By James Kwak
It’s been more than five years since the peak of the financial crisis, and it seems clear (to me, at least) that not much has changed when it comes to the structure of the financial sector, the existence of too-big-to-fail banks, and the types of activities that they engage in. It’s also clear that the Dodd-Frank Act and its ensuing rulemakings have embodied a technocratic perspective according to which important decisions should be left to experts and made on the grounds of economic efficiency. Even the Consumer Financial Protection Bureau, the Dodd-Frank achievement most beloved of reformers, is essentially dedicated to correcting market failures, which means attempting to achieve the outcomes that would be generated by a perfect market.
The big question is why we went down this route. The traditional explanation, and one that I’ve tended to assume in the past, is that it was a question of political power. Wall Street banks and their lawyers simply want less regulation of their industry, and they feel more comfortable granting actual rulemaking power to regulatory agencies that they feel confident they can dominate through the usual mix of congressional pressure, lobbying, and the revolving door. Given that the Obama administration also wanted to avoid structural reforms and preferred to rely on supposedly expert regulators, the outcome was foreordained.
In a recent (draft) paper, Sabeel Rahman puts forward a different, though not necessarily incompatible explanation. He draws a contrast between a managerial approach to financial regulation, which relies on supposedly depoliticized, expert regulators, and a structural approach, which imposes hard constraints on financial firms. Examples of the latter include the size caps that Simon and I argued for in 13 Bankers and the strict ban on proprietary trading that has been repeatedly watered down in what is now the Volcker Rule.
By James Kwak
Yesterday the House Financial Services Committee held a hearing on the too big to fail problem. Ordinarily a hearing includes a couple of witnesses chosen by the majority who say one thing and one or two witnesses chosen by the minority who say exactly the opposite thing. In this, however, it was hard to tell who was chosen by which side (although I can guess), given the extent of the agreement among former Fed bank president Thomas Hoenig, current Fed bank presidents Richard Fisher and Jeffrey Lacker, and former FDIC chair Sheila Bair.
All agreed that the too big to fail problem still exists, five years after the financial crisis, and that it continues to distort the market for financial services. For example, Lacker, who is perhaps the most sanguine about Dodd-Frank (he likes the living will provisions of Title I), said, “Given widespread expectations of support for financially distressed institutions in orderly liquidations, regulators will likely feel forced to provide support simply to avoid the turbulence of disappointing expectations. We appear to have replicated the two mutually reinforcing expectations that define ‘too big to fail.’”
There was disagreement over whether Dodd-Frank, and the Orderly Liquidation Authority regime that it created, would continue the practice of bailing out failing financial institutions, with Bair arguing that Dodd-Frank “abolished” bailouts. Of course, everyone is against bailouts, but at the same time everyone is in favor of protecting the financial system and the economy against disaster.
This guest post is by Ilya Podolyako, member of the Yale Law School Class of 2009 and a friend of mine. Ilya led the Progressive Economic Policy reading group with me and served as an adjunct professor of law at DePaul University this past spring.
One of the key provisions of the Dodd-Frank Act is Title VII, which requires all non-exempt derivatives transactions to go through a central clearinghouse (this report provides a good summary). As James and Simon have explained, the Dodd-Frank Act uses the term “swap” as a big basket that captures most financial products that we would normally call derivatives: options, repos, credit default swaps, currency swaps, interest rate swaps, etc.
Prior to the passage of the Act, most of these products were sold over-the-counter by certain large institutions. That is, in form, a transaction where you wanted to buy a credit default swap triggered by some event (say, the bankruptcy of Ford Automotive) resembled a trip to the car dealership. The dealer had inventory on the lot; this inventory was split into several different models / types of product; individual instances of a given model were relatively homogenous and varied mostly by color and minor adornments (spoilers, leather seats, etc.). If you were looking for a car of a given make and model that had certain extra features, a dealer might be able to get one custom-built for you at the factory, but you’d have to wait for the item and pay extra. Of course, the salesperson would not be able to accommodate all requests – if you show up to your average Chevy dealership and ask to buy a jet-powered car, you are likely to leave empty-handed no matter how much money you have, even though a few other individuals have been able to procure said exotic item.