Dodd-Frank Bill signed ------------------------------------------ The Dodd-Frank bill was signed into law by the President today. Created as a response to the near collapse of the financial system in 2008, this is a landmark regulation. It aims to make the financial system safer, end the ‘too big to fail’ safety net of the large banks, and protect customers from the sort of lending practices that led to the sub-prime boom and bust. Unfortunately, the lobbying power of the big banks combined with a lack of will on Capitol Hill leave the final bill with very little chance of succeeding in its aims. How banking panics happen “Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone” - Walter Bagehot Banks borrow money from depositors and lenders, and then lend it to other companies and individuals. They hope that the people who borrow money from them will invest the money productively and pay it back to the banks on time and with interest. That allows the banks to return this money to their own depositors and lenders, while keeping a nice chunk of the interest for themselves. Of course this doesn’t always happen. Some borrowers will waste the money they borrowed and won’t be able to pay it back. Banks know that this will happen, and they’ve become fairly effective at minimizing the so-called default risk through credit checks, collateral, and a variety of other methods. They also hold equity as a buffer against the risk of default. The bigger problem for a bank happens when its depositors lose faith in the safety of their bank. This usually happens because there is some bad news about the bank which causes people to panic and rush to the bank to withdraw their money. The only way a bank can prove that it is safe and sound is by returning all their depositors’ money immediately, and no bank can do that. When such a panic affects a large number of banks, it can put the whole financial system in danger of collapse. The panic of 2007 The financial crisis began in the shadow banking industry in the summer of 2007. In effect, banks, hedge funds, insurers, and other large financial institutions lost faith in each other, and tried to get back the money they had lent to each other. FDIC insurance protects depositors up to $250,000, so most ordinary people didn’t rush to withdraw their money and there were no long lines outside branches. Companies and large banks transact billions of dollars in the shadow banking market everyday; these ‘repo’ transactions are equivalent to overnight deposits that are not covered by FDIC insurance. Banks lost faith in each other when they realized that the housing bubble was bursting. Lots of people wouldn’t be able to repay the mortgages they had taken out, and banks would be left holding large losses. But with the growth of securitization and derivatives, nobody had any idea where the losses actually sat. All the large banks and institutions claimed to be safe, but it was clear that not all of them could be. In response, market participants simply stopped lending to each other. The entire market shut down for a couple of days after Lehman went bust. Academics will debate the causes of this crisis for a long time, but a few things became clear as the crisis progressed: While some individual banks were safe, many of the largest banks in the country did not have enough equity to cover their losses. In the end, the government had to use tax-payer money to bail them out. Increasing securitization and the use of derivatives fuelled the growth of the shadow banking industry which is now bigger than the regular banking industry. Regulators lacked the expertise and the tools to understand or deal with problems in this industry Banks and other institutions became adept at manipulating the patchwork of financial regulators in the US. Between the Federal Reserve, the OTS, the OCC, the FDIC, state banking departments, the SEC, and the CFTC, nobody was looking at structural problems and acting to control them. What the Dodd-Frank bill does The Dodd-Frank bill has had many innovative clauses during its long journey through Congress. Sadly, the large banks and their lobbyists have succeeded in watering them down to the point where its unclear if they will have much of an impact: The Volcker rule was supposed to limit the ability of banks to engage in risky proprietary trading. A forward looking clause that aimed to prevent the next crisis, it was significantly watered down to the point where it has little impact on any of the large banks today. The Consumer Finance Protection Agency was created with the promise of simplifying how consumers get credit. The lobbyists managed to drive through an exemption for auto loans, and got it housed within the Federal Reserve. The agency still has some teeth and independence, and its ability to act as a voice for consumers depends largely on the effectiveness of its first director. The Resolution mechanism gives regulators the ability to seize and wind-down any large financial institution. Unfortunately, it doesn’t give them any money. If its ever used, the money will come from tax-payers, with nothing more than a vaguely worded promise to recoup the money What the Dodd-Frank bill doesn’t do Beyond making it easier for regulators to take over failing financial institutions, the bill doesn’t really attack any of the root causes of the crisis. More than what it does, the bill is noteworthy for what it doesn’t do: Fannie Mae and Freddie Mac are completely ignored. Still tax-payer owned and funded, they continue to be huge time-bombs on the government’s balance-sheet. The bill does nothing to make banks hold more capital. While the Basel framework is due to introduce new rules later this year, it doesn’t look like they are going to do a much better job Except for the OTS, no other regulatory body is being eliminated. In fact, with all the additional burdens imposed by the Dodd-Frank bill, many of them are looking to increase their size and scope. A simpler system with fewer regulators would have helped avoid the turf wars that happened in 2008. Net Impact All in all, the bill doesn’t really make any major structural changes to the financial industry. In fact, some of the most game changing provisions are likely to be last minute additions such as the Durbin amendment limiting interchange rates, or the ‘expert’ clause that could put the ratings agencies out of business. The last time the US went through a financial crisis in the 1930s, it led to the Great Depression and landmark bills such as the Glass-Steagall act. Those bills protected the American public from financial crisis for over 70 years. The full impact of the Dodd-Frank bill will take months and even years to become clear. But its highly unlikely that Dodd-Frank will be as successful as Glass-Steagall was.