in terms of regulations. Yet, it pays little attention to international regulatory efforts or coordination. The government assumed that reforms in the US would be the first to appear and that the system would therefore become a regulatory template for the rest of the world (Acharya et al. 2011, 35-48). The DFA’s length makes it a very long and complex piece of legislation that is hard to implement, thus hindering its very purpose.
Some argue that a simpler rule would be required for better success. While the act, as stated is 848 pages, the rules and regulations demanded by this law now exceed 8,843 pages, and keeps growing. Comparatively, significant and successful acts in the past such as the 1913 Federal Reserve act and the 1933 Glass Steagle Act were only 32 and 37 pages respectively. Red tape effects are therefore feared, with substantial compliance costs to firms (The Economist, 2012). On top of compliance costs, the DFA has the effect of reducing banks’ profit margins, thus making them less competitive internationally.
As Tom Joyce, a debt capital strategist at Deutsche Bank in 2010, pointed out, “every major provision of the bill has the side effect of either creating downward pressure on industry profitability – which is likely to be significant – or upward pressure on the amount of capital that needs to be provided in various different businesses”; in fact “industry returns on equity are going to go down from about 15 percent on average today to between 11 and 13 percent going forward. Some estimates have it even going even lower” (Monsarrat, 2010).
This would also impact smaller banks which would need to expand in order to survive the strengthened regulation (Veith, 2012). Consequently, while the DFA reflects an attempt to adapt to the complexity and the frantically changing nature of the current financial system, its detractors raise the question of potential loopholes that can occur in such a piece of legislation. One of the main loopholes is “collateral transformation”. This allows traders to “transform” risky securities into the high-grade bonds that clearinghouses require traders to post as collateral.
This can be done by temporarily swapping out their lower-grade securities with banks for high-grade bonds such as Treasuries (Weise, 2012). Both parties – banks and traders – are winners, traders have quality collateral while banks collect fees and interest for lending. However, if traders are wrong, the banks will be left holding risky bonds instead of high-grade securities. Moreover, if the banks borrow the high-grade bonds, the original lender could set off a ripple effect through the market by calling back the collateral.
Hence, a downward spiral could follow, something that the Dodd-Frank reforms are supposed to prevent (Timone, 2012). The bank of New York Mellon estimates that investors will need as much as $4 trillion in good collateral to comply with the new regulations (Weise, 2012). Other critics argue that foreign owned banks are likely to change their legal classification so as to escape the new 4% capital requirement, as did the British bank Barclays in November 2010 (Einrich, 2011). This would bring unjustified asymmetries within the same market in terms of capital requirement, mainly penalising American banks.
In the same vein, anticipating the Volcker rule, banks have already dropped the term “proprietary” trading and renamed it so as to escape the DFA definition. These few examples show the limitations of the act and once again reflect the reactivity of markets constantly innovating to find profitable alternatives. The risk is to strangle the American economy with too much regulation in favour of other world regions with less stringent regulation. Whereas it attempts to restore stability and confidence in the markets, it might end up being counterproductive, especially in the midst of a recession.
The Dodd-Frank Act was an attempt by the Obama administration to restore financial stability and improve investor confidence after the 2007 financial crisis. The most important lesson from the crisis is that important financial institutions can impose costs on the entire system. Therefore, the act focuses on addressing systemic risk and sets three goals to restore stability: increase accountability transparency, end “too big to fail”, and protect investors and consumers. The success of the government’s ‘modified laissez-faire’ approach depends on the Fed’s ability to carry out its responsibilities.
This will require complete cooperation on the part of financial institutions. Banks, however, were some of the most ardent critics of the Act when it was first passed, leading to intensive lobbying which could be dangerous for the economy. Therefore, while the Dodd-Frank Act is a positive step towards a safer and more regulated financial system, regulators must be wary of overly strict legislation on the one hand, and loopholes on the other, which would render the American banking system less competitive. Bibliography: Acharya, Viral V. , Thomas F. Cooley, Matthew Richardson, and Ingo Walter.
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