Let's Turn Back the Clock on Dodd-Frank
The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) is now the law of the land. This Rube Goldberg monstrosity offers 2,319 pages for lawyers to explain; 243 rulemakings for regulators to conjure up, and investment managers and bankers to worry about and lawyers to interpret; and 67 studies to ensure that no professor or graduate student goes hungry.
The financial crisis of 2008 afforded the US Congress and the US Securities and Exchange Commission (SEC) a rare opportunity to make fundamental changes to the way Wall Street operates, and to address risk-taking on Wall Street and basic issues like leverage. This opportunity was squandered and used instead to publicly vilify and to punish Wall Street firms by creating a bill stuffed with virtually every item on the Democrat Party’s financial markets regulation wish list. Dodd-Frank also promotes a wide variety of public policy objectives that have nothing to do with the cause of the crisis or the failure of AIG, Bear Stearns and Lehman Brothers.
Dodd-Frank is almost twice as long as the NASA operating manual for the space shuttle (which is 1,176 pages long). How can a law 2,319 pages long possibly make any sense? What were these people thinking?
The absurdity of the sheer length of Dodd-Frank should have been obvious to everyone involved in drafting it, but it was not. Why should politicians and bureaucrats in Washington be circumspect about massive, endless government intrusion into, and regulation of, almost every facet of our financial system? More pages occasion more regulators, more bureaucrats and more lawyers -- full employment for everyone pushing paper and making rules that govern our lives. Market participants in the financial community, and the public, are now stuck with a law which probably no one understands and which probably no one will ever understand -- and that is before we see thousands of pages more in rulemakings and studies.
Far worse than the gargantuan size of Dodd-Frank is the damage it will do to our financial system and economy in the future by enshrining into law the misguided concepts of “too big to fail” and “systemic risk.” These concepts, which have yet to be defined with any intelligible specificity, even by their proponents, make the mistake of incentivising investment bank chief executive officers (CEOs) to take in the future even more risk than they did prior to the crash of 2008. If a gigantic trading bet pays off big then the CEOs and their portfolio manager colleagues make millions of dollars; but if the loss if big enough potentially to bankrupt their firm then Dodd-Frank relieves the CEOs and the portfolio managers of the risks they have taken by using taxpayer funds to mutualise the loss on the ground that the firm is “too big to [let] fail”! Dodd-Frank insures moral hazard, and makes likely the waste of hundreds of billions of tax dollars for bailouts in the future.
If Congress believes that insuring the imprudent risk-taking of Wall Street firms is wise economic policy, why stop there? Why should only rich Wall Street CEOs and portfolio managers get bailed out? Why not ensure everyone’s risky trades, including yours and mine? At least then taxpayers will be getting something in return for insuring the risk-taking of Wall Street firms.
The crisis of 2008 demonstrated that some form of regulation is warranted -- but not the overwrought and ill-conceived provisions agglomerated into Dodd-Frank. Among Dodd-Frank’s many inapposite prohibitions are a ban against commercial banks and “nonbank financial companies” engaging in certain types of trading activities; a ban on brokers that have placed investments in asset-backed securities from engaging in any transaction posing a “material conflict of interest” within one year of the placement; and a ban on banks from investing more than 3 percent of so-called “Tier 1 capital” (essentially cash and liquid assets) in collective investment vehicles engaging in hedge fund strategies. But these activities had little or nothing to do with the cause of the crisis of 2008.
The financial firms that collapsed did not fail because there were engaged in the foregoing and now proscribed activities; they failed because they were leveraged up to 40-to-1. The one issue Dodd-Frank properly could, and should, have addressed is leverage. Both the Federal Reserve and the SEC have always had the power to regulate the debt-to-equity and asset-to-equity ratios of financial firms. But Dodd-Frank, in all those pages, does not address this fundamental cause of the collapse of AIG, Bear Stearns and Lehman Brothers. All Dodd-Frank had to do was illuminate the Fed’s and the SEC’s existing authority to regulate leverage ratios and prescribe anew that leverage may not exceed X-to-1. This would be a simple, determinate and understandable constraint on the unrestrained greed of Wall Street, and would reduce greatly the likelihood that excessive risk taking by Wall Street firms would trigger a financial crisis in the future.
Is it too late to turn back the clock? Congress has an opportunity to make substantive changes to Dodd-Frank. After recent discussions in Washington with senior Republican staff members, I know there is sympathy for pruning and amending Dodd-Frank. Write to your Senator and Representative now!
Ron Resnick is a co-founder of CounselWorks, which provides strategic business advice, and regulatory and compliance consulting services, to hedge funds, investment advisers, private equity firms and broker-dealers.