IRLE

IRLE WORKING PAPER #111-11 October 2011

The Two-Tiered Politics of Financial Reform in the United States

John T. Woolley and J. Nicholas Ziegler

Cite as: John T. Woolley and J. Nicholas Ziegler. (2011). “The Two-Tiered Politics of Financial Reform in the United States.” IRLE Working Paper No. 111-11. http://irle.berkeley.edu/workingpapers/111-11.pdf

irle.berkeley.edu/workingpapers                

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#    (      %      *  (     (       (           ' TheTwoͲTieredPoliticsofFinancialReformintheUnitedStates   JohnT.Woolley PoliticalScienceDept. UniversityofCalifornia,SantaBarbara [email protected]  J.NicholasZiegler PoliticalScienceDept.  UniversityofCalifornia,Berkeley [email protected]   October2011   The literature on regulation has typically emphasized the ability of concentrated interestgroupstosecuretherulestheyprefer.Oneviewarguesthatconcentrated interests are consistently able to impose diffuse costs across large and unorganized interests.A second, largely compatible, view emphasizes the ability of powerful interestgroupstomobilizeexpertiseandtoprovideinformationalgoodstopoliticians whoadjusttheirlegislativeproposalsaccordingly.ThispapershowsthattheDoddͲ Franklegislationforfinancialreregulationin2010departsfrombothversionsofthis now conventional wisdom.Instead, this paper shows that both political parties adopted what we call a twoͲtier political strategy of (1) maintaining good relations withtheestablishedfinancialeliteand(2)simultaneouslyrespondingtothedemands ofgrassͲrootsadvocacygroupsformorestringentregulation.Asaresult,DoddͲFrank ActfallsfarshortofathoroughͲgoingredesignoftheregulatorylandscape,butalso amounted to considerably more than business as usual.While the DoddͲFrank Act creates new regulatory instruments and powers that hold the potential for farͲ reachingchanges,mostoftheexistingagenciesandmarketparticipantsremainintact. This pattern of twoͲtier politics is evident through the four primary policy domains treated in the legislation:macroprudential regulation, consumer protection, reestablishmentofthepartitionbetweendepositbankingversusproprietarytrading (theVolckerRule),andtheregulationofderivativestrading.    ThispaperisarevisedversionofachapterpreparedforRenateMayntz,ed.,CrisisandControl: InstitutionalChangeinFinancialMarketRegulation(CampusVerlag:forthcoming,May2012).For researchsupport,theauthorswouldliketothanktheInstituteforResearchonLaborand EmploymentatUCBerkeley,theDivisionofSocialSciencesatUCSantaBarbara,theMaxͲPlanck InstitutfürGesellschaftsforschung,Cologne,and,fortheirconstructivecomments,themembersof theMaxͲPlancknetworkonFinancialRegulationandInstitutionalChange.  Introduction



Thefinancialcrisisof2007Ͳ2008originatedinitskeyessentialswithintheUnitedStates.Despitethe crossͲnationalinterdependenciesthattypifytwentyͲfirstcenturycapitalmarkets,Americanfinancial institutionswereunderminedbydeepimperfectionsthatoriginatedinU.S.assetmarketsandthen spreadtoothercountries.

 ThecrisisinvolvedtremendouscostsandsignificantdisruptiontoinstitutionsthroughoutU.S. society.TheLehmanBrothersbankruptcyofSeptember2008triggeredaprofounddiscontinuityin

America’sfinancialmarkets.ThreevenerableWallStreetinstitutions–BearͲStearns,MerrillLynch,and

LehmanBrothers–wereabsorbedbytheircompetitorsorallowedtofailoutright.

AccordingtoestimatesbyDeutscheBank,U.S.financialinstitutionsexperiencedlosses

(includingassetwriteͲdowns)totalingatleast$1.1trillion;fundsequalto30percentofGDPwere committedtosupportingthefinancialsectorintheUnitedStates(DeutscheBank,2010).U.S.stock marketsfellonaverageintwoconsecutiveyearsbymorethan14percent,thefirsttimethathad happenedsincethe1930s.Nationally,housingpricesdroppednearly18percentfrommid2007tothe endof2010butinseveralimportantregions,thepricedeclinewasupwardsof30percent(US,Federal

HousingFinanceAgency,2011).TheU.S.unemploymentrateincreasedfrom4.5percentinApril2007 to10.1percentinOctober2009;thenumberofunemployedincreasedfrom6.8millionto15.6million

(U.S.DepartmentofLabor,2011).TheU.S.Federalbudgetdeficitexpandedfromabout1.2percentof

GDPin2007tonearly11percentofGDPin2011.In2007,U.S.grosspublicdebtwasabout64percent ofGDP.By2011,thathadincreasedto103percent.

Theonsetofthesemassiveimpactsin2008wasfollowedcloselybyanationalelectioninwhich thefinancialcrisiswasasignificantissue.TheRepublicansweresweptfromofficeandthevictorious

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 Democratsclearlybelievedtheyhadamandateforchange.InFebruary2009,ObamatoldtheBusiness

Councilthathesupported“comprehensivefinancialreform”toensurethatsuchacrisiscould“never happenagain”(Obama2009a).Previously,U.S.financialexpertshadasubstantialconsensusonseveral reformstothestructureandprocessofregulation.TheseideaswerereadilyavailabletopolicyͲmakers in2009.Therewasalsonoshortageofanalysesofthecausesofthefinancialcrisis.

Giventhiscombinationoffactors,itishardtothinkofperiodsinpostͲWorldͲWarIIAmerica equallyripeforinstitutionalchange.OneofthecentralfindingsinthehistoricalͲinstitutionalist approachisthatperiodsofcontinuityarepunctuatedbyexogenousshocksthatdisruptsettled institutionsandproduceverysignificantchange(Krasner,1984;Steinmo/Thelen/Longstreth,1992;

Baumgartner/Jones2009).Buildingonthisapproach,analystslikeStreeckandThelenhavepointedout thatcumulativelyverysignificantchangecanalsooccurgradually,evenwithoutmajorpunctuation points.Thus,whenweencounterperiodsofsignificantshock,likethefinancialcrisis,itisimportantto askhowmuchtheresponsedeflectsthesystemfromthetrajectorythatmighthavebeenpresent previously.

ThecrisisresponseintheUnitedStatesseemedtoforetellaprofoundchangeveryunlike anythingthatmighthavebeenotherwiseanticipated.Anumberoflargebankswereeffectively nationalized.Thelargestinsurancecompanywasexplicitlynationalized.Thetwolargestgovernment sponsoredenterprises,heavilyengagedinmortgagefinance,wereplacedundergovernment conservatorship.Twoautomobilemanufacturerswerenationalized.Inanefforttokeepthefinancial systemafloat,theFederalReserveabandonedadecadeͲlongpracticeofavoidingselectivecredit allocationandinsteadworkedassiduouslytosupportspecificmarketsectorsincludingthecommercial papermarket,thesecondarymortgagemarket,investmentbanks,commercialbanks,andmoney marketfunds.

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  ButdidtheseeventssignalalargershiftintheU.S.politicaleconomy?Didtheshocktranslate intomoreenduringinstitutionalchange?TheDoddͲFrankAct,(formallytheDoddͲFrankWallStreet

ReformandConsumerProtectionAct(PL111Ͳ203),wassignedintolawonJuly21,2010.Itrepresents themostambitiousoverhaulofthecountry’sfinancialregulationssincethe1930s.Itestablishesa powerfulcouncilofregulatorstomonitorfinancialmarketsforsignsofsystemicrisk.Thiscouncilhas extensivenewpowerstocloselargefirmsinfinancialdistressbeforetheycollapse.Thebillmandates newrulestoforcemostderivativescontractsontopublicmarkets.Itredrawsanumberofbureaucratic boundariesandcreatessomenewfundingmechanismsforseveraloftheexistingregulatoryagencies.It mergesonefunctionalregulator,theOfficeofThriftSupervision,intoanolderagency,theComptroller oftheCurrency.Itincludesanumberofadditionalchangesintherulesthatgovernexecutive compensation,thelicensingofcreditratingagencies,andtheregistrationofinvestmentvehiclessuchas hedgefundsandprivateͲequitygroups.Equallyimportant,itcreatesanentirelynewregulatorybureau forconsumerfinancialprotection.Thesechangesareveryreal.Theyarewidelyexpectedbyclose observerstohavefarͲreachingconsequences.

 Despitethesebroadchanges,theDoddFrankActfallswellshortofanewinstitutionaldesignfor financialregulation,anditcertainlydoesnotshiftthebasiccontoursoftheU.S.politicaleconomyaway fromatransactionͲbasedmarketeconomy.Ratherthanaunifiedorlogicallyconsistentplanforreform, thebillcomprisesanunwieldysetofcompromisesinseverallinkeddomainsofregulatorypolicy.In somedomains,industryinterestswerepromotedbyacohesiveelitethathaddominatedfinancial policymakingforseveraldecades.Inotherdomains,specificpolicyentrepreneurs,workingwiththe backingofnewlymobilizedofgrassͲrootscoalitions,succeededinopeningthepolicymakingprocesstoa broaderrangeofactors(Kingdon2011,Zahariadis2007).Thereformsalsofailedtopitcontending

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 theoreticalparadigmagainstoneanotherashadoccurredinsomeothermajorinstancesofeconomic turmoilandpolicychange(Hall,1989).

 Suchanoutcome–ofsignificantbutlessͲthanͲtransformationalchange–requirescloser examination.Theapparentopeningforfundamentalredesignofpolicyandinstitutionsdidnotleadto anydeepͲseatedchangeinorganizationalstructures.Onlyonenewagencywascreatedandnew regulatorypowerswereverycautiouslydrawn.Inmanymorecases,existingpowerswerereallocated amongexistingagencieswhilepriorproceduresandtoolswereenhanced.Howcanweexplainthe limitedscopeofreformincomparisontotheprofoundanxietyprovokedbythetriggeringcrisis?

 Severalstrandsofliteratureprovideplausiblehypotheses.OnehypothesisfromtheinterestͲ groupliteraturewouldholdthatconcentratedindustryinterestswereabletobeatbackproposalsfor unfavorableregulation(Wilson1980)andtotrumpmorediffusecoalitions(Olson1965,1984).

Alternatively,itcouldbethatexistingregulatoryagencieshadsufficientautonomyandwieldedenough clouttoprotecttheirpreͲexistingjurisdictions(Carpenter2011).Athirdpossibility,drawnfromthe institutionalistliterature,suggeststhatincrementaladjustmentscan,overtime,allowexisting institutionstopersistingraduallychangingformthroughexceptionallyturbulentenvironmentalchanges

(Thelen2004).

Ratherthanchoosingamongthesealternativeexplanations,wedrawonelementsofallinorder toemphasizethecoalitionalpoliticsthatshapedtheDoddFranklegislation.Morespecifically,weargue thatthisreformrequiredacreativebrokeringofelitesandgrassͲrootsinterestsbyCongressandthe

WhiteHouse.ThiscomplexcoalitionbuildingpreventedCongressfromenactingaconsistent overarchingdesignforregulatoryreform,butitalsoallowedforarangeofnewregulatorypowersthat may,overtime,yieldconsequencesmoresubstantialthanapparentfromstrictlyformalchangesinthe regulatorylandscape.Thelegislationclearlyreflectedthefinancialsector’sfamiliarinterestͲgroupveto

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 politics,butthatpoliticswasalteredsubstantiallybyanewdynamicofpoliticalmobilization.Inpart, thenewmobilizationresultedfromtheObamaadministration’sinitiallegislativeproposal,which affectedinterestsfarbeyondthetraditionalcorefinancialsector.And,inpart,itresultedfromthe configurationofintereststhatinfluencedCongressionalaction.Inparticular,thisnewdynamichinged onseveralfactors:

1. acleareffortbytheexecutivebranchtomaintaincontinuityamongexistingorganizations

andelitesinthefinancesector;

2. politicalentrepreneurshipbysophisticated,independentpolicyexperts;

3. grassͲrootsadvocacyorganizationsnewinfinancialregulation;

4. opennesstohistoricalcontingenciesarisingfromelectoralpoliticsandtheproceduralrules

ofCongress.



ThesefactorscoalescedinapatternwecalltwoͲtieredpolitics.ThepatternoftwoͲtieredpoliticswas anticipatedintheexecutivebranchproposalsandwasfurthershapedintheCongressionaldebatesthat followed.TheObamaWhiteHouse,continuingtheapproachoftheBushWhiteHouse,wenttogreat lengthstostabilizefinancialmarkets.TheObamaadministrationcontinuedthesameemergency responsemeasuresthattheBushadministrationputinplaceinOctober2008,andcraftedasetof reformproposalsthatmaintainedmostoftheexistingregulatorylandscape.This“preservationist” approachinitiallyhelpedtheWhiteHousemaintainstrongtieswiththefinancialelitewhowereseenas necessaryformanagingthecrisis.ItwasamplifiedandreinforcedbybusinessͲfriendlyblocksinboth

Congressionalparties.

AconsequenceoftheWhiteHousepreservationisttacticwasthatthemostpowerfulfinancial firmsandassociationsremainedpotent.Theywereabletoblockmanymeasurestheymostintensely

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 opposed.Theywerenot,however,abletosquelchtheproposalsofseveralpolicyentrepreneurs,most notablyPaulVolckerandElizabethWarren,whointerestingly,werepropelledtotheforefrontlargelyby theWhiteHouse.Inadditiontothesepolicyentrepreneurs,anewcoalitionofpolicyadvocatesinjected freshvoicesintothepolicymakingprocessandlimitedtheswayofthecountry’sfinancialpolicyelite.As aresult,thesecondtieremerged,withWhiteHouseencouragement,andcreatedscopeforthemost interestingreformefforts.

 Accordingly,forbothWhiteHouseandCongressionalleadersthereweretwodifferentlogics operating.Ontheonehand,theyworkedassiduouslytomaintainfriendlyrelationswiththeWallStreet elitewheneverpossible.Someanalystsbegantospeakofthe“gildednetwork”betweenWallStreet andWashington(Carpenter2011)whileothersclaimedtheWallStreetelitehadbecomeaveritable oligarchy(Johnson/Kwak2010)morereminiscentofdevelopingcountriesthanadvanceddemocracies.

ThroughitshighͲpoweredcompensationincentives,thefinancialelitehelpeddefinetheupperfrontier ofanincreasinglyskeweddistributionofwealthandsimultaneouslyconsolidatedeverstrongertiesto theWashingtonpolicycommunity(Bebchuk/Fried,2006;Bartels,2010;Hacker/Pierson,2010).This elitesharedacommitmenttodeepcapitalmarketswithintheUnitedStates,andinsistedthatany regulatorychangesinthedomesticmarketshouldbecarefullygearedtocorrespondinginternational agreementswithintheGͲ20countries.

 AtthesametimethattheycultivatedthisWallStreetelite,Washingtonleaderswantedto accommodatethepopularbacklashagainstpreciselytheclosedelitepoliticsthathadpreviously dominatedfinancialregulation.Forthisreason,theWhiteHouseandtheCongressionalDemocrats neededtocultivatecoalitionsthatwouldconferbroaderlegitimacyontheiractions.Accordingto

GunnarTrumbull,such“legitimacycoalitions”hadoftentakentheformofindustryallianceswith regulators(Trumbull,forthcoming2012b).IntheDoddͲFrankdiscussions,activistͲregulatorcoalitions

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 appearedintheformofgrassͲrootsadvocacyorganizationsthatmobilizedWashingtonexpertiseto challengeslongstandingindustrytiestoregulatorsandkeyCongressionalcommittees.

Theunavoidabletensioninthisstrategycreatedunusualopennessthatperturbedalegislative processalreadyvulnerabletoquirkydevelopmentsdrivenbyinstitutionalrulesandprocedures.

Congressionaloutcomesfrequentlyturnedonunpredictableelectoralcontingenciesandrapidshiftsin publicopinion.Thelegislativeoutcomewasamixofsignificant,iflimited,structuralchangeswithmany provisionsforenhancedtoolsandproceduresthatwouldenableexistingregulatorstosupervisea financeindustrychastened,butbynomeansreconstructed,bythecrisis.Thepotentialforregulatorsto adoptimportantchangeswasaccompaniedbythepotentialforhostileintereststoweakenfuture regulationsandtheregulatoryagenciesthemselves.

Inthefollowingpages,weelaboratethisargumentinseveralsteps.First,weverybrieflyreview theregulatorylandscapebeforethefinancialcrisis.Second,weprovideacompressedchronologyofthe reformdebate,showinghowtheprimarysitesofdiscussionshiftedovertime.Andthird,weillustrate thedistinctivefactorsthatshapedtheDoddͲFrankoutcomebyreviewingdebatesinthemajordomains coveredbythelegislation.



I.TheExistingRegulatoryLandscapeontheEveoftheCrisis

Thecrisisof2007Ͳ2008wasdeeplyrootedinthehistoricaldevelopmentofAmerica’sregulatory landscape.Forover175years,twotrendsdominatedU.S.financialregulation.Thefirstwas decentralization.Privatebankswereinitiallycharteredonlybythestates.UndertheU.S.Constitution,

Congressalonehaspowerto“coinmoney,”butStateshavethepowertocharterbanks.Insurancehas alwaysbeenastateͲregulatedindustry.TheOfficeoftheComptrolleroftheController(OCC)was establishedin1863toprovideaunifiedcurrencyduringtheCivilWarandtoanchormorestable

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 conditionsforthelargerbanksthatneededanationalcharter.Notuntil1913wastheFederalReserve

Systemcreatedwith12regionalbranchesandacentralBoardofGovernorsinWashingtonDC.

 ThesecondtrendaffectingU.S.regulatorystructureiscompetitionwithindustrysegmentation.

Since1933,theregulatorystructurewasorganizedaroundindustrysegmentswhichproved,startingin thelate1970s,tobeporous.Competitionarosebetweensegments,anddifferentiationbetween productsandfirmsdeclined.Nonetheless,groupsoffirmshadwellͲestablishedlinksto,andprovided importantpoliticalsupportfor,regulators.Thisregulatoryequilibriumwasfundamentallyunstablewith bothindustryandregulatorstypicallyeagertopoachonadjacentturf.

Threefurtherdevelopmentsinthesecondhalfofthetwentiethcenturywereespecially important.ThefirstoftheseshiftswasthegrowingpreferenceamongfinancefirmsforaholdingͲ companystructurethatprojectedtheiractivitiesintoanumberofpreviouslyprohibitedmarkets.

CongressexplicitlyextendedtheGlassͲSteagallprovisionsinthe1950sbydisallowingdepositbanking andsecuritiesactivitieswithinthesamemultiͲbankholdingconglomerate,butmanyothercombinations werepermitted.Thenewholdingcompaniesresistedthetraditionalfunctionalclassificationandwere mostlyoverseenbytheFederalReserve.OnlylaterdidtheSecuritiesandExchangeCommission(SEC) andtheHomeLoanbankingagencyalsogainsupervisoryauthorityoverthoseholdingcompaniesthat chosetodesignatethemaspreferredor“lead”regulators.Throughthisextendedshift,theFederal

Reservestaffacquiredgrowingknowledgeofemergingbusinessmodelsandsteadilygainedin reputationforsophisticatedregulatorypolicy.

Thesecondsignificantshiftincludedacompoundsetofchangesinthesophisticationoffinancial instruments,thevelocityoftransactions,andthegeographicscopeoffinancialmarkets.Thesechanges rapidlygainedmomentuminthe1990sandearly2000s.Theyrepresentedamajortransformationat theindustrylevelratherthanthefirm.Thesechanges,oftencalledfinancialization(e.g.,Davis,2009;

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 Krippner,2011),meantthatvastnewmarketsbegantolinkfinancialinstitutionsglobally,largelyoutside thepurviewofexistingregulatoryagencies.

Afinaltrendinvolvedderegulation,whichnotonlyreducedtheconstraintsonfirms,but explicitlyeliminatedthedifferentiationbetweendifferentkindsoffinancialfirms.Thusthrift institutionsbecamelargelyindistinguishablefromcommercialbanks,andinvestmentbankingand commercialbankingfunctionswereperformedwithinasinglecorporateentity.Severalturningpoints arenoteworthy:

x Interestratecapsforthriftinstitutionswereremovedin1982.

x Anewindependentregulator,theOfficeofThriftRegulation(OTS),wascreatedin1989.

x The1999GrammͲLeachͲBlileyAct(GLBA)effectivelyrepealedrestrictionsagainst

universalbankingactivities.

x TheCommoditiesFuturesModernizationAct(2000)explicitlybarredfederalagencies

fromregulatingnewmarketsinderivatives.

 Inshort,consistentwiththethesisdevelopedbyStreeck/Thelen(2005)andMahoney/Thelen

(2010),theU.S.financialregulatorysystemgraduallyanddramaticallyevolvedoveraperiodof65years inresponsetocompetitivepressuresandperiodicshocks.Theseinstitutionalchanges,togetherwitha powerfulfaithinthestabilizingforceofmarketsystems,preparedthewayforthefinancialcrisis.The deregulatoryeffortssince1982diminishedthecapacityofexistingregulatoryagencies.Theresultwasa kindofinstitutional“displacement”whereregulatoryinstitutionswerereplacedpiecemealbytherules ofopenmarketcompetition.Butthisresultwasnotaformofdynamicinstitutionalstability.Instead marketsandregulatoryinstitutionsbecameincreasinglyfragile.Thebundlingofresidentialhousing loansintosoͲcalledmortgagebackedsecurities(MBS)promptedawildproliferationofnewlysecuritized loansandrelatedfinancialinnovationsthatcreatedtherapidlygrowingmarketsknownastheshadow

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 bankingsystem.Asearlyas2004,governmentreportsnotedthattheGLBAhadmadeitexcessively easyforfinancialconglomeratestopositionmajoractivitiesoutsidethejurisdictionsoftheregulatory agencies.Withincreasingurgencyby2007,officialreportswerepointingoutthejurisdictionalgaps betweenkeyregulatoryagenciessuchastheSECandtheFederalDepositInsuranceCorporation(FDIC), aswellastheOCCandtheOTS(GAO,2007).Thisgrowingfragilityculminatedinadangerouscrisisin theeconomy’skeybankingandregulatoryinstitutions,whichweresustainedonlythroughthe extraordinarydecisionͲmakingoftheTreasuryandtheFederalReservein2008.



II.TheChronologyandPoliticalContextofReform

 LegislativeeffortstorevampU.S.regulatorystructuresfollowedandhadtodealwiththe consequencesofemergencymeasuresadoptedtoamelioratethecrisistriggeredbyLehman’s bankruptcyinSeptember2008.Withinweeks,theBushAdministrationpersuadedareluctantCongress toenacttheTroubledAssetReliefProgram(TARP),whichauthorizedtheTreasurytospendupto$700 billioninassetstaintedbythecollapseofmortgagesecurities(amajorityofHouseRepublicansvoted against).AfterBarackObamawonthepresidentialelectioninNovember2009,histransitionteam workedcloselywithBushAdministrationofficialstorefinetheTARPprogram,whileplanningthenew

Administration’sownlegislativeagenda.Evenbeforetheelection,Obama’scommitmentto preservationwassignaledbyhisrelianceonwellͲconnectedmainstreameconomicadvisors.

UpontakingofficeinlateJanuary,2009,thenewWhiteHouseplacedtoppriorityoneconomic stimulusandaplanforhealthreform;financialreformwasalesserpriorityintheAdministration’svery largeagenda.InJuneof2009theAdministrationreleasedaWhitePaperoutliningmeasuresfor regulatoryreformaccompaniedbyastatementbythePresident(U.S.Treasury,2009;Obama2009c).

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  Congressionalmovementtoconsidernewregulatorylawswasquicklyapparentinanumberof differentHouseandSenatecommittees.TheTreasuryproposalsofJunebecamethestartingpointfor thebroadbillsdraftedintheHouseofRepresentativesbytheCommitteeonFinancialServicesandin theSenatebytheCommitteeonBanking.HearingswereheldbytheHouseCommittee,chairedby

RepresentativeBarneyFrank,throughthefallof2009,followedbypassageoftheHousebillin

December.

InOctober,2009,GoldmanSachsledinvestmentbanksinannouncingtheirplantodistribute largebonusestoitsexecutives.Infollowingweeks,WhiteHousepollingshowedthatthepublicthought

ObamawastooclosetoWallStreet(Heilemann2010).OnDecember13,Obamaappearedonthe televisionnewsshow60Minutestosaypointedly“Ididnotrunforofficetobehelpingoutabunchof, youknow,fatͲcatbankersonWallStreet.”Heexpressedfrustrationatthefactthatbanksthatwere bailedout“arefightingtoothandnail...againstfinancialregulatoryreform”(Obama2009d).

Inthiscontext,inJanuary2010,PresidentObamaagainraisedthesalienceoffinancialreform.

Headvocatedimposinga“FinancialCrisisResponsibilityFee,”toassurethatgovernmentwouldbe reimbursedforthecostofthebailouts.Shortlythereafter,heappearedwitheconomicadvisorand formerFederalReserveChairmanPaulVolckerinsupportoftoughregulationstosegregatedeposit bankingfromproprietarytrading—the“VolckerRule.”Daysbefore,onJanuary19,RepublicanScott

BrownhadwonanupsetvictoryinaspecialelectioninMassachusettstofilltheseatofthelateSenator

EdwardKennedy,averyliberalDemocrat.ThiscriticallyreducedtheDemocrat’sseatshareto59,one lessthanthe60thpivotalvoterequiredtostopfilibustersintheSenate.WhileBrownwasavery moderateRepublicanonmostissues,hiselectionexacerbatedanalreadytenseandhighlypartisansplit inCongress.

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 InMarch,theSenateCommitteeonBanking,chairedbySenatorChrisDodd,tookupthebilland debateditthroughApril.InApril,reformsreceivedamajorboostwhentheSECfiledfraudcharges againstGoldmanͲSachsinconnectionwiththedesignandmarketingofinstrumentsknownascredit defaultswaps.Insubsequentdays,ObamagaveaforcefulspeechtotheBusinessCouncilsupporting financialreform.Afteranumberofamendments,theSenateapproveditsversionofthebillonMay20 andrequestedaconferencecommitteewiththeHousetomeshdifferencesbetweenthetwoversions.

AtoughsetofConferencedeliberationsoccurredfromJune10throughJune29,2010,afterwhichthe reconciledbillwaspassed,easilybytheHouse(June30)andonlybytheminimumfilibusterͲproof majorityintheSenate(July15).ThebillbecamelawastheDoddͲFrankActwhenPresidentObama signeditonJuly21,2010.

 OneofthekeyfactorsdrivingthedynamicoftwoͲtieredcoalitionbuildingwasthebreadthof theinterestsaffected.Theseinvolvedmanygroupsbeyondthetraditionalcorefinancialinterest groups.TheCenterforResponsivePolitics,whichtrackslobbyregistrationsandexpenditures,identified

697financialsectorlobbyingorganizationsin2010.Theirdataalsoshowedthat788organizationswere registeredtolobbyconcerningHR4173,theDoddFrankBill.OfthoseDoddͲFranklobbies,only36 percentwereidentifiedasmainstreamfinancialsectorgroups.Remarkably,nearlytwoͲthirdsofthe groupsmobilizedtoinfluencetheDoddͲFranklegislationwere“nonfinancial.”Theseproportionsreflect thebroadreachofthelegislation,andhelpedcreateopportunitiestoshakeuptraditionalcoalitions.

Eveninthisheatedatmosphere,financialreformengagedthegeneralpublicfarlessthanhealth carereform,whichpassedinMarch2010.TheagendaͲsettingmediawerefocusedfarmoreintensively onhealthcarereform.Inagraphicreviewingmajoreventsin2010,TimeMagazineprominently mentionedhealthcarereform,butdidnotmentionDoddͲFrank(27December2010,32Ͳ33).Thegraph infigure[1]fromGoogleTrendsshowsinindexesforthenewsreferencevolumeaswellasGoogle

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 searchesthatthepublic’sattentiontofinancialreformrankedconsistentlylower.Thispatternsuggests stronglythatevenadramaticcrisisdidnotovercomethepoliticalbarriertopopularinvolvementposed bytheperceptionthatfinancialissuesareprimarilytechnicalinnature.





III. SystemicRiskRegulation

TheDoddFrankActcreated(TitleI)anewFinancialStabilityOversightCouncilasitscentral solutiontotheproblemofsystemicrisk.ThisnewCouncilgroupsthemainfunctionalregulators together,overseesthefinancialsystemasawhole,andexercisesthepowertoestablishenhancedlevels ofregulationforthelargestfinancialservicesfirms.

Theideaforsuchacouncilappearedassoonastheimmediaterescueoperationsoflate2008 begantotakehold,allowingpolicymakerstofocusonlongerͲtermreformsthatwouldpreventsimilar crisesinthefuture.TheObamaAdministrationfollowedtheprevailingregulatorywisdombyseeking bettertoolsformonitoringsoͲcalled“systemicrisk”andnewpowers,inextremecases,torestructure firmsdeemedsignificantenoughtoendangertheentirefinancialsystem,Inbothrespects,the

Administrationrevealedastrongpreferenceforcontinuityintheregulatorystructureandinthemajor firmsthatdominatedtheindustry.

WhileunfamiliartomanymembersofCongress,theproblemofmonitoringsystemicriskwasby nomeansnewtothefinancialpolicyelite.Indeed,keymembersofthiselitesharedabroad understandingofhowthecrisishadunfoldedandwhytherecipesofthepastfailedtoworkin2008.In criticalrespects,thetemplateforrespondingtosystemicriskemergedfromtherescueofthefamous hedgefund,LongͲTermCapitalManagement(LCTM),in1998.SinceLTCMhadbeenfinancedbyWall

Street’skeyinvestmentbanks,theNewYorkbranchoftheFederalReserveconvenedtheheadsofa

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 dozenmajorfirmsinSeptember1998tofinanceaprivateͲsectorbailout.Inthespaceofaweekend, thesefirmsstoppedanycontagionbytakinga90percentownershipstakeinLTCM(Lowenstein2001;

McKenzie2008).TheseniorofficialswhoweretograpplewiththeimpendingcollapseofLehman

BrotherstenyearslaterwereallfullyfamiliarwiththeLCTMbailoutasparticipantsorcloseobservers

(seeStewart,2009).

 Thisfamiliarsolution–asolutionnegotiatedwithaconsortiumofmarketparticipantsconvened bytheNewYorkFed–failedinresolvingtheproblemsatLehmanBrothersinSeptember2008.By backstoppingJ.P.Morgan’sacquisitionofBearͲStearnsinMarch2008,theFedhadsignaledits willingnesstoreversemarketoutcomesthatthreatenedwidercontagion.InmidͲSeptember,top policymakers–includingTreasurySecretaryHankPaulson,ChairmanoftheFederalReserveBen

Bernanke,andChairmanoftheNewYorkFedTimGeithner–gatheredagaininlowerManhattanto spearheadaprivateͲsectorbailoutforLehmanBrothers.WhenaprivateͲsectorsolutionfailedto materializeandpolicymakerstoldLehmantofileforbankruptcy,financialcentersaroundtheworld weregrippedbyfear.Theconsequencewasaprofoundcrisisofconfidencethatspread instantaneously,freezinganoverͲleveragedsystemofcreditmarketswhiledramaticallydeepeningthe downturnthatsoonbecameknownastheGreatRecession.

 AlthoughLehman’sbankruptcywasnotpredicted,thegapsinthecountry’sregulatorystructure werewellunderstoodbeforehand.HankPaulson’searlierexperiencewithLCTMlefthimacutelyaware oftherisksposedbyhighlyleveragedandinterconnectedfirms.AsTreasurySecretary,he commissionedamajorstudyforredesigningtheU.S.regulatorysystem,entitledBlueprintfora

ModernizedFinancialRegulatoryStructure,issuedinMarch2008,sixmonthsbeforetheLehman bankruptcy(U.S.Treasury,2008).TheBlueprintsaidtheU.S.systemoffunctionalregulationbybusiness areamadelessandlesssenseasfinancialfirmsmovedincreasinglyintomultiplepartsoftheindustry–

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 commercialbanking,securitiesbrokerage,investmentbanking,mortgagelending,andtheirown proprietarytrading.Theexistingframeworkmeantnosingleregulatoryagencywasresponsiblefor monitoringriskacrossthesystemasawhole.ThePaulsonBlueprintthereforerecommendedthata singleagencybemaderesponsibleforwhatitcalled“macroͲprudentialregulation,”whiletwonew agenciesshouldbeestablished,onewithconsolidatedresponsibilityfordayͲtoͲdaymonitoringand inspectionacrossallfinancialmarkets,theotherforenforcingoverallconductͲofͲbusinessregulation.

 TheMainActors.AstheObamaAdministrationtookoffice,thenewTreasurySecretary,

TimothyGeithner,commandedextensiveknowledgeoftheregulatoryproblemsandprescriptionsof theprecedingdecade.TheAdministrationWhitePaperof2009outlinedanew“systemicrisk”council.

CalledtheFinancialStabilityOversightCouncil(FSOC),thenewcouncilwouldshiftmacroprudential responsibilityawayfromtheFederalReserve(wherePaulson’sBlueprinthadproposedputtingit).The

FSOCwouldbechairedbytheTreasurySecretary.AftertheTreasury,theFederalReservewas preeminent,withoperationalauthorityforsupervisingallsystemicallyimportantcompanies,butits responsibilitiesweresubmergedwithinabroadersetofvotingmembers.Thesevotingmembers consistedmainlyofexistingfunctionalagencies.InadditiontotheTreasurySecretaryandthechairman oftheFederalReserveBoard,theyweretoincludetheComptrolleroftheCurrency,theChairofthe

SEC,theChairofFDIC,theChairoftheCommoditiesFuturesTradingCommission(CFTC),theDirectorof theFederalHousingFinanceAgency,theChairoftheNationalCreditUnionAdministration(NCUA)

Board,theDirectorofthe(new)ConsumerFinancialProtectionBureau,andoneindependentmember withinsuranceexpertisetobeappointedbythePresidentwithapprovalbytheSenate.

 Giventheseverityofthecrisis,theunderlyinggoalofsystemicriskregulationwasbeyond controversy.Neitherthefirmsnortheirchampionsineitherpartycouldplausiblyclaimafter2008that marketdisciplinealonewassufficient.WhiletheideaofasystemicͲriskcouncilquicklygained

15

 acceptance,theroleoftheFederalReserveremainedopentoquestion.TheHouseversionofthe legislationspecifiedtheFed’sroleasthatofagentoftheFSOC(DoddͲFrank,2010:subtitleA.,section

1100ofthebillaspassedintheHouse;SeealsoDavisPolk,2010:2,10).TheinitialSenateCommittee draftsinNovember2009proposed,bycontrast,tostripallregulatorycompetenciesfromtheFederal

Reserveaspartofathoroughregulatoryredesign.ButbyMarch2010theSenatehadconverged towardtheHouseproposalstogroupexistingagenciesintoanewmacroprudentialcouncilwhichwould includetheChairmanoftheFederalReserve(WashingtonPost,12December2009:BradyDennis.See alsoDLAPiper,2010).Withintheexpertcommunity,someobserversfeltthedutiesofdayͲtoͲday prudentialregulationwouldburdentheFedwithunnecessarytasksthatcouldundermineits independenceinmonetarypolicy.OtherspecialistssaidtheFedpossessedsuchpreponderantexpertise that,asformerFedgovernorAlanBlinderputit,“wewouldhavetotieourselvesinknots”tomovethe tasksofsystemicͲriskawayfromtheFed(quotedinBloombergNews,9May2009:RobertSchmidt).

Existingregulators,suchasSheilaBair,chairpersonoftheFDIC,acceptedtheroleoftheFed,but preferredthatthesuperͲcouncilofregulatorsbeentrustedwiththesettingofoverallguidelinesfor macroͲprudentialregulation(BloombergNews,9May2009).Suchproposalsechoedearliereffortsto deepencoordinationinfinancialregulationsincethelate1970s(FFIEC,2011).

 BeyondthepreciseroleoftheFed,Congressionaldiscussionfocusedonthecriteriabywhich firmswouldbedesignatedas“systemicallyimportant”andthereforesubjecttoheightenedregulatory standards.Banksofover$50billioninassetswereautomaticallydesignatedas“systemically significant.”TheSenatebilldivergedfromtheHousebyseparatingBankHoldingCompanies(BHCs) fromsystemicallyimportantNonͲBankHoldingCompanies(NBHCs).ForNBHCs,theSenateproposal calledupontheFSOCtodevelopcriteriaanddecidebyatwoͲthirdsmajorityofvotingmembersthata particularfirmwouldcomeundertherulesofenhancedsupervision.ThedesignationofNBHCsseemed

16

 likeanesotericissue,butthestakeswerehigh.Thedetailsdeterminedwhetherconglomerateslike

GeneralElectricorIBMaswellashedgefundsorprivateͲequitygroupswouldbeincludedunderthe newrequirementsforenhancedregulation.Atthepeakofthecrisis,theremaininginvestmentbanks becamebankholdingcompanies,subjectingthemselvestoFedregulation,inordertoqualifyforhelp fromtheFederalReserve(NewYorkTimes9/21/2008).Butnothingpreventedthemfromdropping theirbankcharters,inwhichcaseundertheHousedrafttheywouldescapethenewrulesforsystemic riskmonitoring(NewYorkTimes,2010).

 OutsideCongress,thedebateoversystemicallysignificantfirmsincludedmoreradicalremedies.

AnumberofobserverssawtheDoddͲFrankreformsastoomodest.Unlessthebankswerebrokenup andcappedinsize,theywouldremain“toobigtofail.”Anumberofbankruptcylawyersandrespected economistssuchasSimonJohnsonrecommendedthisapproach,arguingthatanythingelsewould eitherelevatetheTreasurySecretarytothepositionofarestructuring“czar”orsimplyleavethebank executivesinplaceasvirtual“oligarchs”(Skeel,2010;Johnson/Kwak,2010).

 SuchproposalswerenevercentralinCongressionaldeliberationsalthoughrelatedamendments weresoundlyrejected.OncethestructureoftheFSOCwasclarified,themainlegislativedebates revolvedaroundtechnicalmattersofdefinitions,procedures,anddegreesofdiscretioninsetting regulatoryrules.Tobolstertheprocessofmacroprudentialoversight,theFSOCwastobesupportedby anewOfficeofFinancialResearch(OFR)withindependentsubpoenapowersandaDirectorappointed directlybythePresident.Virtuallyallversionsofthebilldirectedregulatorstoaligndomestic regulationswithinternationalagreements,andtheTreasurytookanactiveroleinpreparingto implementtheBaselIIIrulesforcapitaladequacy(Bernanke,2011;seealsoKerwerandGoldbach,this volume).TheotheraspectsofmacroͲprudentialregulationwerearealmwherethespecialists’ specialistsheldsway.CongressionalRepublicanstendedtocriticizethebillforimposingburdensome

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 compliancecosts,whileCongressionalDemocratshadtowrestlewithhowtodefinenewandmore effectiveinstrumentsofmacroͲprudentialoversight.

 InterestͲGroupInfluence.Giventhebroadagreementonimprovingmacroprudential regulation,industrygroupswereinitiallyrestrainedintheircriticismoftheDoddͲFrankproposals.From theirviewpoint,asuperordinatecouncilthatleftdayͲtoͲdayoversightwithfamiliarregulatoryagencies hadadvantages(Ryan,2009).SuchaCouncilwouldamelioratetheregulatory“gaps”thatappeared betweenthefunctionalregulatorsasnewfirmsenteredtheindustry.AslongasthenewinformationͲ gatheringpowerswerenotusedtooaggressively,mostindustrygroupsaffirmedtheirsupportforthe newFSOC.Asthelegislationmovedfromenactmentintotheimplementationphase,however,some divergencesamongindustrygroupsbegantoappear.

 TheSecuritiesIndustryandFinancialMarketsAssociation(SIFMA)supportedastrong macroprudentialregulator..SinceitsmemberfirmswerealreadyhighlyregulatedbytheSEC,SIFMA favoredabroadambitforthenewriskregulator.Thenewsystemicriskcouncilcouldthenfillimportant gapsintheregulatorylandscapeanddampencompetitionfromnewandlessregulatedentrants.The mainlimitonthecouncil’sactivitiesshouldconcerninformationͲgathering,whereSIFMArecommended closecoordinationwithexistingregulatorstoavoidduplicativeinformationrequirements.The securitiestradersemphasizedrepeatedlythatU.S.regulatorsshouldcoordinatecloselywiththeGͲ20to obtaincomparableregulatorystandardsattheinternationallevel(Ryan,2009).

 Otherindustryassociationsrangedintheircommentsfromsupportivetorestrained.Butfewof themsawanymileageinopposingthegoalofsystemicriskmonitoringwhilethelegislationwasbeing formulated.Severalmonthsafterpassage,theAmericanBankersAssociation(ABA),highlycriticalof otherelements,clearlyfavoredmacroͲprudentialregulation.TheABAsawsystemicͲriskregulationasa promisingwaytosubjectnewerfirmstothesamekindofrulesthatitsownmembers–mostly

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 traditionalbanks–hadlonglivedwith.TheU.S.ChamberofCommerceexpressedfarmorequalified support.TheChamber’sCenterforCapitalMarketsCompetitivenessemphasizedthenegative consequencesofdefiningtheconceptof“systemicallyimportant”toobroadly.IncontrasttotheABA, theChamberexplicitlyopposed“bankͲlikeregulationforlargenonbankfinancialinstitutions,”arguing thattheprocessofdefiningnewruleswouldcreateunwarranteduncertaintiesforfirmslikeGeneral

Electricortheautocompanies’financingsubsidiaries(McTighe,2010;Hirschman,2010).

 Laborandconsumergroupssoughtamacroprudentialregulatorwithenoughpowertobringthe entireshadowbankingsystemwithinitspurview.Thepreciseorganizationallocationandstructureofa newregulatormatteredlessthangivingitadequatetoolstogathercomprehensiveinformationthatthe alternativeinvestmentvehicles,hedgefundsandprivateequitygroups,hadpreviouslybeenableto keepconfidential(Silvers,2009).

 ByestablishingtheFSOCasthecentralexecutivebodyforregulatorypolicy,theDoddͲFrankAct achievesseveralpurposesandsidestepsseveralirresolvablecontroversies.ByincludingtheChairman oftheFederalReserve,theFSOCcandrawontheFed’sdeepexpertisewithoutputtingmacroͲ prudentialmonitoringentirelyintheFed’shands.Asenacted,thelegislationgivestheFSOCtenvoting membersincludingtheTreasurySecretaryaschair.Byincludingtheexistingfunctionalregulators

(excepttheOTS,noweliminated),thelegislationsatisfiesindustryrepresentativeswhowantedtoavoid thecostsofswitchingfromagencieswithwhichmostofthecountry’sbanksandfinancialͲservicesfirms werealreadyfamiliar.Yet,owingtotherealpoweritwasgiventointerveneincasesofsystemically importantfinancialdistress,theFSOCalsorespondstothosewhosaidanewandpowerfulregulatory bodywasessential.



IV.ConsumerProtection

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 AwidelyͲhailedchangeoftheDoddͲFrankbillwasthecreation,inTitleX,ofanew,independent

ConsumerFinancialProtectionBureau(CFPB).Thisbureauhassomeelementsfamiliarforindependent agencies:theDirectorisappointedbythePresidentforarelativelylongtermandcannotbedismissed exceptforcause.However,itdiffersfrommanysuchagenciesinthatdecisionsdonotneedthesupport fromabipartisanboardofvotingcommissioners.Aboveall,theCFPBisuniquelylocatedwithinanother independentagency,TheFederalReserve.FundingfortheCFPBisdefinedbylawasapercentageofthe

FederalReserve’sbudgetandisthus,liketheFeditself,notdependentupontheCongressional appropriationsprocess.Moreover,theFedexplicitlyhasnoroleinoverseeingtheCFPB.

 Fewobserversarguethatgeneralconsumerlendingpracticeswerethecentralcauseofthe financialcrisis(bycontrasttoderivativesmarkets)althoughtheydidcontribute.TheCFPBprovidesa classicexampleofthewayawellͲdevelopedreformproposal,widelydiscussedpriortothecrisis, becamepoliticallyviableinthesubsequenthighlyͲchargedatmosphere(Kingdon2011).Theadoptionof theCFPBwashardlyacertainty,andmajorgroupsinthefinancialindustryresisteditstrongly—winning onsomekeypoints.TheagencydrewpowersfrommanyotheragenciesincludingtheFedandthe

FederalTradeCommission.

Sincethebiggestandmostpowerfulfinancialinstitutionsdonotearntheirprofitsfromlending toordinaryconsumers,theywerelittleinclinedtofightontheseissues.Asaresult,thisissuehadthe potentialtosplittheindustry.Communitybanksandthrifts,alreadycloselyregulated,mightbe expectedtowelcomecloserregulatoryscrutinyfornonͲbankcompetitorsincludingpaydaylenders, mortgagecompaniesandconsumercreditagencies.Preciselybecauseofitsbroadreach,however,the proposalcouldpotentiallygalvanizeinoppositionthethousandsoforganizationsmakingconsumer loans

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 ElizabethWarren,PolicyEntrepreneur.VirtuallyeveryaccounttracestheCFPBbacktotwo academicarticlesbyElizabethWarren,aprofessoratHarvardlawschool(Warren2007andBarͲ

Gill/Warren2008).Thearticlespowerfullymakethecasethatconsumersfaceamuchmorerisky marketforcreditproductsthanforphysicalproductsbecauseoftherelativelylaxregulationinthecase ofcreditproducts.Inthesearticles,WarrencalledforthecreationofaFinancialProductSafety

Commission.BarͲGillandWarren2008(p.98)recommendedasinglenewregulatoryagencywitha broadmandateor,“anewconsumercreditdivisionwithinanexistingagency(theFRBorFTC).”They didnotspecifythatitbeanindependentagency.

Asimportantasthosepapers,however,wasElizabethWarrenherself.By2008,shewasa seasonedandskilledreformerknownasacreative,unflappableandintelligentadvocate.Her connectionstoObamadatedto2004.ShewasalsoclosetoHillaryClintonandmanyothermembersof

Congress.Shehadachievedprominencein2005asanopponentofbankruptcyreform

(Sullivan/Warren/Westbook2001,2004).Herresearchwascitedrepeatedlyin2008inCongressional hearingsandnewsreportsandhadbeenreflectedinlegislationthatlongpredatedDoddͲFrank.

InOctober2008,whenCongressauthorizedTARP,itcreatedtheCongressionalOversightPanel

(COP)to“reviewthecurrentstateoffinancialmarketsandtheregulatorysystem.”(U.S.Senate,COP)In

November,inanimportantdevelopment,SenateMajorityLeaderHarryReidnamedWarrenasaCOP memberandshewassubsequentlyselectedaspanelchair.TheCOPwasprimarilyfocusedonthe questionofhowTARPfundswerebeingusedandhowbankswereaccountingforthem.Warren becameaveryvisiblecriticofTARP,frequentlyinterviewedontelevision.

 InlateJanuary2009,theCOPissueda"SpecialReportonRegulatoryReform."Thisreport, preparedbyacademicconsultants,comprehensivelysurveyedpriorinvestigationsandstudies concerningfinancialreform.ItwasfullyupͲtoͲdatewiththeinternationalcontext,citingtheFinancial

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 StabilityForumaswellasBaselIandII.TheReportincludedalistofrecommendationsforpolicyaction includingacallto“CreateaNewSystemforFederalandStateRegulationofMortgagesandother

ConsumerCreditProducts”(p.30).ThisportionofthereportcloselyparalleledBarͲGillandWarren

2008,andsuggestedcreationofeitheranewindependentagencyorplacingthenewregulatorwithin theFederalReserveBoard(p.35).Thereportincludedalengthyminorityanalysiswhichaccurately anticipatedtheargumentsleveledattheCFPBinsubsequentdebates.

InFebruary2009,WarrenblastedtheTreasuryforfailingtospendTARPmoneyasCongresshad beenpromised.TheObamaAdministration,however,“didnotechothecongressionalconcerns”

(WashingtonPost,6February2009:A03).InshortWarrenwasknowntotheObamaadministration earlyon,butwasclearly,atthatstage,notonthesamewavelengthasTreasurySecretaryGeithner.

OnMarch25,2009,theFinancialProductSafetyCommissionActof2009,influencedby

Warren’sideas,wasintroducedsimultaneouslyintheHouseandSenate.ItwaspromotedbyHouse

FinancialServicesCommitteeChair,BarneyFrank(Newsweek,20April2009:34).AgroupofSenators whohadcosponsoredthebillwroteGeithnerurgingthattheconsumerfinanceagencybeincludedin theAdministration’splan(WashingtonPost20May2009:A01).IntestimonyinlateMarchconcerning financialreformplans,Geithnerwascriticizedbyconsumeradvocatesformakingnomentionof consumerissues(WashingtonPost,27March2010:D01).ReportssurfacedinlateMay2009that

SecretaryGeithnerandNationalEconomicCouncilChairLarrySummerswerediscussingincludingthe consumerprotectionagencyintheadministration’sreformproposal,butthattheadministrationwas stillundecidedontheconcept(ibid).

TheJune2009Administration“WhitePaper”calledforcreationofa“singleregulatoryagency,” tobecalledtheConsumerFinancialProtectionAgency,essentiallyWarren’sproposal(U.S.Treasury

2009).Powersoverconsumerprotectioninfinancewouldbetransferredtothenewagencyfromthe

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 severalagenciestowhichtheyhadbecomedispersedovertheyears:theFed,OCC,OTS,FDIC,FTC

(FederalTradeCommission),NCUA,andtheDepartmentofHousingandUrbanDevelopment(HUD).

Strikingly,asidefromtheFTC,therewaslittlebureaucraticresistancetothesereforms.

 ANewCoalition.AtvirtuallythesametimetheAdministrationunveileditsproposal,anewproͲ reformcoalitionwasannounced,knownastheAmericansforFinancialReform(AFR).Thiscoalition, whicheventuallynumberedmorethan250consumergroupsandlabororganizations,providedforthe firsttimeinthehistoryofU.S.financialpoliticsacohesivenonͲindustryvoice.AFRwasfinancially marginalincontrasttothetraditionalmajorlobbygroups—itsannualbudgetwasreportedtobearound

$1.5M;theChamberofCommercereportedlyspentover$700Minlobbyingonallissuesin2010.

Commentsfromrepresentativesofthefinancialindustryearlierintheyearsuggestedthatthey believedtheconsumerfinancialprotectionproposalswereunlikelytobeseriouslyconsidered.Once theyshowedupintheAdministration’sWhitePaper,theindustrybegan“lobbyingfuriously”in opposition(Heilemann,2010).TheAmericanFinancialServicesAssociationstatedthattheycouldnot acceptasolutionthatinvolvedanewseparateagency.AlobbyistfortheFinancialServicesRoundtable saidflatly,“ourgoalistokillit”(AmericanBanker,13July2009:1).Oppositionalsocamefromthe

AmericanBanker’sAssociation,theAmericanLandTitleAssociation,theIndependentCommunity

BankersofAmerica,theChamberofCommerce,andmanyothers.

Theopponentssucceededinmakinganumberofchangesasthelegislationprogressed.Early on,theyeliminatedarequirementthatlendersberequiredtoofferbasic,standardized(“plainvanilla”) productstofacilitateconsumercomparisonshopping.Theywononstronglanguagerequiring coordinationandcommunicationbetweenCFPAandotherbankregulators.Theywonrequirementsfor disputeresolutionprocesseswhenregulatorsdisagreedamongthemselves.Laterintheprocessthey restrictedthenewagencytoenforcing(asopposedtowriting)regulationsonlyforthelargestfirms

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 (largerthan$10Bassets),whereasotherfunctionalregulatorswouldenforceregulationsforsmaller firms.Eventuallytherewasanagreementtocompletelyexemptautodealers(whomakeconsumer loans),fromagencyoversight.

As2010progressed,PresidentObamarepeatedlyendorsedtheideaofanewindependent agency.InApril,theSECbroughtfraudchargesagainstGoldmanSachs,andinMay,opinionpolls showedthatthepublicstronglysupportedstricterbankregulation.Inthisenvironment,reform advocateswereemboldened.TheSenateBill,passedinlateMay,placedtheCFPBinsidetheFederal

Reserve.Notonlyhadtheagencynotbeenkilled,ithadbeengrantedmorerobustautonomy.The

FSOCmay“stay”CFPBregulations(TitleX,Section1023).However,suchanactionrequiresatwoͲthirds voteintheFSOC,andeachmembervotinginfavormustrepresentanagencywhichhasindependently determinedinapublicmeetingthattheCFPBproposalwouldputbankingsystemsafetyandsoundness atrisk.Contrarytotheurgingofthefinancialindustry,theCFPBmaynotpreemptstatelawwhenstate lawprovidesmoreconsumerprotectionthandoesFederallaw.Thiswasamajorchangetothestatus quo.

 Implementation.theCFPBreceivedarelativelyhighnumberofnewrulemakingauthorities grantedunderDoddͲFrank(thoughfarfewerthangrantedtotheSEC,FRS,andCFTC).Theinitial implementationproblemconfrontingCFPBwasthecreationofanentirelynewagencyfromgroupsof staffdrawnfromseveralexistingagencies.MostCFPBauthorityofficiallybeganonJuly21,2011,butas earlyasMarch2011theagencyhadafunctioningwebsitedispensingadvicetoconsumers,inviting comments,andofferingassistancewithcomplaints.

 ObamaappointedElizabethWarrentolaunchtheagencyͲͲadecisionstronglyopposedby

RepublicansinCongressandmostofthefinancialindustry.Shewentona“charmoffensive”with financialindustryexecutivesinordertotrytogettheagencyofftoagoodstart(WallStreetJournal15

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 March2011).Sheadvisedbankersthathermaintargetsarenonbankfirmsmakingpaydayandstudent loans,doingdebtcollection,andlendingformortgages.Sheemphasizeda“principledapproach”to supervisionratherthanstrictenforcementofpreciserules.

 Ofcourse,theimpactoftheCFPBremainstobeseen.Opponentssucceededinblockingthe appointmentofElizabethWarrenastheagency’sfirstdirector.Thefactthattheagencyexistsatall, andhasdrawnresourcesfrommanyotherexistingagenciesisaremarkableevent.Thefactthatitis wellͲfinanced,headedbyasingledirector,andlodgedin,butnotcontrolledby,Fed,isevenmore remarkable.Atthesametime,theagency’senforcementscopeisrestrictedtotheverylargestfinancial firms,andithasnomandatetorequirethecreationofthestandardized,easilyunderstoodinstruments initiallyrecommendedbyWarren.Whileitisatremendousaccomplishmentinsomerespects,the agencyisultimatelyofmoreconcerntoconsumeradvocatesthantothefinancialpolicyelitethatcared mostabouttheshadowbankingworldanditsunregulatedderivativesproducts.



V. TheVolckerRule.

TheportionoftheActknownas“theVolckerRule”(TitleVIsections619Ͳ621)attemptstorequire bankstoseparaterisky,speculativeactivityconductedonbehalfofthebank,fromthebasicbanking functionsservingbankclients.Thelatterenjoyavarietyofexplicitpublicguaranteesandsupports.The

Volckerrulewasalsoseenasaddressingconflictsofinterestthatmightemergebetweenbanks operatingfortheirowninterestsandthoseoftheirclients.

TheCongressionaldebateovertheVolckerrulewashighlyvisiblebutbysomeaccountsnot reallyverycontentious.Contrarytoseveralpressaccounts,theVolckerRuledidnotrecreatethebrightͲ lineseparationofcommercialandinvestmentbankingoftheGlassͲSteagallActof1933.However,the echoofGlassͲSteagallhasbeenwidelynoted.

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 TheObamaAdministration’sJune2009WhitePapercalledforregulatoryactiontostrengthen firewallsbetweenbankingaffiliatesthatdealtinOTCderivativesversusthedepositͲtakingpartsofa bankthatenjoyedfederalguarantees.Thatproposalwasrelativelytimidcomparedtowhatemerged laterintheprocess.ConsistentwiththeinitialAdministrationplan,theversionofthelegislationpassed bytheHouseofRepresentativesinDecember2009madeonlyanodtowardthekindofseparation requiredbytheVolckerRule—atthattimethephrasehadnotyetbeencoined.

 Inresponsetoincreasinglynegativepublicopinionaboutthebankbailouts,theObama

AdministrationdecidedinDecember2009,asamatterofpoliticalstrategy,tobackstrongerlegislation andtoidentifyitrhetoricallyas“theVolckerRule”inordertodrawonthedeferenceaccordedthe formerFedChairman.Obama’sdecisionwasannouncedinJanuary2010,togeneralsurprisebecauseof thewidespreadbeliefthatthisdirectionwasopposedbyLarrySummers,DirectorortheNational

EconomicCouncil,andTimGeithner,TreasurySecretary.Obama’sannouncementfollowedhardona

WhiteHouseproposaltoplacea“FinancialCrisisResponsibilityFee,”ontheliabilitiesofthelargest financialfirmsinordertorepaytheloansandsubsidiesprovidedbytheGovernment.Bothproposals markedahardeningofObama’sapproachtofinancialreform.

 Insubsequentmonths,thedraftlegislationconcerningtheVolckerRulebecamestrongeras criticismofGoldmanͲSachsbecamesharper;manyobserverssawthesedevelopmentsaslinked.Shortly aftertheSECchargedGoldmanwithcivilfraud,astrongerversionoftheVolckerRule,knownasthe

MerkleyͲLevinAmendment(MLA)wasintroducedinMay2010.Amongotherdifferences,MerkleyͲ

Levinprohibitedproprietarytradingasamatteroflaw,notjustprospectiveregulation,andappliedto all“bankingentities”ratherthantoonlyinsureddepositaryinstitutions.

 CongressionalconsiderationofMLAbecamelinkedwithanothercontroversialprovision,the

BrownbackAmendmenttoexemptautodealersfromcoveragebytheConsumerFinancialProtection

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 Agency.BothpassedtheSenateinlateMayinanapparentcompromise.TheMLAwasweakenedin

ConferenceCommitteeinordertowinthesupportofnewlyͲelectedMassachusettsRepublicanSenator

ScottBrownonavotenecessarytohaltdebate(Cassidy2010).Inthiscase,languagewasinsertedthat permitsbankstoinvestupto3percentoftheirtier1capital(not,asinapriordraft,themoreinclusive

“commonequity”)inhedgefundsandprivateequityfunds,providedthattheymaynotownmorethan

3percentofafund’scapital.

 Volcker’sEntrepreneurship.Theideaofrestrictingbanks’involvementwithproprietarytrading wasnotamongtheideasproposedinpriorU.S.regulatoryreformdocuments.Norhadthisbeenan issuefortheGͲ20.By2006,securitiesregulators,mostprominentlyinAustralia,wereexpressing concernsaboutproprietarytradingasasourceofconflictsofinterest(Australia,Securitiesand

InvestmentCommission2006).However,inlate2008,followingthecrash,industryobserversnoted thatproprietarytradingwas“underscrutiny”becauseoftheextensiveleverageinvolved(WallStreet

JournalMarketWatch,31October1998).

 ThemainagendaͲsettingeventwasareportissuedonJanuary12,2009bytheGroupof30(GͲ

30),aprivatepolicyͲadvisorygroupwhichwasheadedbyformerFedChairmanPaulVolcker,whohad beennamedbyObamainNovember2008tobeChairmanofthePresident’sEconomicRecoveryBoard

(Groupof30,2009).Thereportcalledforlimitingtheproprietaryactivitiesof“systemicallyimportant bankinginstitutions”that“presentparticularlyhighrisksandseriousconflictsofinterest.”TheGͲ30 alsocalledforprohibitingbanksponsorshipormanagementofhedgefundsandurgedthatinpackaging andsaleof“collectivedebtinstruments”banksshouldberequiredtoretaina“meaningfulpartofthe creditrisk.”

 Theideagainednoimmediatetraction.WhenVolckeroutlinedtheproposaltoCongresson

February26(Volcker2009),closeobserversdoubtedthatitwouldplayasignificantroleintheU.S.

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 reform.Therewasawidespreadimpressionwasthat,despitehisofficialadvisoryposition,Volcker lackedstronginfluencewithObama.Consistentwiththatview,theideaoflimitingbankproprietary tradingfiguredmodestlyintheAdministration’sJune2009“WhitePaper,”(p.31)anditwasnot mentionedatallinObama’saccompanyingpublicstatement(Obama2009c).Themediararely mentionedthetopic.WhenObamamadeamajorspeechonfinancialreforminNewYorkCityin

September2009,heagainomittedanymentionoftheVolckerruleorproprietarytrading(Obama

2009e).WhenVolckercontinuedtoadvocateforprohibitionofproprietarytradingafewdayslater,the

WallStreetJournal(17September2009)speculatedthathewaslikelyatoddswiththeObama

Administration.TheNewYorkTimes(20October2009)observedthatVolcker“maynotbealoneinhis proposal,butheisnearlyso.”

 TheHousebill,passedDecember11,2009onastrictpartyͲlinevote,didnotincludea prohibitiononproprietarytrading,butitdidspecifythattheFederalReserveBoardcouldrestrictthe abilityofafinancialfirmtotradeonitsownaccount(Section1117).

 KeyEvents.TheprogresstowardadoptingtheVolckerRulewasprimarilyaresponsetopublic angeraboutbailoutsandbonuses—angerthatcamefromboththerightandtheleft.Obamadecidedin lateDecember2009toreversecourseexplicitlyandprominentlysupporttheproposal.Indoingthis,he hadtoovercometheobjectionsofGeithnerandSummers(Alter2010,Heilemann2010).One prominentobserverwasquotedatthetimeassayingthechangewasa“fundamentalshift”

(WashingtonPost22January2010).

 ThereactionfromWallStreetwasangerandasenseofbetrayal.Congressionalreceptiontothe ideawas,initially,lukeͲwarm.WithindaysofObama’sannouncement,Volckertestifiedbeforethe

SenateBankingCommittee.ChairmanDoddspokepassionatelyofhiscommitmenttoaddressingthe problemoftooͲbigͲtoͲfailandhisdesiretomaketheideaoffuturebailouts“absolutelyoffthecharts.”

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 Hepointedoutthatthecommitteehadheld52hearingsinthepastyearthathadthoroughly consideredtheproblemsofreform.TheVolckerRuleissue,hesaid,cameuplateandwasgenerally viewedasapoliticalresponsetotheRepublicanvictoryintheMassachusettsspecialelection.Dodd warnedagainsttryingtodotoomuch,andadded,presciently,that“Idon’twanttogotothefloorofthe

UnitedStatesSenatebeggingfora60thvote.”VolckerpointedoutthatthePresident’sdecisionlong precededtheMassachusettsspecialelection,apointDoddconceded(US,Senate,Committeeon

Banking,HousingandUrbanAffairs,2010).

 Withinamonth,therewereleakedaccountsthattheAdministrationwasbackingawayfromthe

VolckerRulebecausetheywerehavingtroublesellingittotheTreasuryandCongress(NewYorkPost,

23February2010).However,momentumswungbackstronglytowardtheRule—andalloffinancial reform—inApril,whentheSECfileditscivilfraudchargesagainstGoldman.Inthisenvironment,many elementsofthestrongerversionoftheVolckerRule,takenfromtheMerkleyͲLevinAmendment, prevailed.

 Implementation.Ultimately,aspassed,theVolckerRuleincludesanumberofcontingencies, exceptions,andlimits.Nonetheless,realadaptationshavebeenmadealready,andtheprinciples articulatedintheVolckerRulepermitmodesofsupervisionandmonitoringthatwerepreviously unknown.ThenewlawdirectedtheFSOCtocompleteastudywithinsixmonthsincludingdetailed guidancetoregulatoryagenciesrequiredtocompletedraftsofregulationswithinanotherninemonths.

Thelawrequiredclarificationaboutthenatureofactivityrelatedto“marketͲmaking”thatwouldbe permitted.OthertermswillbeclarifiedinpartthroughastudytobeconductedbytheGAO.TheFSOC reportedreceivingover8000publiccommentsaboutitsreport,ofwhich6,550weresubstantiallythe sameletterarguingforstrongimplementationoftheVolckerRule(US,FSOC2011).Thisseemstohave

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 reflectedmobilizationbyAmericansforFinancialReformcoalitionpartnerPublicCitizen(Krawiec2011).

Theremainingcommentsaddressedindetailtheambiguitiesandproblemsinimplementingthelaw.

 TheFSOCreportwasastatementofintenttostronglyenforcethenewlaw.Thereport innovatedinproposingquantitativemetricsthatcanbeusedtomonitorbankinvestmentactivitiesand thatmaysignalanengagementinprohibitedproprietarytrading.Thereportnotesthatitsdirectionwill imposeadditionalburdensonregulatoryagenciesandonbankingentitiesaswell.

BytheendofJanuary2011severalmajorbankshadalreadydecidedtoclosedowntheir proprietarytrading(WallStreetJournal,1September2010;BusinessInsider,3September2010;

Dealbook,29September2010;FinancialTimes,1October2010).Despitetheopportunityfora considerableperiodtoimplementchangesrequiredbyregulationsyettobepromulgated,theleading investmentbanksmovedquitepromptlytorevealplanstoeliminateproprietarytrading.Skeptics suspectedthemofessentiallyreassigningpeopletopermittedareasrelatedtomakingmarkets.

ThenextstepisrulemakingbytheSEC;CFTC,FRB,FDIC,andOCC.Theproposedregulations wereexpectedinOctober2011.Additionaljointrulemakings“shall”addressactivitiesthatmay threatenU.S.financialstability,additionalcapitalrequirements,internalcontrolsandrecordkeeping.



VI.NewRegimeforDerivativesTrading

 Derivativesregulationrepresentedoneofthemosturgentbutdifficultreformtasks.This problemwastakenupinDoddFrankinTitleVII,whichsetnewrulesfortransparentpricingandpublic documentationinmostderivativesmarkets.Derivatives,ascontractualagreementsbasedon underlyingassetsorcommoditiesorrevenuestreams,werecentraltothefinancialcrisis.Asabroad classofinstruments,theyhadbecomeacoreelementinthebusinessstrategiesofthousandsoffirms.

Sincetheywereprivate,overͲtheͲcounter(OTC)contracts,theycouldinjectinestimablelevelsof

30

 uncertaintyintoavarietyoffinancialmarkets.Thiscombinationofcentralityanduncertaintymeantthe prospectofregulatingderivativesunleashedaremarkablehighͲenergypolitics.Affectedconstituencies includedinterestgroupsfromallpartsofthebusinesscommunity,labor,professionalgroups,consumer advocacygroups,andpublicofficialsfrommanyfederal,state,andmunicipaljurisdictions.

 Reformproponentshadtwomaingoalsinthederivativesdebate:first,tosegregatederivatives tradingfromotherbankingactivities;and,second,totakederivativesoutoftheunregulatedshadow bankingsystembyforcingthemintomoreopenvenuesasfullydocumentedtransactions.Bothgoals provokedbitterresistancefromparticularsegmentsofthefinanceindustry,butbothappearedinthe finalbill.Asenacted,bothmeasuresprovisionsgiveregulatorsthetoolstolimitdramaticallyexcessive riskͲtakinginderivatives,butonlyifregulatorsareprovidedwithadequatestaffingandexpertise.

 Despiteearlierdebatesonthesubject,derivativeshadremainedlargelyunregulatedintothe early2000s.Theycameintoexistenceashedginginstruments,similartocommoditiesfutures,tohelp marketparticipantsinsurepredictablerevenuesforagriculturalproductsoranticipatedrevenuesin foreigncurrencies.Asthecomplexityoftheassetsunderlyingderivativesexpanded,theirnotionalvalue begantodwarfallothermarkets.Bythelate1990s,thevolumeofmortgageͲbackedsecuritieswas growinggeometricallyandthepopularityofthecreditͲdefaultͲswapsthatinsuredtherevenuestreams fromthemappearedtobegrowingevenmorequickly.InMay1998,theCFTC,ledbyChair,Brooksley

Born,issuedaconceptpaperproposingthatderivativesberegulatedbytheCFTC(CFTC1998).Inan episodefamousforitsshortͲsightedness,TreasurySecretaryRobertRubinsidedwithFedChairmanAlan

GreenspanandotherregulatorsinopposingBorn’sview.TheCommoditiesFuturesModernizationAct, passedinlate2000,legallybarredtheCFTC(oranyfederalregulator)fromassertingjurisdictionover offͲexchangederivatives(Hirsch:2010;McLean/Nocera:2010,104Ͳ106).

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 Throughtheearly2000s,theideaofregulatingderivativescontinuedtopercolate.Iconic investorWarrenBuffettdescribedderivativesas“financialweaponsofmassdestruction”in2003and hisremarkswerewidelyquoted(e.g.,CongressionalRecord,4March2003:5309).Between2005and early2008,theFinancialStabilityBoardleddiscussionsoftheGͲ20toensurethatthe“operational infrastructure”forOTCderivativesmarketswassound.Overthesameperiod,theFederalReserveBank ofNewYorkheldseveralindustrymeetingspursuingthesamegoals(FederalReserveBankofNewYork,

2008).ByNovember2008,theU.S.TreasuryhadshiftedtowardanactivistpositionwithintheGͲ20by circulatinganActionPlaninpreparationfortheGͲ20PittsburghsummitthefollowingSeptember, includingeffortsto“reducethesystemicrisksofCDS”whilealsobolstering“infrastructureforOTC derivatives”(U.S.DelegationtotheGͲ20,2008).By2008,allrelevantactorsacknowledgedthat financialderivativeshadplayedakeyroleinthefailureofBearͲStearnsinMarchinfreezingcredit marketsafterLehmanwentbankruptinSeptember.

KeyActors.Giventheurgencyofimprovingoversightforderivatives,manyactorsstakedour earlypositions.Inearly2009,billswereappearinginvariousCongressionalcommitteestoaddressthe dangerofspeculationinderivativesforenergyandagriculture.Seekingtomaintaintheinitiativeon financialregulation,SecretaryGeithnerwrotetoHouseSpeakerNancyPelosionMay13,2009,amonth beforepublicationoftheAdministrationWhitePaper,tooutlineAdministrationproposalson derivatives.

 TheTreasury’splanshowedthatthefinancialpolicyelitewasreassessingitsearlierviews withregardtothederivativesbusiness.Theearlierconsensusheldthatsophisticatedbanksand hedgefundscouldusederivativestopromoteabetterallocationofriskandresources.Butafter thecrash,regulatorshadtoacknowledgethatderivativescouldalsoconcentrateriskin“opaque andcomplexways.”AccordingtotheTreasuryDepartment’sreport,“thebuildͲupofriskinthe

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 overͲthecounter(OTC)derivativesmarkets,whichwerethoughttodisperserisktothosemostable tobearit,becameamajorsourceofcontagionthroughthefinancialsectorduringthecrisis”(U.S.

Treasury,2009:43).Accordingly,Treasuryproposedthatderivativesbetradedthroughverifiable transactionsandguaranteedbyregisteredclearingͲhouseinstitutions.Insteadofthe“lax regulatoryregime”thathadtakenshapeby2008,theTreasuryreportsaidadequateregulation requiredthatclearingthroughcentralcounterparties.(U.S.Treasury,2009:47).

ThisproposalwouldhaveeffectivelyreversedtheCommoditiesFuturesModernizationActof

2000.Toimplementthis,theTreasuryplanaskedtheSECandtheCFTCtomeshtheirrules.TheCFTC’s dutiesweretobedramaticallyexpandedtocovermostderivatives,whiletheSECwouldcooperateby continuingitsoversightof“securityͲbased”derivatives.

 Giventhestakesinvolved,abroadrangeofinterestssoughttoshapetheTreasury’sproposalsas theymadetheirwaythroughCongress.Owingtotheunprecedentedprofitsthatderivativeshad generated,financialͲservicesfirmsmobilizedquicklytopressformoremoderatechanges.Theywanted tostabilizethemarketwithoutsubjectingthemainplayerstomajorsurgeryand,aboveall,without addingonerousrequirementsformarginorcapitalreserves.

 Perhapsmoresurprising,withinafewmonths,thebroadergrassͲrootsadvocacyorganizations alsometthechallenge.Theysecuredthenecessaryexpertiseandbegantopushtheirownpositionson issuesofderivativesregulation.Bysummer2009,theAmericansforFinancialReformhadbegunto articulatealternativestoindustryproposals.

 ThemainCongressionalbodiesinvolvedinderivativeswere,again,theHouseCommitteeon

FinancialServicesandtheSenateCommitteeonBanking.Buttheoriginsofderivativesinagricultural trademeantthatthesecommitteessharedjurisdictionwiththeHouseandSenateagriculture committees.Thissharedjurisdictionbecamepivotalatalaterpointbecausethetwoagriculture

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 committeesretainedoversightfortheCFTC,whichwasnowproposedtobetheleadagencytooversee thelargestfinancialmarketsinexistence.

 ThepatternofinterestͲgroupactivismonderivativeshighlightedthetwoͲtieredpoliticsthat increasinglyconfrontedelectedofficials.Initiallytheinterestgroupterrainwascharacterizedbythree features.First,whileindustrygroupsshiedawayfromopposingtheAdministration’splansfor monitoringsystemicrisk,theywerefullypreparedtoopposeanymeasuresonderivativesfromthe outset.MajornonͲbankingfirmsimmediatelyscrutinizedtheplansforregulatingderivatives.Even beforeCongressionalcommitteestookuptheTreasury’sproposal,companiesincludingCaterpillar,IBM, andBoeingAerospacewerepushingbackagainsttheregulationstheyanticipated(WallStreetJournal,

10July2009:KaraScannel).

Second,derivativeshadbecomesodeeplyenmeshedintheeconomythatfirmsinalmostall sectorsreactedtotheproposalsfornewregulation.Severalindustryassociationssaidtheirmembers neededcustomizedderivativestooffsetspecificrisksintheireverydaybusinessactivities–something quitedistinctfrompurelyfinancialspeculationthatmightrequirespecialregulatoryprovisions.One prominentexample,theCoalitionforDerivativesEndͲUsers,wasformedinAugust2009and commentedregularlyondraftlegislationthroughthefall(CoalitionforDerivativesEndͲUsers,2009a).

Thisconsortiumincludedmanyfirmsthatcountedassignificantplayersinfinancialmarkets,butits componentorganizationsweresufficientlybroadinmembershipthattheycouldplausiblydistinguish themselvesfromtheWallStreetbanksatthecenterofthecrisis(CoalitionforDerivativesEndͲUsers,

2009b).

Athirdfeatureoflobbyingonderivativeswassharedacrosstheindustryspectrumandthe consumeradvocacygroups.Allofthemdisplayedatendencytoformdedicated,issueͲspecific coalitions.TheConsortiumofDerivativesEndͲUserswasoneclearexample,andthefinancialͲservices

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 firmsadoptedaparallelapproach.TwoassociationsthatrepresentedthemainmarketͲmakersand dealersinderivativesweretheISDA(InternationalSwapsandDerivativesAssociation)andSIFMA(the

SecuritiesIndustryandFinancialMarketsAssociation).TheyapproachedtherelevantCongressional committeesjointlyinNovemberandDecemberof2009.AndafterthebillwassignedintolawinJuly

2010,thesetwogroupsbegantoworkalsowiththeSecuritiesAssociationoftheAmericanBankers

Association(ABA)andanumberofotherindustryassociationsinfinancialservices.

 GrassͲrootsadvocacygroupsfromtheprogressiveLeftalsomobilizedsurprisinglyquicklyaround theissueofderivatives.Althoughconsumerprotectionandexecutivecompensationrankedhigher amongtheinitialprioritiesoftheAmericansforFinancialReform,thisgroupadvancedinformed argumentsforseriousregulationofderivatives(Tekiela,2011).InAugust2009,AFRurgedCongressto requirethatallderivativesbetradedonregulatedandfullytransparentexchanges.TheAFRspecifically arguedagainstthekindofexemptionsproposedbyindustrygroupssuchastheEndͲUsersCoalition.

 ThetensionsoftwoͲtierpoliticsappearedsharplyfromtheautumnof2009onward.The financeindustryhadreliableentréetotheHouseofRepresentativesviathebusinessͲfriendlymembers intheNewDemocratCoalition.WithindaysaftertheLehmanbankruptcy,thisgroupsetupataskforce onfinancialreformcoͲchairedbyMelissaBean(D,NY)andRepresentativeJimHimes(D,Ct),aformer bankeratGoldmanSachs.TheNewDemocratsprevailedupontheHouseFinancialServicesCommittee toexemptderivativesendͲusersfromthe“discussiondraft”ofOctober2009(Propublica,25October

2011:SebastianJones/MarcusStern).Whenhearingswereheldontheinitialproposals,theCFTC

Chairman,GaryGensler,immediatelywarnedthatsuch“endͲusers”exemptionswouldenablebanksto shieldamajorportionoftheirderivativesbusinessfromanynewregulatoryoversight.TheAmerican forFinancialReformsupportedtoughlanguage,testifyingthatfullypublicexchangeswouldprovidea saferarenaforderivativestradethanwouldcentralizedclearinghousesfavoredbythebusinessͲfriendly

35

 Housemembers(WashingtonPost,7October2009“BradyDennis;seealsoGensler,2009;Johnson,

2009).

 KeyEvents.AslegislativeactionmovedfromtheHousetotheSenate,reformersgained resourcesthroughunpredictedpoliticalevents.TheFinancialCrisisCommissionheldwidelytelevised hearingsinJanuary2010,andtheunrepentantremarksofseveralWallStreetchieftainsshiftedthe atmosphericsinfavorofmoresweepingmeasures.AlsoinJanuary2010,apopularcriticofWallStreet’s culture,MichaelLewis,publishedabestsellingbookonthepathologiesofthederivativestrade,which becamevirtuallyrequiredreadingforCongressionalstaffers.Then,asnotedabove,camethespecial electionofScottBrown,alteringSenatepolitics.

 AstheSenateapproachedavoteonthefinancialoverhaulinAprilandMayof2010,the dynamicoftwoͲtierpoliticsbuildingbecameunmistakable.OnApril16,PresidentObamamadeapoint ofsignalinghisintenttovetoanybill“thatdoesnotbringthederivativesmarketundercontrol”

(Obama,2010).Amoresurprisingsourceofhelpforthenetworkofprogressivegroupscamefrom

SenatorBlancheLincolnofArkansas,thechairoftheAgricultureCommittee.Lincolnhadalienatedthe leftwingoftheDemocraticpartybyhelpingblock“thepublicoption”inhealthcare.Then,evenmore controversially,sheopposedPresidentObama’seffortstostrengthenthepositionoflaborunionsin plantͲlevelorganizingcontests.Inresponse,theArkansasbranchoftheAFLͲCIOlaborfederation decidedtosupportafarmoreliberalcandidateintheArkansasprimaryelectionsinMay2010.Lincoln reactedbychampioningtougherlanguageonderivativesregulationthaneithertheHouseortheSenate committees.SenatorLincoln’samendmentstrengthenedthebill’sprovisionsbyrequiringallbanksto puttheirderivativesͲtradingdesksintoseparatesubsidiariesthatwouldhavetobecapitalized independentlyfromallpartsofthefirmthatenjoyedfederalguarantees(AssociatedPress,1March

2010;HuffingtonPost,10June2010:SamStein).

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  ProponentsofstrongerderivativesregulationbegantocoalesceinAprilandMay.Asheadof theCFTC,GaryGenslerpublishedanessayintheWallStreetJournal,arguingthatitwastimetotreat complexderivativeslikecommodityfuturesandbringthemunderthecontrolofclearinghouseswith knownpricesandpublicrecordͲkeeping(Gensler,2010).Thoseargumentsweresupportedby anotherbusinesscoalition,theCommodityMarketsOversightCoalition.Itsmembersincluded householdoildeliveryfirms,truckingassociations,someairlines,farmersandotherretailers.

Arguingthattheywereinfactthegenuineusersofderivativesinmarketsthathadbeenfloodedby speculatorssince2000,thisgroupkeptinclosetouchwiththeCongressionalagriculturepanels.

TheyreinforcedtheviewsofCFTCChairmanGenslerbyarguingagainstexemptionsfromtheclearing requirementsthatmightallow“hedgefundsandotherfinancialplayers”toshieldlargeportionsof theirportfoliosfromscrutiny.Forgoodmeasure,theyexplicitlyattackedtheauthenticityofthe muchlarger“CoalitionforDerivativesEndͲUsers”bywritingthat“theyarenottraditionalendͲusers,” andthat“itisquestionablewhetherinfacttheyhavetheissuesofthecommercialendͲusersat heart”(CMOC,2010).AlthoughtheAFRdidnot,asarule,coordinatewiththisconsortium,itsviews weresosimilarontheclearinghouseissuethatAFRreͲpostedtheletteronitswebsitewithinaday.

 WhentheSenateandHouseconfereesmetinJunetoreconcilethebillspassedbyeach chamber,thedynamicoftwoͲtierpoliticsproducedunexpectedandimportantconsequences.Blanche

Lincolnemergedastheexceptiontoaprocessoflegislativedilutionthatseemedparticularly conspicuousintheareaofderivatives.WhiletheVolckerrulespokegenerallytopreventingspeculation byinstitutionswithfederalbankingguarantees,theLincolnAmendmentrequiredanadditional“pushͲ out”ofallderivativestransactions,whetherclientͲlinkedorpartofthebank’sownproprietarytrading portfolio.Now,progressivegroupsincludingtheAFR,visiblysupportedLincoln’seffortsinthe conferencecommittee.ThefinanceindustrystillthoughtitsbackersintheNewDemocratCoalition

37

 wouldbeabletoweakentheVolckerruleandstriptheLincolnAmendmentoutofthefinallegislation.

ThebusinessͲfriendlygroupwrotetotheconfereesonJune16,urgingthemtorestoretheHouse languageonlimitstothederivativesrulesandtoremovetheLincolnAmendment(HuffingtonPost,14

June2010:ShahienNasiripour/RyanGrim;Propublica,25October2011:SebastianJones/MarcusStern;

WashingtonPost,24June2010:DavidCho).

 Asdiscussionsapproachedaconclusion,CongressionalleadersstartedtolimittheirfaceͲtoͲface contactswithrepresentativesofindustry.Therewaslittledoubtthatthemajorbankscouldreachthe keycontactsbytelephone,butmanylobbyistsbegantocomplainthattheywerelosingfaceͲtoͲface access(WallStreetJournal,14June2010:AaronLuccetti/DamianPaletta).Sincetheoverhaulwasto countasoneoftheObamaAdministration’smajorlegislativeachievements,thepressureonkey committeememberstoreachagreementmountedsteadily.

Atthesametime,theroleofCFTCchairmanGaryGenslerbecameespeciallynoteworthy.Given thecomplexityofthederivativesissue,itwasnotsurprisingthattheheadsoftheagriculture committees,SenatorLincolnandRepresentativeCollinPeterson,welcomedhisavailability.Other legislatorssaiditwas“alittleunusual”toseehimconferringwithlegislatorssoregularly.Accordingto oneaccount,duringaparticularlylong20Ͳhoursession,Gensler“hoveredjustbehindlawmakers,and couldbeseenwhisperingtostaffandnegotiatorsastheHouseandSenatesoughttoironoutthe2,300Ͳ pluspagebill”(WallStreetJournal,15July2010:MichaelCrittenden/VictoriaMcGrane).

Towardtheendoftheconferencenegotiations,SenatorLincoln,resolutelyindependent, claimedthatherlanguagewould“makebanksgetbacktobeingbanksandthoseofuswhogrewupin smalltownsinAmericaunderstandwhatthatmeans”(Politico,24June2010:CarrieBudoff

Brown/MeredithShiner).Ultimately,shecompromisedbutonlyinpartbyallowingbankstocontinue theircustomarytradeininterestͲrateswapsandforeigncurrencyswaps,whileotherderivativeshadto

38

 gothroughseparatesubsidiaries.Whetherforelectoralreasonsorunderlyingconviction,Blanche

LincolnprovidedthelegislativevoiceforthesameviewsthattheProgressiveLefthadlesssuccessfully urgeduponCongressinearliereffortstosecuretougherregulationofthederivativesmarkets



Conclusion

Thefinancialturmoilof2008gavethenewObamaAdministrationnochoicebuttoinitiatemajor financialreformsasitcameintoofficein2009.Atthattime,avaguecommitmenttofinancial regulatoryreformwasbalancedagainsteconomicstimulus,energypolicy,educationreform,andhealth carereformasPresidentialpriorities(Obama,2009).Buttherealityoffinancialdistress–acuteinmany cases–gavefinancialreformevengreaterurgencyamongthefinancialpolicyelitethatdominatedthe industry.

 BypassingtheDoddͲFrankAct,theCongressproducedabroadͲgaugedpieceoflegislation.In termsofstructuralchangesaffectingkeymarketparticipantsandtheircorrespondingregulators,the changesenactedbythelawweresignificantbutcautious.Thesestructuralchangesincluded:

x EstablishingtheFinancialStabilityOversightCouncilasanewbodycomposedofexisting regulatoryagencies; 

x Eliminatingoneexistingbankregulator,theOfficeofThriftSupervision,bymergingit intotheOfficeoftheComptrolleroftheCurrency; 

x Creatinganewagency,theConsumerFinancialProtectionBureau,withthepurposeof settingrulesandmonitoringcomplianceoffinancialproductsforretailfinancial products. 

Asimportantasthesestructuralchangesmayturnouttobe,thenewlawmandatesimportantnew proceduresforgoverningthekeycompetitorsandregulatoryagenciesinfinancialmarkets.Amongthe centralregulatorychangeswere:

39

 x Enhancedprudentialregulationforsystemicallyimportantfirms,includingthe impositionofhighercapitalandmarginrequirementsatlevelstobesetbythe regulators; 

x Thespinningoffof(most)proprietaryͲtradingactivitiesbybanksorotherdepositͲtaking institutions(VolckerRule); 

x Thespinningoffof(most)derivativesactivity,whetherasproprietarytraderormarketͲ makingdealer,bybanksorinstitutionsthatbenefitfromfederalgovernment guarantees(LincolnAmendment); 

x Theshiftingof(most)standardizedderivativescontractsfromprivatecontractsto centralizedcounterpartytransactions. 

Thesechanges,bothstructuralandprocedural,wereimportant.Theirultimatesignificancewilldepend uponimplementationdecisionsandthejudicialinterpretationsthatfollow.Inthisperiod,regulatory agencieswilldevelopthecapabilitiesnecessaryfortheirrevisedmissions,proposethenewrulesthat implementthelaw,receivepubliccomments,andprepareforthelegalchallengesthatmakeregulatory lawamatterofongoingpracticeintheUnitedStates.WhiletheprocessesofadministrativeruleͲ makingwillremainprocedurallynormal,theywillbecontestedwithheightenedvigorinthecaseofthe

DoddͲFrankAct.Thereisnodoubtthatthepartiesandinterestgroupshavechosentofightover financialreforminthelegalthicketsofpostͲenactmentimplementationasmuchasinthebrighterlight ofpublicdebate.AsoneWashingtonnewsletterputinearly2011,a“pitchedbattle hasbeenjoined overtheregulationsthatarebeingwrittentoimplementDoddͲFrank”(PrattLetter,2011)

 TheDoddͲFranklegislationrepresentsanambitiousefforttoadapttheunderlyingstructureof corefinancialandregulatoryinstitutions,butwithoutrebuildingthem.Inthissense,theDoddͲFrank legislationconfoundsthesimplestpredictionsfrominstitutionalisttheory:thatmajorexternalshocks aretheprimarysourceofinstitutionaltransformations.Inthiscase,theexternalshockwasseverebut

40

 profoundinstitutionaltransformationdidnotfollow.TheDoddͲFrankoverhaulthereforeprovidessome supporttoamoreincrementalviewofinstitutionalchange.Despitethemagnitudeoftheexternal shock,itwasnotenoughtocompletelydelegitimizeleadinginstitutionsortoshatteroldcoalitions.

RepublicansandDemocratsalikedisplayedaconsistentpreferenceformaintainingthekeyinstitutions inthefinanciallandscape.Thederegulatorychangesinthedecadesprecedingthecrisiscanonlybe characterizedasaprocessofintentionalinstitutionalevolution:institutionaldisassemblyviatherepeal ofkeylawsandthehollowingoutoftheregulatoryagenciesthathadpreviouslypreservedmarket stability.

 Interestingly,theDoddFrankreformincludedchangesthatclearlydivergedfromtheother prevalenttheoriesofregulatorypolicymaking.ThecreationoftheCFPBrandiametricallycountertothe goalsofsomeofthemostentrenchedinterestgroupsinthefinancesector,particularlytheAmerican

BankingAssociation.And,forsimilarreasons,thechangesinagencyjurisdictionsdonotconforminany simplemannertopredictionsthatbureaucraticagenciescandefendtheirturfsuccessfully.

Forthesereasons,theDoddͲFranklegislationmustbeunderstoodastheresultofother distinctivefactors:

ThepreservationistapproachoftheObamaWhiteHouseputgreatemphasisontheneedto avoidfurtherdisruptiontotheincumbentmarketparticipantsorthekeyregulatorybodies.This emphasisonmaintainingcontinuityinthefinancialpolicyeliteclearlysupportedtheexistinginterest groupsinthefinancialarena.Butthepoliticsoffinancewereshakenupbyanumberofunusually knowledgeableandskillfulpolicyentrepreneurs.TheeffortsofElizabethWarrenandPaulVolcker(and, perhapsbehindthescenes,GaryGensler)gaveaverydifferentcasttodebatesthatwouldotherwise havebeendominatedbyfamiliardynamicsofconcentratedinterestͲgrouppressure.

41

 Atthesametime,aformofgrassͲrootsmobilizationrepresentedbytheAmericansforFinancial

Reformreflectedpopularangerandtheeffortsoftheadvocacygroups.TheAFRbroughttogethera rangeoflaborunionsandconsumergroupsand,perhapsmostimportant,areservoirofexpertisethat pushedtheDemocraticpartytosubordinatethepreferencesofestablishedindustrygroupsonseveral occasions.ItwaspartlytheorganizationalskilloftheAFRthatenabledthisresult,butalsopartlythe depthofthepopulistbacklashagainstthefinancialestablishmentthatforcedCongressionalleadersto seekbroaderlevelsofsupportthanavailablefromtheindustrygroupsalone.

 TheresultwasapatternwecalltwoͲtierpolitics,inwhichbothpoliticalpartiessoughttoappeal totheestablishedactorsandthepopularactivistsatthesametime.AtthelevelofeliteortopͲtier politics,bothpartieshadstrongtiestoWallStreetassymbolizedbytheseamlesstransitionfromHank

PaulsontoTimGeithner.BeyondWallStreet,thepartieshadsomewhatdifferentconstituenciesinthe businesscommunity,theRepublicanswithmanyofthemultinationalmanufacturingandextractive segments,theDemocratswithmoresupportfromtransportation,infrastructure,anddomesticallyͲ orientedmanufacturingsegments.Atthelowertierofgrassrootscoalitionbuilding,theparty constituenciesdifferedespeciallyclearly.ForDemocrats,thetwoͲtierstrategymeantappealingto labor,consumeradvocates,andthebroadnetworksofactivistsknownasthenetroots.For

Republicans,thetwoͲtierimperativemeantmaintainingloyaltyfromtheircorebusinessconstituencies whilealsoplacatingtheTeaPartyandotherpopulistgroupsthatrejectedtheveryeliteconsensusthat haddominatedfinancialpolicyforseveraldecades.

 ThistwoͲtierdynamicislikelytoappearinotherpolicyareasinthecomingyears.Forfinancial regulation,thetwoͲtierdynamicdistinctlyhelpedpolicyentrepreneurslikeElizabethWarrenandPaul

Volcker.WithouttheongoingscrutinyprovidedbytheAmericansforFinancialSecurity,itisunclear

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 whethertheConsumerFinancialProtectionBureauortheVolckerRulewouldhavesurvivedthe legislativeprocess.

Butanother,equallyimportanteffectoftwoͲtierpoliticswasthepronouncedsusceptibilityto unpredictedpoliticalevents.ThespecialelectionofRepublicanScottBrownasMassachusettsSenator inJanuary2010ledtoasignificantdilutionofthelanguageoutliningtheVolckerruleintheConference negotiationsofJune2010.AndtheelectoralchallengethatfacedSenatorBlancheLincolnwithinthe

ArkansasDemocraticprimaryelectionsin2010ledhertoinsistuponmuchtougherprovisionsforthe regulationofderivativesthanwouldotherwisehavefounditswayintothefinallegislation.

 Thesefinaltwistsinthelegislativeprocessdirectlyshapedtwoofthemostimportantprocedural changestoaffectU.S.financialmarketsthroughthecrisisandtheregulatoryresponse.Thefirstchange, bydilutingtheVolckerrule,meantthatafterDoddͲFrank,theseparationofdepositbankingfrom proprietarytradingwassignificantlylessclearͲcutthanitmighthavebeen.Thesecondchange,by bringingSenatorLincoln’slanguageintothefinalbill,createdafarstrongersetoftoolsthanregulators wouldotherwisehavereceivedintheireffortstosqueezeexcessivelevelsofriskoutofthederivatives markets.Giventhecentralityofbothissuestotheworkingsofcontemporarycapitalmarkets,itishard tounderestimatetheimportanceofpoliticalcontingencyintheDoddͲFrankoutcome.Muchofthe institutionalcontextcanbewellaccountedforbyourfamiliartheoreticalperspectives.Keyfeaturesin theoutcomeaswellasthepoliticalprocessthatproduceditcan,however,canonlybeexplainedbya newformoftwoͲtierpoliticsinwhichelectedofficialshavetobalancegrassͲrootsadvocacy organizationswiththemostpowerfulelitesandinterestgroupsinthepoliticalarena.





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 Figure1.GoogleTrendsGraphsofVolumeofNewsandofInternetSearchesConcerning“HealthCare Reform”and“FinancialReform”intheUnitedStates 



BLACKANDWHITEVERSIONTHATEMPHASIZESTHECONTRAST:



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