After the Music Stopped (part 3)

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Having discussed the origins of the financial crisis and the government efforts to end it, Blinder turns to the issue of financial reform. The centerpiece of the reform effort was the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, named for the chairs of the Senate and House banking committees. All but three of the Republicans in Congress opposed it, making it “the most partisan vote on major financial-market legislation in memory.” The bill required a lengthy and complicated process of issuing specific regulations, leaving the opposition with many opportunities to delay or obstruct the process of implementation.

Here are some of the issues the legislation addressed:

  • “Too big to fail”: Reformers wanted to stop large financial firms from assuming that Washington would come to their rescue if they made high-risk financial bets and lost. Some advocated just letting them fail, while others said they should be prevented from growing so large that their failure would devastate the economy. Dodd-Frank took a moderate approach, forbidding taxpayer bailouts but giving the Federal Deposit Insurance Corporation new authority to oversee an orderly liquidation of those failing companies designated as “systemically important financial institutions.” They could still be big, and still fail, but hopefully not as messily.
  • Systemic risk regulation: Reformers wanted an “agency charged with the responsibility of scouring the financial landscape for hazards that could, under adverse circumstances, become systematically important–and perhaps taking action when it finds them.” Dodd-Frank created a new Financial Stability Oversight Council for that purpose.
  • Glass-Steagall: Some reformers wanted to reinstate the Glass-Steagall separation of commercial banking from investment banking, in order to protect depositors’ money from being invested in high-risk securities. Glass-Steagall had been repealed by the 1999 Gramm-Leach-Bliley Act. Blinder himself, however, believes that most of the behavior that got banks in trouble would have been permissible under Glass-Steagall anyway, since it involved commercial banks and investment banks doing foolish things separately rather than within the same institution. In any case, Dodd-Frank did not reinstate the Glass-Steagall barriers.
  • Capital and liquidity requirements: Reformers wanted to prevent banks from becoming over-leveraged–putting too much money at risk with too little capital in reserve to cover losses. Dodd-Frank set higher capital and liquidity requirements, especially for “systemically important financial institutions.”
  • Rating agencies: The problem here was the cozy relationship between rating agencies and the companies whose securities they rated. Reformers suggested that companies not be able to choose their rating agency, or that the agency have greater legal liability for mistakes. Dodd-Frank only required that the problem get further study. It did put an end to legal provisions requiring that rating agencies be used.
  • Proprietary trading: Proprietary trading is trading for a bank’s own profit rather than as a service to its customers, although the distinction is sometimes hard to make in practice. It can increase the risk for customers, as well as taxpayers if the accounts are government-insured. Dodd-Frank adopted a version of the “Volcker rule” prohibiting proprietary trading, but with many exceptions. The law prohibited banks from running a hedge fund or a private equity fund.
  • Regulatory reorganization: Reformers complained that the US had no federal insurance regulator or nationwide mortgage regulator. Dodd-Frank required little regulatory reorganization. It did fold the Office of Thrift Supervision, which had been ineffective during the crisis, into the Office of the Comptroller of the Currency.
  • Consumer protection: Dodd-Frank created the new Consumer Financial Protection Bureau. The law did not require some of the things reformers wanted, such as “plain-English” disclosures and “plain-vanilla” financial products (for example, a well-diversified mutual fund of stocks and bonds as the default choice within a retirement plan), but it gave the bureau the authority to order them. The law exempted auto financing from the bureau’s authority.
  • Derivatives: Dodd-Frank increased the authority of the SEC and the Commodity Futures Trading Commission to regulate derivatives. It required that more derivative transactions be conducted through central exchanges and clearinghouses, rather than private transactions. “Standardization and exchange trading breed transparency, competition, and lower trading costs.” The bill did not ban the most speculative use of derivatives, to make bets on the price movements of securities one doesn’t own.
  • Mortgage finance: Dodd-Frank set stricter standards for mortgage loans. It also required securitizers–firms that pooled mortgages for investors–to hold at least 5% of a mortgage pool themselves, so they would have some “skin in the game.” Hopefully they would then concern themselves with the quality of mortgages they securitized. It also called for more study of mortgage-backed securities and who would issue them. Having so many mortgages securitized by government-sponsored but private agencies (Fannie Mae and Freddie Mac) “made it too easy to privatize gains and socialize losses” by creating expectations of government bailouts.

Overall, Blinder characterizes Dodd-Frank as a regulatory success, hardly perfect but pretty good.

So where do we go from here? According to Blinder, the government will need to continue the financial reforms, but phase out the measures designed to respond to the national financial emergency. For the Federal Reserve, that means gradually tightening monetary policy before economic recovery leads to inflation. The Fed’s purchase of securities in its “quantitative easing” program has held interest rates down and given banks a “mountain of excess reserves” to lend out whenever they choose to. Raising the interest rate it pays on these reserves would be one way of discouraging excess lending and too rapid growth of the money supply. For fiscal policy, the challenge is to reduce the federal deficit at a measured pace without derailing the recovery. The Congressional Budget Office projects short-term deficit reductions as crisis spending declines, but serious long-term problems if health-care spending continues to rise. Some of the future deficit reduction “will take the form of higher taxes–sorry, Republicans. Most of it will be lower spending–sorry, Democrats.”

In my first post on Blinder’s book, I said that he didn’t deal as much as I would like with underlying causes of the financial crisis. I think that also affects his expectations regarding the future. He seems to regard the Great Recession as an unfortunate interruption on the path to prosperity, but one that we can put behind us with some temporary economic measures and some reforms of the financial system. He paints a fairly positive picture of the economy in the decades leading up to the crisis, emphasizing the relatively low unemployment rate. He sees no reason why we can’t get back to economic growth and low unemployment within a few years.  If, on the other hand, the previous economic growth was unsustainable because of fundamental imbalances in the global and domestic economy, the path to prosperity may be longer and harder. The US has the dual challenge of improving its global competitive position and allowing a larger portion of its citizens to share in the growth of income. We weren’t achieving either goal very well before the crisis, despite low unemployment, so we may have to do some things very differently if we’re going to achieve more sustainable growth now.

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