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Key Changes That Reduced Systemic Risk ELECTRONICALLY REPRINTED FROM JANUARY 2015 Financial Regulatory Reform: Key Changes That Reduced Systemic Risk By George W. Madison, Gary J. Cohen, and William A. Shirley wave of retrospection regarding the Dodd-Frank Historical Perspective A legislation1 rolled through the press late last sum- In September 2008 and for several months thereaf- mer. Although articles and opinion pieces marking the ter, the US economy, the strongest in the world, was occasion of Dodd-Frank’s fourth anniversary looked on the brink of collapse. The most severe financial crisis back with a critical eye, this article is the first in a series in 80 years had idled 26 million US workers, wiped out of three that look forward. We start our series with $11 trillion in household wealth, caused four million the principal success of financial regulatory reform home foreclosures, and placed another four million since the financial crisis of 2007–2009. Dodd-Frank families at serious risk of foreclosure. The crisis also is a touchstone for this discussion, but we also take precipitated the failure of esteemed financial institu- up other important initiatives, such as those related to tions and businesses of all sizes, and required the federal Wall Street’s continued reliance on various forms of government to rescue the global financial system before short-term funding. In our second article, we explore millions more US jobs, homes, and businesses were opportunities for improving the current regulatory destroyed.2 framework—where we believe Dodd-Frank and other regulatory reforms did not get things entirely right— One prevalent partisan narrative laid the blame for and in the third, we share our views of the next frontier the crisis at the feet of governmental housing policy, in regulatory reform. as it told a story of Fannie Mae and Freddie Mac implementing lax mortgage underwriting standards Throughout our narrative, we focus closely on the that led to the housing bubble and, ultimately, soaring role played by nonbanks as well as banks in the finan- default rates.3 However, the congressionally chartered cial crisis. This focus is essential to understanding the Financial Crisis Inquiry Commission determined the regulatory successes, the current regulatory opportuni- causes to have included widespread failures in financial ties, and the next big regulatory thing. We use the term regulation and supervision, faulty corporate governance “shadow banking” even though it can obscure rather and risk management practices at financial institutions, than illuminate the issues at hand. As an alternative, we excessive leverage, risk-taking, speculation in the also talk about “maturity transformation,” that is, the derivatives markets, failures of credit rating agencies, practice of borrowing on a short-term basis to lend or and a breakdown in accountability and ethics.4 There otherwise invest on a longer term basis. This mecha- was plenty of blame to go around as a largely unre- nism is essential in any capital-based economy, and strained financial system reach its “Minsky moment”5 although it was historically the domain of banks, today in September 2008. many nonbanks, operating via the capital markets, serve the same function, and their part in the financial crisis In the wake of the crisis, Congress enacted Dodd- was key. Frank, a comprehensive legislative framework intended to plug holes in the financial regulatory umbrella that were exposed by the crisis. The legislation, which was initiated at the US Treasury Department, was negoti- George W. Madison and Gary J. Cohen are partners and ated over a period of months with Congress, with William A. Shirley is counsel of Sidley Austin LLP. During the regulators of various stripes, and with other interested financial crisis, Mr. Madison served as general counsel of the US parties. It eventually comprised 2,300 pages and con- Treasury Department (2009–2012), Mr. Cohen served as general counsel of the Financial Crisis Inquiry Commission (2010–2011), templated hundreds of interpretative regulations and and Mr. Shirley served as general counsel of AIG Financial studies, many of which are as yet unfinished. The Products Corp. (2007–2011). reaction to financial regulatory reform ranged from some admiration, to grudging respect, to howls of important financial institutions should or should not be hostility peppered with charges of partisan overreach.6 saved. In essence it ignores the need to make it both Notwithstanding the harsh critique (some of it mer- unlikely that such institutions will ever again need to ited), there is little doubt that Dodd-Frank and its prog- be “saved” and yet likely that if one (or more) of them eny have effected lasting and positive cultural change ever does face critical distress, the federal government within financial institutions, have lowered financial will have the right tools to do what is necessary to firm risk profiles, and have strengthened important avoid systemic crisis. regulatory mandates. The history of financial crises, their causes and reme- Criticism of financial regulatory reform is not a diation, is replete with unique, market driven events new phenomenon. The 1929 stock market crash and accented by human frailty. Each crisis has been differ- the Great Depression forced a reluctant Republican- ent, and each legislative response has been tailored to dominated Congress to support the US Senate’s Pecora address not only identifiable causal connections, but hearings7 on market manipulation, insider trading, politically attractive targets. The Dodd Frank legisla- and preferential insider arrangements that plagued tion was intended to stabilize the US financial system the Roaring Twenties. When control of Congress by containing excessive risk-taking and restoring public changed hands with the election of Franklin Delano confidence. But it also set its sights on Wall Street and Roosevelt in 1932, the Pecora inquiry was reinvigo- its institutions in ways that were more politically con- rated, and Congress enacted foundational securities venient than causally relevant. laws, which were met with vociferous condemnation by business leaders and New Dealers alike.8 Despite We will take up our primary criticisms of Dodd- subsequent attempts to weaken this legal framework, Frank in our second installment. For now, suffice it to there is no doubt that the market reform legislation say that we do not believe that Dodd-Frank in its cur- of the 1930s—particularly the Securities Act of 1933, rent form provides a complete box of tools for regula- the Securities Exchange Act of 1934, and the creation tors faced in the future with the potential collapse of a of the Securities and Exchange Commission (SEC)— large, interconnected financial institution whose failure were powerful regulatory tools that restored and have could cause a catastrophic collapse of the US and global maintained worldwide investor confidence in US financial system and impoverish millions of US citizens. financial markets. Dodd-Frank’s tools, however, are not insignificant, The last four years also find significant parallels in and therefore we belatedly join the celebration of its the history of the savings and loan crisis of the 1980s, fourth anniversary by considering a few legislative pro- which led to the enactment of the Financial Institutions visions and related regulatory initiatives that have been Reform, Recovery and Enforcement Act of 1989, as successful in reducing systemic risk and the need to well as the history of the corporate and accounting again face “too big to fail.” scandals in the late 1990s, which led to the Sarbanes- Oxley Act of 2002.9 Liquidity Crisis Leads to Great Recession On the occasion of Dodd Frank’s fourth anniversary, The Great Recession began as a liquidity crisis it became fashionable again for pundits and politicians among interconnected financial institutions, which to criticize the support given to the financial system by was followed by a capital crunch in the traditional the federal government and ask whether Dodd-Frank banking world. Panic of a particular sort ensued; some solved for all time the “too big to fail” issue10—in other dominos fell, and more were propped up by the federal words, whether regulatory reforms initiated by Dodd- government. Frank will prevent US taxpayers from having to rescue financial institutions that threaten US financial stability. A hallmark prophylactic measure of financial regu- This formulation of the question oversimplifies the latory reform under Dodd-Frank is the extension of issues at stake and raises a dangerously false dichotomy capital requirements in enhanced form to the largest by focusing policy arguments on whether systemically BHCs, to certain US operations of non-US banks, and 2 • Banking & Financial Services Policy Report Volume 34 • Number 1 • January 2015 eventually to systemically important nonbank financial system.15 In other words, it has been one of the engines institutions. Like other measures, capital requirements of shadow banking. can be a mixed bag. On the one hand, Dodd-Frank and the international accords constituting the Basel III Its most prevalent component is the “repo” market, framework have increased the quality and quantity of particularly the “tri-party repo” market. Generally, in capital maintained by financial institutions.11 The larger the repo market, broker-dealers, hedge funds, and other a firm’s capital cushion, the more likely the firm will institutional investors borrow cash overnight or on an be to survive a global financial panic, and the safer intraday basis from cash-rich lenders such as mutual and sounder will be the financial system. Not only funds and banks. The borrowers use US Treasury do the regulatory requirements prescribe capital levels bonds or other securities as collateral. In effect they based upon the type, quality, and riskiness of associ- finance portfolios of securities the way a Main Street ated assets, but Dodd-Frank’s simpler but overlapping business might finance inventory or capital equipment, restrictions on basic balance-sheet leverage, together but with the need to renew the “loans” on a daily basis.
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