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 ! " # $ %& '% ( %# ) * %&'+ % ( % ,-,./-,, $ *! # $ *! # % % 011 ' *1 1 1/2/,3 * 4 * '5 ( * * * 4 '6 %* % ( 4 * 4 7 ( * 8 * ( *' 9 " * * /-,- ( ( ' % * :,; * * :/; * * ( * * * '6 %9 "6 * * * * * % ' $ 9 " 6 * * * % 7 * * ' ( * * 0 * % % *( *: < ;% * ( ( *' # ( % * ( ( ( ' 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 Americasfinancialmarkets.ThreevenerableWallStreetinstitutionsBearͲStearns,MerrillLynch,and LehmanBrotherswereabsorbedbytheircompetitorsorallowedtofailoutright. 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 1 Democratsclearlybelievedtheyhadamandateforchange.InFebruary2009,ObamatoldtheBusiness Councilthathesupportedcomprehensivefinancialreformtoensurethatsuchacrisiscouldnever 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. 2 ButdidtheseeventssignalalargershiftintheU.S.politicaleconomy?Didtheshocktranslate intomoreenduringinstitutionalchange?TheDoddͲFrankAct,(formallytheDoddͲFrankWallStreet ReformandConsumerProtectionAct(PL111Ͳ203),wassignedintolawonJuly21,2010.Itrepresents themostambitiousoverhaulofthecountrysfinancialregulationssincethe1930s.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 3 theoreticalparadigmagainstoneanotherashadoccurredinsomeothermajorinstancesofeconomic turmoilandpolicychange(Hall,1989). SuchanoutcomeofsignificantbutlessͲthanͲtransformationalchangerequirescloser examination.Theapparentopeningforfundamentalredesignofpolicyandinstitutionsdidnotleadto anydeepͲseatedchangeinorganizationalstructures.Onlyonenewagencywascreatedandnew regulatorypowerswereverycautiouslydrawn.Inmanymorecases,existingpowerswerereallocated amongexistingagencieswhilepriorproceduresandtoolswereenhanced.Howcanweexplainthe limitedscopeofreformincomparisontotheprofoundanxietyprovokedbythetriggeringcrisis? Severalstrandsofliteratureprovideplausiblehypotheses.OnehypothesisfromtheinterestͲ groupliteraturewouldholdthatconcentratedindustryinterestswereabletobeatbackproposalsfor unfavorableregulation(Wilson1980)andtotrumpmorediffusecoalitions(Olson1965,1984). Alternatively,itcouldbethatexistingregulatoryagencieshadsufficientautonomyandwieldedenough