On November 1, 2010, I attended an event sponsored by the Rock Center for Corporate Governance at Paul Brest Hall, Stanford University. I’ve noted a few times that students don’t seem to be taking advantage of Rock Center events. This time the hall was comfortably crowded.
Background: Enacted in July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) reshapes the regulatory framework for the US financial system. Its goal is to “create a sound economic foundation to grow jobs, protect consumers, rein in wall street and big bonuses, end bailouts and too big to fail, and prevent another financial crisis.”
Some highlights include: creating a new independent watchdog, “The Consumer Financial Protection Bureau” at the Federal Reserve; creating “The Financial Stability Oversight Council” to identify and address systemic risks; ending “too big to fail bailouts”; reforming the Federal Reserve; bringing transparency and accountability to the derivatives market; introducing mortgage reform; raising standards and regulating hedge funds; introducing new requirements and oversight of credit rating agencies; giving shareowners a say-on-pay on executive compensation; giving the SEC authority to grant shareholders proxy access to nominate directors; and introducing substantive new bank and thrift regulations.
Dan Sicoliano did a great job of moderating the event… keeping the panelists on track with pointed questions and within time-frame. This post reflects my notes. I attempted to attribute remarks to the speakers, rather than trying to keep them in context. A video will be posted by the Center within the next couple of weeks. That will provide an accurate record but, in the meantime, the following might get you reflecting on the topic.
Stanford Graduate School of Business Professor Darrell Duffie, a leading authority of the financial system and author of How Big Banks Fail and What to Do about It. Duffie gives Dodd-Frank an incomplete grade. It worsened “too big to fail.” Expects the nine member Financial Stability Oversight Committee to have a hard time agreeing on when to use their powers, making losses larger. Thinks bankruptcy code revisions might provide more predictability.
Quickly described some key reforms:
- Imposing reporting, capital and margin requirements on the most active OTC derivatives market participants, major swap participants (MSPs) and swap dealers (SDs).
- Subjecting many derivatives to central clearing and exchange trading in regulated trading systems; and
- Establishing more clearly the jurisdiction of the key derivatives regulators, the SSEC and the Commodity Futures Trading Commission (CFTC), and repealing exemptions and exclusions that stood in the way of their regulation of the multi-trillion dollar OTC market.
Dodd-Frank still incorporates exceptions for counterparties, allows them to exercise contractual rights after a one business day grace period. If I understood correctly, Duffie is concerned that unless counterparties understand what will happen and when, such action could cause a liquidity run.
Dodd-Frank falls short in segregation of markets and establishing collateral requirements. Rule writing will be critical on anything standard enough to be cleared either through exchange or swap execution (like a limited order book ). Dealer banks will want to control competition, at the expense of creating wider markets.
When the next financial crisis hits, at least they should have a better understanding of the infrastructure. We can’t freeze the system where it is. Give it our best try to make it transparent. Oversight was lacking.
With regard to the crisis, thinks regulatory failures were at top but governance failures were right up there. Companies had no idea of their exposure to subprime. Boards don’t have a very good track record. Need education, better expertise, risk management to understand… not so much reliance on traditional auditing, need better advice on risk and liquidity. Played role not in the event but in its significance, its magnitude.
Capital requirements. Basil III is pillar of our new capital requirements. It will make a significant difference because capital required will be 3 times that of Basil II but phased in over 9 years. 2nd part – liquidity requirements could cover 30 days. Lowers likelihood banks will become distressed but faces Push-back from big financial institutions, especially European and lowers growth in GDP.
Off-balance items to be accounted for, at least to some extent… and skin in game requirements. Questions if our definition of banks is broad enough. Sees capital roles being pushed outside banks to other, less regulated, companies.
Stanford Law School Professor Joseph Grundfest (JD ’78), a former Commissioner of the Securities and Exchange Commission and an expert on capital markets, corporate governance, and securities litigation. (see SSRN)
95% of the action is in the definitions as the rulemaking proceeds. Legislation fails to address some significant problems. Financial segment of the economy is now even more concentrated. The remaining banks are bigger after mergers to save the failing.
Resolution Authority parachute is so unlikely to work that no one want to test. Bond market investors. Enhanced moral hazard. Solution? Look elsewhere. important thing is to build system with incentives to make that situation appropriately small. Society has a very large crisis. To avoid a crisis… don’t have one. One of the best solutions is information.
More transparency. We didn’t know where the bodies were buried. Could counter-parties pull through? They were operating in the dark. We had no idea of likely consequences of action. Throw the biggest blanket over the situation that we can to protect ourselves. We didn’t understand how piece A connected to piece B. That’s necessary. Corporate governance – how much involved? Far down the list. Crisis was more profoundly political. Corporate governance caused a magnification. Whistleblower bounty provision has little to do with failure. Violation, sues, collects 10%-30%. Could make governance a nightmare depending on how rules are written. Company programs can’t compete with SEC awards.
Better align risk-taking? Yes, it was a factor. Incentives probably weren’t in the top 5. Institutional investors need better risk analysis, and so do boards. Regulatory failure. Government had authority. The data was there at AIG and elsewhere but regulators didn’t understand the implications. It was a collective failure. Need better risk management.
What set of events will cause a death or near death experience? Dialing those factors in would help to determine if can assume that risk or not.
Cost of doing business for banks will go up. Other institutions outside Basil III will be more profitable. That’s the direction institutions will involve. Federal reserve remains as only effective tool but at same time we find it to be a weaker tool the expected.
We looked to get as much as possible from TARP. Ultimate cost $50B. Got most money back. Surprised to get money back from AIG, autos, Citi, BofA. Too big to fail, insufficient. Needlessly complex. Biggest weakness is failure of “too big to fail.” Gives government stewardship (through the resolution authority) but can’t do that for a multi-billion dollar company. Can’t wind down one because others will fail. Haircut debt. You’ll trigger a funding crisis among the others.
Go back to 1930’s; there were massive changes. Now we’re writing thousands of pages. How likely is it that they are going to prevent next crisis. Unlikely, if it is 20 years down road. Bear Sterns had equity alignment and economic incentives to take risk.
We share belief that the sun is going to come up tomorrow. Asking people to be wise in advance is difficult. We can’t legislate wisdom.
Increased buffer if we get it wrong. We know bankruptcy doesn’t work because of the interlocking contracts. Didn’t work for Lehman. After Lehman, not only financial companies but industrial companies started failing, cascading through the whole economy.
Greenspan existed in political environment. It is hard for anyone in such an environment to take the punchbowl away. This crisis was more leveraged.
Within two weeks of TARP, we switched from buying the capital to buying the banks. Congress gave authority to do whatever needed… extraordinary authority. Buying assets was most politically feasible but valuations were plunging to nonexistent. Ended buying the banks as it became politically viable.
Takeaway: Dodd-Frank falls short on solving “too big to fail.” Investors and companies will have to take on a higher burden of risk analysis. Financial innovation will keep moving outside the regulated arena, even as that arena expands. Additionally, it is yet to be seen how the election outcome will influence rulemaking and implementation. Rep. Spencer Bachus, the incoming chair of the House Financial Services Committee, in July dubbed Dodd-Frank a “government takeover of the economy.”