Seven years out from the global financial crisis, Europe is in turmoil, while the U.S. appears a bastion of stability -- and one piece of controversial legislation has been key.
- By Jeffrey E. GartenJeffrey E. Garten teaches courses on globalization at the Yale School of Management, where he was formerly dean. He was previously undersecretary of commerce for international trade in U.S. President Bill Clinton's administration and a managing director of the Blackstone Group. His next book, From Silk to Silicon: The Story of Globalization Through Ten Extraordinary Lives will be released March 1, 2016.
With a spate of good economic news in the United States, including ever lower rates of unemployment, a buoyant stock market, and even the prospect of a big trade agreement this year, it is becoming easier to forget the horrendous financial crisis of 2008 and the massive government response. That included the set of financial reforms embodied in the Dodd-Frank Wall Street Reform and Consumer Protection Act, better known as “Dodd-Frank.” Named after the two men who led its passage, Sen. Christopher Dodd (D-Conn.) and Rep. Barney Frank (D-Mass), the legislation embodied the most sweeping set of financial regulations since the 1930s. This month — July 21 specifically — is the five-year anniversary of its enactment. It was a critically important achievement, but it could easily come unwound.
Before evaluating its extraordinary significance, its serious shortcomings, and the awesome challenges still ahead, it’s worth taking a second to consider why, in the midst of so many other urgent events occurring right now — the collapse of Greece, the last inning of the negotiations on nuclear weapons with Iran, and truly tragic humanitarian problems — it is worth focusing on financial regulations. America’s banking and capital markets are not only crucial to America’s own economic welfare but they are at the center of international economic activity. They provide extensive two-way linkages between the United States and virtually every other country. They complement military power as a source of influence, and beyond that they reflect America’s capitalist culture all over the world. But when all is said and done, they exist within a set of constantly evolving regulations, and global stability can quickly collapse if that framework for government oversight isn’t strong. Dodd-Frank is at the heart of that framework today.
Let’s begin with why the legislation is an impressive accomplishment.
It reversed the tide toward rampant deregulation that had gathered force since the 1980s. In an interview I conducted at the Council on Foreign Relations in late June with Federal Reserve Governor Daniel Tarullo, who has been at the center of financial regulation since 2009, he pointed out that for many reasons — some deliberate, some out of neglect — the growing size and complexity of U.S. financial markets since the 1980s was not matched by the strengthening of regulatory foundations. Dodd-Frank changed that. It required larger capital cushions for financial institutions, more conservative debt-to-equity ratios, larger liquidity positions, well-capitalized clearinghouses and exchanges for heretofore opaque derivatives, and stress-testing banks under extreme crisis scenarios, to cite just a few examples.
Dodd-Frank enlarged the scope of regulation from a focus on individual financial institutions to the stability of the overall, interconnected global financial system. It put a spotlight on the portion of that system that wasn’t regulated like banks are — the so-called shadow banking system of hedge funds, asset managers, mutual funds, securitized lending, and various other lending mechanisms — which is much larger than the universe of deposit-taking banks. Thus the act is causing regulators to develop policies that take into account how the overall system is connected and how a problem in one corner can spread to another. Unbelievable as it seems, before Dodd-Frank no one had the mandate or the tools to do that. This is now one of the responsibilities of the Financial Stability Oversight Council, a new regulatory oversight body composed of all regulators and empowered to oversee all financial dealings, no matter what kind of institution they come from. Dodd-Frank also created the Office of Financial Research at the Treasury Department to bring together for the first time extensive information and expertise from both inside the government and outside it in order to map the entire global financial network, trace capital flows, and identify vulnerabilities.
The act focused squarely on big financial institutions that have been considered “too big to fail.” Led by the Federal Deposit Insurance Corp. (FDIC) and the Federal Reserve, the government is developing the tools and policies to gradually wind down even the largest and most complex banks without requiring a taxpayer-funded bailout. Washington is determined to avoid what happened with the chaotic demise of Lehman Brothers, where the only choice was between a bailout and a messy bankruptcy, with the latter having taken place and resulted in a near collapse of global markets. As a result of Dodd-Frank, big financial institutions must submit to the regulators wind-up plans that simplify their respective institution’s operational and legal structures so that in an orderly closing-down, the knock-on effects for the rest of the financial system are manageable.
Furthermore, Dodd-Frank created new protections for consumers being sold defective financial products, as happened so rampantly in the lead-up to the crisis when, for example, subprime mortgages were sold to home buyers who couldn’t remotely afford them. Before the legislation, consumer safeguards were scattered among many agencies, if they existed at all. Soundly working financial markets require trust among participants, and preventing the kind of appalling rip-offs that happened before the crisis is surely one important imperative in creating such confidence. When I talked last week to Frank and Dodd, both retired from Congress, each cited the establishment of the Consumer Financial Protection Bureau as one of the legislation’s most important provisions (and one of the toughest to have gotten passed).
Another vital accomplishment: The legislation provided the impetus for a more robust international framework for the global marketplace. Indeed, many of the act’s provisions have been emulated in the United Kingdom and in EU financial legislation, and the thrust of Dodd-Frank has influenced thinking in Japan, Australia, Singapore, and Hong Kong. In my discussion with him last week, Dodd expressed a view — which I agree with — that because the law was passed so soon after the crisis, it allowed the United States to lead the Group of Twenty major countries (the G-20) in its effort to build a stronger global regulatory architecture. To that end, one achievement is the strengthening of the Financial Stability Board, comprising finance ministers, central bank governors, and top regulators, to coordinate development of regulatory standards over the last five years. Another is closer cooperation with other countries to deal with the next crisis. In October 2014, to take one instance, a crisis-scenario planning exercise, mimicking military war games, took place between the United States and the U.K. and involved Treasury Secretary Jacob Lew, Fed Chair Janet Yellen, Chancellor of the Exchequer George Osborne, Bank of England Governor Mark Carney, and several others, such as FDIC Chairman Martin Gruenberg. Such elaborate and intense joint operational planning never took place before Dodd-Frank. “I think it is fair to say that all the major jurisdictions of the world are focused on this issue,” Gruenberg said in a speech to the Peterson Institute for International Economics this past May.
It’s not all roses, of course. It’s no secret that in highly polarized Washington, the Dodd-Frank legislation is criticized on all sides. Sen. Elizabeth Warren (D-Mass.), for example, told an audience at Bard College in April that the Justice Department and the Securities and Exchange Commission are being too lenient in holding bankers accountable for transgressions, that the too-big-to-fail provisions should encompass not only new processes but a forced breakup of banks into smaller entities, and that bankers’ pay needs should be more rigorously tied to long-term results. On the right, the House Committee on Financial Services and the Senate Banking Committee have attempted to chip away at a number of the law’s provisions, including constraints on trading derivatives. On the House Committee on Financial Services’ website, the first paragraph on its page about its Dodd-Frank oversight work gives a sense of its views: “The Dodd-Frank Act … directs federal regulators to burden job creators and the economy with more than 400 new rules and mandates.”
To be sure, the legislation has its flaws. Writing an 848-page bill in the immediate aftermath of a crisis leads to laws that can be too lengthy and complex and prescriptions that in hindsight reveal themselves to have been ill-advised. And enacting such comprehensive laws so quickly and with so many action-forcing deadlines can cause serious strains in the important relationships between regulators and their Wall Street counterparts that are required for sustained effectiveness.
In my course at Yale University called “Wall Street and Washington,” for example, guest speaker H. Rodgin Cohen, the preeminent Wall Street lawyer who represents both banks and government agencies, and who has the confidence of both, told my students that he had never seen such confrontational relationships between banks and regulators during his professional career spanning some four decades. The sheer enormity of the Dodd-Frank requirements was putting intense and often counterproductive pressure on everyone, Cohen explained.
There are also several big, outstanding challenges for financial reform. For example, Dodd-Frank needs to be amended to give smaller banks relief from some of the laws that are designed for institutions that are bigger and more globally connected institutions. To date, moreover, regulatory reform has not addressed the critical need to overhaul the entire government-subsidized system for housing finance, including Fannie Mae and Freddie Mac, which puts far too much reliance on the public purse. Not moving on that issue is a massive omission in addressing the U.S. financial system.
It is also imperative for Washington to review the overall effect of all the mandates that Dodd-Frank has imposed on banking institutions — including capital requirements and prohibitions against banks’ trading for their own account — to make sure that in a global crisis, the markets are not so hamstrung by the sum of regulatory constraints that essential liquidity evaporates, causing a crisis to get infinitely worse. Legitimate concerns about that possibility were expressed by JPMorgan chairman and CEO Jamie Dimon in his annual letter to shareholders this past April, and by the chairman and CEO of the Blackstone Group, Stephen Schwarzman, in a widely discussed Wall Street Journal op-ed in June.
I know of no financial expert or official who believes there won’t be big, tumultuous crises coming our way in the future. But what regulators can at least try to do is reduce how often these tragedies occur, improve the government’s capability to manage them when they do, and lower the costs of a big crisis to society when they happen. Dodd-Frank provides the basis for doing just that.
But that assumes the momentum for reform can be sustained. I wouldn’t bet on it. The further away we get from the financial crisis, the easier it is for opponents to weaken Dodd-Frank’s foundations. As Dodd told me, financial reform has almost no powerful constituents, while its opponents are supported by many financial institutions as well as associations with deep pockets and extensive lobbying clout. To take one example, as time goes on it becomes easier for Congress to strangle budgets and effectively neuter the Securities and Exchange Commission and the Commodity Futures Trading Commission, both essential to policing complex capital markets. An equally real threat, articulated to me by Frank, is if a new administration elected in 2016 fails to appoint highly qualified and dedicated regulators not just to enforce the laws but to adapt them to rapidly changing financial markets. One thing is for sure: The next generation of regulators will not have had the searing experience of peering into the abyss of a near meltdown of global markets, as so many of the current group do, and they are thus unlikely to have had as acute an understanding of how quickly and devastatingly a crisis can emerge.
Another concern, voiced to me by Dodd, is whether American financial leadership can be sustained for building a strong international financial framework for harmonization of regulations toward high rather than lowest-common-denominator standards. There are reasons for skepticism when it comes to such leadership in general, considering Congress’s failure to give China a greater voice in the IMF and the international isolation of Barack Obama’s administration when it came to trying to thwart the establishment of Beijing’s initiative for an Asian Infrastructure Investment Bank. Without strong U.S. prodding, the pace of global regulation could wane, creating dangerous gaps in the emerging edifice for international financial stability.
So light a candle to celebrate Dodd-Frank’s anniversary and congratulate the U.S. government for what it has achieved, but worry about Dodd-Frank’s future too. When you think of the damage caused by the 2008-2009 crisis — the expensive bailouts, the tragically long recession that caused the United States and others to forfeit trillions of dollars of growth and resulted in soaring unemployment and widespread foreclosures that devastated millions of lives — making solid financial reform stick is surely one of the most important challenges of our time.
Jeffrey E. Garten teaches at the Yale School of Management, where he was formerly the dean. Previously he was undersecretary of commerce for international trade in U.S. President Bill Clinton’s administration and a managing director of the Blackstone Group. His book From Silk to Silicon: The Story of Globalization Through Ten Extraordinary Lives will be published in March 2016.
Garten is chairman of Garten Rothkopf, a Washington, D.C.-based international consultancy. David Rothkopf, editor and CEO of Foreign Policy, is also a partner in that firm.
Photo credit: SAUL LOEB/AFP/Getty Images