Harvard Law & Policy Review

financial crisis

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Repeal of Dodd Frank Act-Heralding a new financial crisis?

By Nicolas Deising* & Nihal Dsouza**

The Dodd Frank Act is considered to be the most ambitious and far reaching legislation regulating the financial sector since the Great Depression of the 1930’s. On the surface, it instills confidence in the financial system. At a deeper level, it is aimed at preventing similar occurrences to the 2008 financial crisis, in which millions of people lost their homes and jobs and trillions of dollars of national wealth disappeared. Despite its benefits, the Act has been criticized for being overly complex and not achieving its stated goals. Most recently moves, both through an executive order and legislative action in the Senate, have been made to reduce the Act’s efficacy and subsequently clear the path for its repeal. These decisions of the new Administration are in line with their policy of minimum governmental regulation.

These measures, however, may prove to be short-sighted as they underestimate the importance of the legislation. The Dodd Frank Act has made the financial system more secure by providing significant tools to ensure stability and consumer protection. It ensured that systematically important banks did not indulge in inherently risky activities such as proprietary trading. By doing so, systemic risk is precluded wherein failing big banks would not be able to pull down smaller ones.

In order to prevent the occurrence of a new crisis, Dodd Frank introduced a new regulatory regime with strict obligations and prohibitions for financial institutions on the one hand and a plethora of provisions for consumer protection on the other. Dodd Frank puts in place a regulatory framework to reduce risks to the financial markets. The Act has numerous sections ensuring that the responsible authorities have the necessary discretionary powers for effective implementation and enforcement. The Securities Exchange Commission (SEC), the Commodities Futures Trading Commission (CFTC), the Board of Governors of the Federal Reserve System and finally the Consumer Financial Protection Bureau (CFPB) are essentially responsible for ensuring implementation of the Act.

The CFPB, established by Dodd Frank serves the vital function of preventing predatory mortgage lending, which was one of the major factors that led to a bubble on the housing markets. Thus, it acts as an independent financial regulator. Furthermore, the Act also created an interagency group, the Financial Stability Oversight Council (FSOC), which is endowed with the authority for monitoring risks to the financial system. Its purpose is identifying risks and responding to them and promoting market discipline. The FSOC consists of representatives from federal and state regulators as well as independent insurance experts. A central component of the Act is the “Volcker Rule” in Title VI, which prohibits speculative activities for commercial banks. In particular, the Volcker Rule doesn’t allow banks to invest in hedge funds or private equity firms. The Act in Title VII also addresses the reduction of risks inherent to derivatives trading. Over-the-counter (OTC) credit derivatives spread and increased the risks posed by asset-backed securities (ABS) and collateralized debt obligations (CDO) during the crisis. Therefore, the Act mandates higher transparency standards and liquidity requirements for financial institutions. To decrease systemic risk, the Act also requires clearing over a central counterparty that sits between the buyer and the seller and guarantees the performance of contracts. Additionally, Dodd Frank mandates exchange trading for several swaps. Exchange trading, in contrast to over-the-counter trading is standardized, transparent, and regulated and consequently safer. Furthermore, the Act imposes higher capital requirements on financial institutions and thereby decreases their leverage. The council has to make recommendations to the Federal Reserve to establish standards for risk based capital, leverage, liquidity, and contingent capital. Another major achievement of the Act is the regulation of credit rating agencies like Moody´s and Standard and Poor’s by creating an Office of Credit Ratings at the SEC.

The Dodd Frank Act has been the subject of numerous criticisms. It has been argued that the Act increases the compliance costs for financial institutions without giving any substantial benefits to the public. Critics also argue that the Act unduly burdens small banks by subjecting them to the same rigorous standards as larger banks, and that this is bad for the economy. Moreover, some scholars have raised arguments against the consumer protection provisions, on grounds that the added cost and complexity makes it more profitable for creditors to concentrate their lending only on well-to-do borrowers, thereby making it harder for middle-class borrowers to access credit. Furthermore, it is contended that increased regulation is inherently bad for consumers because banks would ultimately pass on the added cost of implementation to them. There are also worries that the Act is overly complex, and that too much regulation itself affects financial stability. In addition, it is argued that excessive regulation and the absence of a level playing field puts U.S. institutions in more difficult position then their European counterparts, leading to regulatory arbitrage.

Most of these criticisms can be addressed and do not justify an outright repeal of the Act. The threat of regulatory arbitrage, for instance, is greatly reduced by the uniformity in the approach taken by the G20, and in any case with the Basel III standards implemented and transposed universally there will be little chance of regulatory arbitrage. Furthermore, it is better for consumers to pay a little more for financial services rather than face the prospect of another banking crisis. It is also important not to forget that the Act provides legislation in important areas that were hitherto unregulated; for instance, it regulates shadow banks and the non-bank financial institutions (NBFI), which were previously contributors to the crisis. It prevents predatory lending and the so-called Ninja Mortgages. Although there is merit in some of the criticisms notably regarding the negative impact on smaller or community banks, the safer way forward, which would be acceptable to both sides of the political spectrum, would be to amend the Act and not try for an outright repeal. A possible solution would be to reduce the burden on smaller banks by ensuring that the strictest requirements are only for the systemically important financial institutions (SIFIs) and not the smaller institutions.

With the passing of almost a decade since the financial crisis, it appears as if lawmakers have gotten lax and forgotten the catastrophic effects which came in its wake and the lack of regulation which led to it, which made some of the most significant financial institutions collapse. Dodd Frank was intended to ensure that SIFI’s would not fail, and this goal remains as relevant today as it was pre-financial crisis. The Act contributes enormously to the progress made in recent years in ensuring a more resilient banking system that can limit the outfall of any potential future crisis. Its repeal would make many bankers happy but would in effect ‘pull the rug out from under’ the global financial system.

* Nicolas Deising is a Research Assistant at the University of Bonn and a PhD Student.

** Nihal Dsouza is a Research Assistant at the University of Bonn and a PhD Student at the International Max Planck Research School for Successful Dispute Resolution (IMPRS-SDR).

Photo Credit: Nakashi

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DIRECTOR ZIENTS: Building an Economy to Last

When President Obama took office in 2009, the economic outlook was bleak. We were losing nearly 800,000 jobs—the equivalent of laying off the entire workforce of West Virginia every month. The unemployment rate was headed to 10 percent. The auto industry and the financial system were on the verge of collapse. We were approaching a second Great Depression.

Fortunately, in the face of stiff opposition, the President took bold, determined action. He moved aggressively to repair our financial system and stabilize housing markets. He fought to get the Recovery Act through Congress, which made critical investments in infrastructure, energy, broadband, and education. It kept teachers and first responders on the job. It immediately cut taxes for middle-class Americans. And it helped the hardest-hit families make ends meet. Analysis by the Council of Economic Advisers suggests that at its peak, the Recovery Act increased employment by nearly 2.5 million jobs, and prevented millions of Americans from falling into poverty—more than 5 million in 2010 alone. At a time when a lot of people here in D.C. were urging us to stand aside and let Detroit collapse, the President engineered the rescue of the auto industry. Since that time the industry has added more than 600,000 jobs and the Obama Administration’s loans have been repaid in full.

That historic response paid off: we averted catastrophe and jumpstarted growth. Just six months after the President entered office, an economy that had been shrinking at an annual rate of more than 8 percent started growing again. American businesses have now created 15.5 million new jobs since early 2010. Unemployment has been cut in half to below 5 percent. The stock market has more than tripled. Rising home prices have replenished trillions of dollars in middle-class wealth. In 2015 alone, real median household income rose by 5.2 percent, and more Americans climbed out of poverty in 2015 than any other year since the 1960s. So far in 2016, wages have grown by 3 percent at an annual rate, much faster than inflation. And we have achieved all this progress despite significant economic headwinds from overseas.

The President’s policies have laid the foundation for a fairer and more durable economy. But at the same time, many Americans feel real anxieties. While many have benefitted from a decades-long economic transformation, some worry that the new economy does not have a place for them. They look at the disruptions that globalization and technology carry and worry that they might be left behind. While these forces have led to remarkable advances, they are also testing the basic promise of America—that every American who works hard has a fair shot at opportunity and economic security.

That is why we have been tackling these challenges from the first days of the Obama Administration. The President has always taken the long view—working to lay a new foundation for an economy that works for all Americans. It is why the President has taken important actions on education—upping our commitments to Pell grants, catalyzing change across the pre-K through 12th grade education system, and proposing universal pre-K and free community college. It is why the President signed into law Wall Street reforms to make our financial system safer and stronger. The Consumer Financial Protection Bureau has put nearly $12 billion back in the pockets of over 27 million consumers as a result of its supervisory and enforcement work. It is why the President has strengthened job training programs by working with employers, community colleges, and training providers to make sure that training dollars are focused on local, in-demand skills and available jobs. And it is why the President signed into law the Affordable Care Act, which has given another 20 million Americans the financial security that comes with health insurance, and made major progress in addressing the spiraling health care costs that were eating into Americans’ wages, harming our businesses’ ability to create jobs, and threatening our fiscal future.

Despite the dire predictions from some here in Washington, long-term investments in our economy have not slowed job growth or caused deficits to skyrocket. In fact, just the opposite. Job growth has been strong. Health care prices have risen more slowly than they have in 50 years. And we have cut annual deficits by about two thirds. But, of course, we know there is more work to be done.

After decades of neglect, we have an infrastructure deficit of over a trillion dollars across our transportation, water, electricity and aviation systems. Our outdated roads, bridges and highways alone impose a hidden tax on American families and businesses of over $150 billion per year through hours lost in traffic, wasted fuel, higher shipping costs, and lost wages and jobs. This year, commuters in Philadelphia and Houston will spend more than 48 hours—two full days— stuck in traffic.

We need to fix our business tax system. Our outdated tax code distorts business decisions, creating incentives for firms to locate production and shift profits overseas and to take on excessive debt. We need reforms to ensure that companies make business decisions based on their business prospects, not their tax strategies.

We also need to expand educational opportunities for young Americans. Our nation’s economy for the decades ahead will be built on the shoulders of today’s students, so it is critical that we prepare them for an economy that is evolving at lightning speed. Increased investments in early childhood education, expanding access to high-quality job training programs, like apprenticeships, and making college more affordable are all essential to ensuring that tomorrow’s workers can compete in an increasingly global economy.

Finally, we need to make sure that all workers benefit from the forces of globalization that have led to so much progress and economic gain around the world. Closer ties around the world have improved the lives of billions of people, but they have also led to disruptions that have hit certain workers and communities very hard. It may be understandable that some want to pull back from a globalized world. But given global supply chains, trying to cut ourselves off from the rest of the world will simply hurt workers and exacerbate inequality. Instead, it is critical that we make our economy more inclusive, through stronger protections and wages for workers; a robust safety net; durable education policies; and trade agreements that protect workers and the environment

The United States has the strongest and most durable economy in the world. We have the most desired products, the strongest exporters, the best workers, and the most innovative businesses. The President has been fighting since his first day in office to build upon those underlying strengths. By building on his successes, and facing directly the challenges that remain, we hope our successors can keep our nation on a path to a more prosperous future.

 

Jeff Zients
Director, National Economic Council
Harvard Law and Policy Review

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CHAIRMAN MASSAD: Bold, Steady Leadership in the Face of the Financial Crisis

As President Obama took office in January of 2009, our nation was in the depths of the worst financial crisis since the Great Depression. We were losing more than 750,000 jobs a month. Ultimately, those job losses totaled nearly nine million. Over five million American families lost their homes. Countless small businesses were shuttered, and about thirteen trillion dollars in family wealth was destroyed, costing many Americans their retirement savings, their chance to go to college, and other opportunities.

We’ve come a long way in the eight years since the President took office. Since 2010, we have seen seventy-nine consecutive months of private sector job growth, adding a total of 15.5 million jobs. The unemployment rate has been cut in half, rising home prices have restored more than six trillion dollars in home equity, the S&P 500 has risen by about three hundred percent, and we have seen the fastest sustained deficit reduction since World War II.

The causes of the crisis were many, accumulating over a number of years. They included a bubble in house and other asset prices; banks and investors taking on excessive risk they did not understand; mounting corporate and household debt; and a neglected regulatory system that had significant gaps and deficiencies. But once a crisis starts and threatens to take down the financial system, the focus must not be on looking for someone—or something—to blame, but instead on stopping the panic and preventing the economy from crashing. And so, President Obama’s administration launched an all-out effort to do just that.

A central part of the effort to stabilize the financial system was the Troubled Asset Relief Program, or TARP. TARP was a bipartisan program that the Bush Administration launched by providing capital to the largest banks. I was honored to serve my country by helping President Obama continue the work of TARP. We provided capital to hundreds of smaller banks, including over eighty-four community development financial institutions. We implemented a housing program that helped five million Americans stay in their homes by modifying their mortgage payments. We restarted the frozen credit markets, by providing backstops and using government capital to leverage private investment. And we prevented the U.S. auto industry from collapsing.

President Obama also took action by requiring stress tests of the biggest banks to determine how much additional capital they needed. And we made sure they raised it.

The work didn’t stop there. In fact, the effort to stop the crisis and get the economy moving involved many other programs—some launched by the Federal Reserve Board, the Treasury, the Federal Deposit Insurance Corporation, and other agencies. These efforts were complemented by the monetary policies of the Federal Reserve and the President’s economic stimulus package. It was a war fought on many fronts, and it succeeded.

President Obama exhibited steely determination and a willingness to be bold and creative. There was no playbook. There was no precedent. And it wasn’t clear what would work. It was a process of considering a number of possible solutions and making corrections as we went.

The President showed wise judgment. He waded through a diversity of opinions on every issue. There were those who said the government should let the market correct itself, while others said we must nationalize the big banks. Some argued our first priority in stopping the crisis must be to not create moral hazard—let those who made bad choices suffer their fate or else there would be no incentive to avoid taking excessive risk in the future.

President Obama recognized that fighting a financial panic is like fighting an out-of-control fire in your neighborhood. Passively hoping it will burn itself out may mean it spreads and takes down the whole community. And as the fire rages, it doesn’t matter whether your neighbor was at fault for smoking in bed. You must still put it out to save the community.

And we did. Our economy recovered faster for it. One need only contrast the slower pace of recovery in countries that failed to act as comprehensively and as expeditiously as we did.

TARP not only enabled our banking system to recapitalize and our credit markets to restart; we also recovered more on all the investment programs than we disbursed—$442.1 billion recovered versus $434 billion disbursed.

Could we have done things better? Certainly. And we should learn from our experience. But given the magnitude and unprecedented nature of what we were facing, some of the second guessing—with the benefit of hindsight—was like criticizing the fire department for using one bucket of water too many.

In my view, our biggest shortcoming was a failure to communicate why the actions were necessary to help Main Street. Many believed we simply helped Wall Street. But the financial system is like the circulatory system—the body can’t live if it isn’t pumping blood to all parts.

President Obama also moved quickly to pursue reforms that would address the weaknesses of our regulatory system and the gaps in oversight. One of the most glaring was the complete lack of regulation of over-the-counter swaps. These types of transactions, such as credit default swaps, brought AIG to the brink of collapse. But for the massive intervention by the federal government, AIG would have fallen, and probably taken our economy down with it. A total of $182 billion was committed over the course of several months to prevent that from happening. Though we recovered all these funds at a profit, such a commitment was an outrage—and should never have been necessary.

As in the United States, swaps were largely unregulated around the world. The market was a tangled spider web of bilateral transactions among the world’s largest financial institutions, with no transparency and nothing to ensure adequate capital or collateral. Therefore, a default by one big bank could easily lead to a cascade of defaults. In the spring of 2009, President Obama joined the other leaders of the G20 in committing to address this issue, through a set of reforms of these markets. The U.S. enacted these measures as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, along with a variety of other measures needed to modernize our regulatory system and address causes of the crisis.

The Commodity Futures Trading Commission was the primary agency charged with implementing these swaps reforms. And we have largely completed the job. The reforms have required that more capital and collateral stand behind these transactions, and that standardized swaps are cleared on central clearinghouses and traded on regulated platforms. They have required that swap dealers abide by basic oversight requirements, and that we increase transparency in this market.

Swaps, which are a type of derivative, are now being regulated in a manner that is more consistent with other derivatives markets—such as futures. These markets have generally functioned effectively over the years. Although most Americans do not participate in these markets directly, they profoundly affect the prices we all pay for food, energy, and most other goods and services. They enable farmers to lock in a price for their crops or airlines to hedge the costs of fuel.

Many other reforms have been implemented under Dodd Frank, with the overarching goal to make the system safe for failure. That is, failure is part of a healthy, competitive economy. We want a system in which the failure of a major financial institution does not create a systemic crisis. Other reforms include increased bank capital requirements, limitations on certain types of risky activities, and developing the means to resolve a large institution without resorting to taxpayer funds. The work is not yet finished on any of these fronts, but the progress we have made over the past six years has been substantial.

Following the 2016 presidential election, repeal of Dodd-Frank is now mentioned as a priority of the incoming Trump administration. But a wholesale repeal seems unlikely. Eliminating all the steps we have taken, which have decreased the risk that a globally significant financial institution’s failure will take down our economy, would not seem to deliver on the President-elect’s promises to working class voters, many of whom believe the government has been captured by powerful interests. Moreover, there is a wide consensus that the reforms made to bring transparency and oversight to the swaps market made sense.  We may see changes in details, but I do not expect repeal of this new framework.

Even before he assumed the Oval Office, President Obama was confronted with one of the most significant challenges any modern president has faced. And I believe that when historians look back, Barack Obama’s legacy will be one of bold thinking and steady leadership—and a commitment to do everything he could to prevent an economic crash and reduce the pain of this terrible event, and then put in place common-sense measures to help ensure this doesn’t happen again.

Should more have been done to help those hardest hit by the crisis? Yes, but TARP funds could only be used, by law, to purchase troubled assets from financial institutions. More importantly, Republicans in Congress blocked other initiatives.

Our economy still faces significant challenges, particularly as a result of structural shifts that have occurred over decades due to globalization. This past election underscores that.   We need to do more to have an economy that creates opportunity for all Americans, such as infrastructure spending, job training, increasing the minimum wage, tax reform, and making higher education more affordable. But we would be much further from that goal if it weren’t for the focus, determination, and good judgment of our forty-fourth president.

Timothy G. Massad is Chairman of the U.S. Commodity Futures Trading Commission. He previously served as the Assistant Secretary for Financial Stability at the U.S. Department of the Treasury, where he was responsible for overseeing the Troubled Asset Relief Program.

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A “Blow” to the Office: How We Think About Failed Prosecutions

By HLPR Online Staff

Prosecutors seem to be caught in a bind.

Last week, the Manhattan D.A.’s high-profile fraud trial against three former leaders of the now-defunct law firm Dewey & LeBoeuf came to an anticlimactic end with the judge declaring a mistrial.  After more than 22 days of deliberation, the jury agreed to acquit on some charges, but deadlocked on the majority of the more than 150 counts.  The press characterized the result as a “blow” for District Attorney Cyrus Vance.

Several weeks before, the U.S. Attorney for the Southern District of New York, Preet Bharara, suffered his own “blow” when the Supreme Court denied cert. from a Second Circuit decision overturning two major insider trading convictions.  The convictions were part of Bharara’s larger crackdown on insider trading in the hedge fund and expert networking industries, with the Second Circuit’s decision forcing Bharara to drop charges against seven others who were part of that effort—itself another “blow.”

At the same time, the political winds are turning fast in the direction of more individual prosecutions in corporate white-collar cases.  What started as a critique about a lack of C-suite prosecutions stemming from the financial crisis has now hit the mainstream.  The Justice Department recently announced a policy shift toward increasing its focus on individuals when investigating and prosecuting corporations, and Hillary Clinton has made individual prosecutions a central tenet of her plan to regulate Wall Street.

For the Justice Department, this is a sharp departure from practice.  Since even before the financial crisis its preferred strategy has been to charge the firms themselves, enter into deferred- or non-prosecution agreements, extract enormous fines, and monitor the firms as they institute new compliance measures.  It’s a nice method for the government because it involves no trials, no appeals, no juries—so no opportunity for the government to lose.  The problem, however, is that it quickly starts to look like culpable employees are getting away with murder, while shareholders are left footing the bill for massive fines.  Moreover, these sorts of corporate crimes—on Wall Street and elsewhere—seem to keep happening.  So the conventional wisdom has now become that we need the deterrence that only the threat of jail time can offer.

The thing about prosecuting individuals, however, is that it can get messy.  Unlike corporations, which will practically always settle charges, individuals sometimes exercise those pesky constitutional rights to trial.  And with trials comes swaths of unpredictability: judges, juries, witnesses, appeals.  This means that sometimes the government is going to lose.  And here is where prosecutors find themselves in a bind: on the one hand they are supposed to be focusing on individuals in white-collar cases, but on the other every time this riskier strategy results in a loss the prosecutor is chastised.

Addressing this issue requires more than just recognizing that prosecutors have a tough job to do.  It’s prosecution 101 that you shouldn’t bring charges unless you are convinced that the defendant is guilty and you can prove it.  The human cost to a defendant of being charged with a crime and facing trial is tremendous even if the end result is acquittal.  But even when bringing the case was the right decision at the outset, the unpredictability of trial will sometimes mean that the prosecutor still loses.  And in these cases, we need to stop thinking about their result as a “blow” to the Government.   This common view has the potential to chill the exact thing that so many are clamoring for: a focus on individuals over corporations in white-collar cases.  In the end, if everybody plays their part right—the prosecutor properly brings charges, the judge fairly adjudicates, and the jury fairly finds for the defendant—then that’s not a blow, that’s justice.