*The paper was presented at the Romanian – Hungarian Bilateral Round Table (Bucharest, November 25-26, 2011)
AUTHOR: Zsuzsánna BIEDERMANN
Abstract
From 2007 on, the United States of America has witnessed one of the most severe economic crises in its history. Financial deregulation and loopholes in the regulatory framework played a major role in the development of an extremely complex and opaque financial system. Financial regulation did not keep pace with the new products of financial markets. In the first part, I briefly describe the process of financial deregulation focusing on the repeal of the Glass-Steagall Act.
The second part of the article shortly analyses the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. When Barack Obama became president, he promised a sweeping, overhaul reform of the American financial system. When examining the long-awaited Dodd-Frank Act, I realized that it will probably fail to prevent actors of financial markets from engaging in the same practices that led to the crisis.
Introduction
Dissatisfied citizens in the United States started a movement called ”Occupy Wall Street” on Sep 17, 2011 to express their growing concern over the role of the financial sector in the global economic downturn. Protests began with an encampment in the financial district of New York City, but soon spread to other American cities. President Barack Obama said demonstrations reflected the broad-based frustration of Americans about how the financial system works. Indeed, the financial sector seems to be returning to the same abusive practices that led to the most severe economic recession since the Great Depression.
The roots of this crisis lie deep in American economic history. America spent decades in economic prosperitiy: the Asian Financial Crisis and domestic financial problems did not have long term negative effect on economic growth, which bred strong faith in the flexibility and adaptation capacities of financial markets and firms as well as the strength of financial regulation.
Repeal of the Glass-Steagall Act: a precursor to the crisis?
A major element of the financial regulation before the crisis was the 1999 repeal of the Glass-Steagall Act. The Glass-Steagall Act entered into force in 1933, after the 1929 collapse of the American stock market and it aimed at maintaining the integrity of the banking system, preventing self-dealing and other financial abuses; and limit stock market speculation . The reason according to a summary by the Congressional Research Service of the Library of Congress: ”In the nineteenth and early 20th centuries, bankers and brokers were sometimes indistinguishable. Then, in the Great Depression after 1929, Congress examined the mixing of the ”commercial” and ”investment” banking industries that occurred in the 1920s. Hearings revealed conflicts of interest and fraud in some banking institutions’ securities activities. A formidable barrier to the mixing of these activities was then set up by the Glass–Steagall Act.”[1]
Decades later, the wall erected between the two types of banking activities seemed more and more permeable as bankers designed new financial products similar to securities, and securities firms created new financial products bearing resemblance to loans and deposits. Actors of the American financial markets started a fierce fight against firm prohibitions in the Glass-Steagall Act. They described the blending of commercial and investment banking activities as a necessary step in the global financial deregulation wave that would help the United States preserve its financial competitiveness. The financial lobby argued that Glass-Steagall act is slowing economic growth by overregulating market activities. As financial deregulation gained pace in –among others- in Great-Britain, Canada and Japan, American financial lobby further pressurized the Congress to repeal Glass-Steagall Act.
Naturally, lawmakers had their doubts about changing the framework of financial regulation. The 1987 summary on commercial vs. investment banking by the Congressional Research Service of the Library of Congress argued for the preservation of the Glass-Steagall Act enumerating four major concerns over financial deregulation:
(1) Conflicts of interest characterize the granting of credit- lending- and the use of credit-investing- by the same entity, which led to abuses that originally produced the Act.
(2) Depository institutions possess enormous financial power, by virtue of their control of the peoples’ money, its extent must be limited to ensure soundness and competition int he market of funds whether loans or investments
(3) Securities activities can be risky, leading to enormous losses. Such losses could threaten the integrity of deposits. In turnm the Government insures deposits and could be required to pay large sums if depository institutions were to collapseas the result of securities losses.
(4) Depository institutions are supposed to be managed to limit risk. Their managers thus may not be conditioned to operate prudently in more speculative securities businesses.
In 1999, the financial lobby managed to convince lawmakers: the barriers separating commercial and investment banking were removed by the Gramm-Leach-Bliley Act. [2] The passage of this act meant that commercial banks, investment banks, securities firms, and insurance companies were allowed to consolidate. This change had far-reaching consequences: the passage of the law led to the creation of giant financial actors that could own investment banks, commercial banks and insurance firms and that’s how it paved the way for companies that were too big and complex to fail. Numerous experts, among others Joseph Stiglitz, criticized the Act for its contribution to a deregulated financial environment and thus indirectly to the 2007 subprime mortgage financial crisis.
Banks, brokerages and insurance companies justified the necessity of a repeal by emphasizing that the demand of financial services has been changing: e.g. there was a growing demand of investments related to savings, so traditional financial institutions’ sphere of activities were constantly widening and became more diverse. In several countries, conglomerates consoldating banking and insurance activities have become key actors of economic life (e.g. Belgium, the Netherlands, Australia)[3]. With the passage of the 1999 act, American financial conglomerates had better chances to compete on global financial markets.
Along with changes in the regulatory environment, in the decades before 2007, due to low interest rates and the abundance of cheap loans, market actors also became too optimistic. A new, more adventurous financial behaviour was spreading. Investors trusted credit rating agencies excessively. Financial innovators produced a great variety of new and complex financial instruments that were designed to spread risk, but finally concentrated risk instead. Loans were sold to banks, banks securitized these loans, investors bought them. Investors were frequently unaware of the risks they signed up for. These packages meant easy money as long as they lasted, the whole system was built on a pile of sand. But as these new financial products became widespread and popular, lenders started lowering standards to attract even more clients. Instead of reducing risk, in reality markets magnified risks.
Rising asset prices hid weak credit underwriting standards and increasing leverage throughout the system. Rewards in the financial sector compensated short-term profits instead of encouraging long-term value.
Operation of financial institutions became extremely complex and opaque that only a few insiders could understand. Gaps and overlaps in the rules resulted in regulators lacking the authority and the will to take action and they could not be held accountable for their impotence.In the meantime, financial regulation did not keep pace with the new products of financial markets.
The aftermath of the crisis and its repercussion on American financial regulation: the Dodd-Frank Act
When Obama became president, he had an ambitious plan to overhaul regulation of the whole U.S. financial system in order to prevent future crises resulting from loopholes in the regulatory framework.
His aspirations were translated into the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed on July 21, 2010 after long months of political wrangling. Obama and numerous experts have characterized the bill as an historic achievement. But if we examine the Dodd-Frank Act that was finally signed by the president, we notice that the original aims of a sweeping, deep reform were significantly modified.
The five key points of the legislation are as follows[4]:
· A too-big-to-fail (TBTF) circuit breaker
The state spent a large amount of taxpayers’ money on saving and recapitalizing systemically important financial institutions that were too big to fail (TBTF). If they had in fact failed, they could have endangered the operation of the whole financial system. But state intervention resulted in growing government debts.
Market belief in extraordinary government support for large firms could have encouraged widespread risky lending among important market actors. Of course, a financial institution normally does take a certain amount of risk by investing, lending, etc. but a systemically important financial institutions’ behaviour might become less prudent if its leaders are convinced they would not have to carry the full burden of potential losses. Thus moral hazard probably played a major role in shifting market trends. The Dodd-Frank Act could be effective if it changed the market’s belief that taxpayers, depositors, and other creditors would shoulder part of the burden of risky financial decisions.
Although the Dodd-Frank Act suggests some basic amendments in TBTF regulation, the original TBTF proposal would have changed the financial industry’s basic model and would have prevented financial institutions from becoming too complex.
The final version of the bill only contains a prescription about a council of regulators with the right to monitor the operation of TBTFs, and a plan that banks will have to put aside enough capital to use if they go bankrupt (thus avoiding further taxpayer-financed bailouts). Banks will also be required to elaborate a ”living will”, a a blueprint of the firm’s operations that would allow regulators to dismantle it in an orderly fashion.
Dodd-Frank also requires regulators to identify TBTF institutions that would face stricter restrictions (tougher capital, leverage, liquidity and other rules), but that has not taken place yet.
So the Dodd-Frank Act does not limit the size of financial institutions, and the crucial step of identifying companies that pose a risk to the American financial system as a whole has so far been omitted, the new legislation has not solved the original problem. The treatment is symptomatic.
· The ”Volcker Rule”
The crisis made people realize that several financial institutions were using clients’ money to indulge in risky investments on the bank’s behalf. The Volcker rule, bearing the name of former United States Federal Reserve Chairman Paul Volcker, originally proposed to prohibit banks, or institutions that own banks, from engaging in proprietary trading that is not on behalf of its clients and from owning or investing in a hedge fund or private equity fund, as well as limiting the liabilities the largest banks can hold. In the final version of the Dodd-Frank Act, banks are allowed to own or invest up to 3 percent of their capital in a hedge or private equity fund.
Although three percent is a negligible amount, the reader should recall that the first efforts to loosen the previous Glass-Steagall restrictions started in the same way. The Glass-Steagall Act was introduced after the Great Crash of 1929 in order to separate investment and commercial banking, thus limiting the conflicts of interest created when commercial banks are permitted to engage in brokerage activities. From the 1960’s, a whole lobbying subculture emerged around Glass-Steagall and, by 1986, lobbyists had achieved considerable results: commercial banks were allowed gross revenues of up to 5 percent from investment banking activities. In 1989, the limit was raised to 10 percent and then in 1996 to 25 percent, effectively rendering the Act obsolete.[5]
Considering that, according to a 2010 report[6], the six largest U.S. banks spent 200 million dollars in 2009 to block bank reform measures in Congress, history may well repeat itself and the Volcker 3 percent threshold Rule will soon be increased.
· Transparency reforms
Transparency reforms aim at preventing future financial crises by firm market and transaction-level transparency, reducing structural leverage and systemic risk throughout the derivatives markets. The regulation of over the counter swap markets includes regulating credit default swaps as well as credit derivatives that were the subject of several bank failures at the beginning of the crisis.
The Dodd-Frank Act provides a comprehensive regulatory framework for the over-the-counter derivatives markets[7] but the numerous exemptions undermine the original objectives.
Bringing light to the $600 trillion derivatives market might truly regulate a corner of the securities market that has long functioned in the shadows. The bill requires standardized derivatives contracts to be traded on an open exchange, with prices and volumes reported publicly. The contracts must also be cleared through a third party, an intermediary, who guarantees that if one party defaults, the investor holding the other side of the trade will still be paid. The bill also requires securities firms to maintain certain minimal levels of capital and banks to segregate derivative operations from their commercial banking business.
But the original tough derivatives propositions that would have forced banks to spin off all swap trading operations have been watered down so that banks are allowed to engage in swap trades like interest-rate swaps, foreign exchange swaps and gold and silver swaps. They only have to spin off their riskiest swaps, such as those for agriculture, metals, and energy. So the regulation leaves around 80 percent of the swap trade business with the banks.
Apart from increased transparency, the Dodd-Frank Act leaves the derivatives industry largely unchanged.
· Consumer protection
The crisis was in large part due to ignorance on the part of consumers. They trusted financial institutions and brokers excessively and often signed contracts without being aware of hidden fees or additional risks. Different actors on the financial market took advantage of consumer trust and placed their own interest ahead of that of the clients.
Before the crisis, the Federal Reserve was responsible for both consumer protection and the safety of national financial institutions, often putting the emphasis on the latter. The Dodd-Frank financial regulatory reform established the Bureau of Consumer Financial Protection to financially educate consumers and to promote financial literacy. The consumer bureau is supposed to give consumers the information they need to understand the terms of their agreements with financial companies. It is working to make regulations and guidance as clear and streamlined as possible so providers of consumer financial products and services can follow the rules on their own. As the Bureau states on its official website: ”An informed consumer is the first line of defense against abusive practices.”
The new agency has the right to regulate credit counseling, payday loans, mortgages, credit cards and other bank products. The Bureau would in theory shield consumers from abuses involving mortgages, credit cards, lending and other financial services.
The Bureau itself is a good proposal that could prevent abuses resulting from consumer financial illiteracy. But its successful operation is still pending since it has become the focal point of continued Republican opposition to the financial overhaul law and Republicans are trying to obstruct and slow down its operation.[8]
· ”Say-on-pay”
Before the crisis, several financial institution managers received huge bonuses for short-term results and were not held responsible in case of bankruptcy (typically landing with golden parachutes). To end this vicious circle of excessive compensation that led to risky investments, Obama’s original proposal aimed at limiting huge compensation packages. However, in the final version of Dodd-Frank, nothing but a “say-on-pay” passage was finally included.
Say-on-pay means that, in their annual proxy statement, public companies are required to provide for a non-binding shareholder vote approving executive compensation.[9] The non-binding shareholder vote on this proposal does not overwrite board decisions, but does determine the frequency of the “say-on-pay” proposal (i.e., every year, every two years, or every three years). In addition to the say-on-pay proposal, whenever shareholders are asked to approve an acquisition, merger, consolidation or sale at a meeting, the company or the person solliciting proxies must disclose any agreements or understandings concerning compensation payable to the named executive officers as a result of such transaction, and shareholders are granted a separate non-binding vote to approve such payments. The results of this vote do not override board action.
Since all these amendments bring about a voting system with non-binding results, it will certainly not be enough to stop excessive compensation of top managers.
Conclusion
All-in-all, the Dodd-Frank reform is not an adequate reply to the questions posed by the financial crisis. The stated aim of the legislation is: ”to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ”too big to fail”, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices…” Despite these ambitious objectives, the Dodd-Frank Act does not treat the root causes of the problems that caused the crisis.
It does not address adequately the problem of breaking TBTF institutions up into smaller entitites. And although they did play a big role in driving Wall Street towards hazardous short-term investments, compensation packages have not been radically changed either. The law also fails to put an end to banks getting involved in dubious investments using their clients’ money. Nor does it reduce securitization and high leverages that set the world on the course to financial meltdown.
Even minor modifications to the current financial system are very hard to implement. The following chart is taken from the progress report of the Davis and Polk law firm, showing that only 74 of more than 400 proposed rules have been finalized. This ratio ferlects considerable efforts by banking industry allies to prevent regulators from realizing their original aims and achieving the spirit of the legislation.
Source: Davis and Polk Dodd-Frank Progress Report[10]
Since the core problems that led to the global financial crisis have not or have only partially been solved by the 2010 financial overhaul legislation, it is more than probable that American financial markets will have to face new, more severe crises. Movements such as”Occupy Wall Street” underline growing consumer concern and the need for change in which both the markets and the average American can believe.
Notes:
[1] Jackson, William D. Glass-Steagall Act: Commercial vs. Investment Banking. Washington D.C., USA . UNT Digital Library. http://digital.library.unt.edu/ark:/67531/metacrs9065/. Accessed January 4, 2012.
[2] Office of the Controller of the Currency: Economics Working Papers
WP2000-5 (April) The Repeal of Glass-Steagall and the Advent of Broad Banking
James R. Barth, R. Dan Brumbaugh Jr. and James A. Wilcox
http://www.occ.gov/publications/publications-by-type/economics-working-papers/2008-2000/wp2000-5.pdf
Letöltve: 2011. 03. 14.
[3] Szüle Borbála: A pénzügyi konglomerátumok létrejöttének kockázati hatásai
Közgazdasági Szemle, LIII. évf., 2006. július–augusztus (661–680. o.)
[4] BRIEF SUMMARY OF THE DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT on http://banking.senate.gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_comprehensive_summary_Final.pdf, Accessed on 6 January, 2012
[5] Sources: www.pbs.org, FRONTLINE’s interviews for „The Wall Street Fix” and published reports by The New York Times, The Wall Street Journal, The Washington Post, Time, Fortune, Business Week
[6] Kevin Connor: Big Bank Takeover
How Too-Big-To-Fail’s Army of Lobbyists Has Captured Washington
Institute for America’s Future
May 11, 2010
[7] Dechert LLP The Regulatory Reset of the OTC Derivatives Markets http://www.dechert.com/library/FS_17_07-10_Dodd-Frank_The_Regulatory_Reset.pdf
Accessed on 5 January, 2012
[8] Already a year after signing the bill, On July 18, 2011, President Obama nominated Richard Cordray, the head of the Bureau’s Enforcement Division, to be the first Director of the CFPB. But due to opposition, this nomination is pending before the Senate.
http://www.consumerfinance.gov/the-bureau/, Accessed on 5 January, 2012
[9] SEC Adopts Rules for Say-on-Pay and Golden Parachute Compensation as Required Under Dodd-Frank Act, http://www.sec.gov/news/press/2011/2011-25.htm, Accessed on 6 January, 2012
[10] http://www.davispolk.com/files/Publication/0070db24-e562-4666-832c-03ad96defd42/Presentation/PublicationAttachment/b1836732-9b89-46be-a9e5-07c77a08d62a/Jan2012_Dodd.Frank.Progress.Report.pdf, Accessed 5 January, 2012
