There are a few things that everyone can agree on about the Wall Street Reform and Consumer Protection Act, also known as the Dodd-Frank Act (after its senior advocates in Congress, democrats Christopher Dodd and Barney Frank). It deeply alters the landscape of the US financial system. It reins in the freewheeling behaviour of banks and other financial institutions that characterized the 1990s and 2000s. And if you drop a printed version of the law on your foot, it would really, really hurt. In hard-copy form Dodd-Frank consumes 2,300 pages, making it equal in weight (if not literary quality) to six boxed sets of the entire Harry Potter series.
Inhabiting that mass of paper is a typically messy work of democratic push and pull—an uneasy mix of consumer activism, taxpayer fury, moneyed lobbying and back-room compromise. Does it make the system safer? Without a doubt: the law outlaws many of the practices that inflated the US real estate bubble. Did advocates of regulation get everything they wanted? No, there are plenty of loopholes. Will it prevent all future financial crises? Of course not. Bubbles are created by human greed and folly, and not even 2,300 pages can repeal that.
As for its day-to-day effect on US financial practice, the law is a work in progress. Any complex legislation inevitably triggers unintended consequences as the affected parties manoeuvre to enforce or evade its provisions, and this legislation is hugely complex. More to the point, the law leaves a lot of its businesses undone. Think of it less as a new code of rules than as a set of directives to guide the creation of new rules. One telling measure of how much work remains: the law demands 243 separate acts of rule-making by 11 different government bodies, some of which don’t yet exist. It orders those agencies to conduct 67 different studies before making any rules and asks for 22 new periodic reports to track the legislation’s effect.
What the law lacks in detail, however, it makes up for in ambition. For better or worse, it pushes the government’s nose into most, if not all, of the US financial system’s nooks and crannies. Among other things, the law aims to do the following:
Defang derivatives: Much of the trading in the obscure contracts that Warren Buffett famously called “weapons of mass wealth destruction” occurred over the counter with a little oversight. Dodd-Frank drags many of those transactions into the sunlight of established exchanges and clearing houses. Also, big banking firms will have to spin off operations that trade the riskiest derivatives so that a blow-up in such contracts won’t bring down the whole company.
Make banks safer: A rule that originated with former chairman of the Federal Reserve, Paul Volcker, would prohibit proprietary trading by banks for their own accounts and reduce their ownership of private equity and hedge funds. Banks will also have to put aside more capital to protect themselves against hard times, although they’ll have years to comply.
Prevent on-the-fly taxpayer bailouts: Aiming to head off last- minute regulatory scrambles, like those that bailed out American International Group Inc. and allowed Lehman Brothers Holdings Inc. to go bankrupt, the bill orders up a new “orderly liquidation” process for financial firms in danger of collapse. The Federal Deposit Insurance Corp. would be able to seize and liquidate a variety of institutions whose failure poses a risk to the system—previously they’ve had the authority to do this only with banks—and the US treasury could retroactively charge big banks for the taxpayers’ trouble.
See tsunamis coming: The law assembles a new 10-member panel of senior regulators from a variety of agencies and charges them with watching out for systemic risks that extend beyond any single regulator’s jurisdiction.
Discipline the “masters of the universe”. For the first time, private equity and hedge funds will have to register with regulators and open their books to examiners.
Apply federal scrutiny to insurance companies: Insurance companies have traditionally been regulated by states, which has led to cozy relationships for some insurers and uneven regulation for all. The law creates a new federal panel to monitor state insurance departments, although it has no regulatory authority of its own.
Hold credit rating agencies accountable: Inflated grades awarded by debt rating agencies, such as Moody’s and Standard and Poor’s, gave investors a false sense of confidence in the toxic securities that triggered the crash. To prevent a repeat, Dodd-Frank requires a study of conflicts of interest between the agencies and debt issuers. The study could result in the creation of a new quasi-government entity to deal with such conflicts. In addition, investors can now sue to recover losses if rating agencies act recklessly in awarding credit grades.
Set mortgage standards: Mortgage lenders now have to verify that a home buyer can actually afford a loan before granting it. In addition, banks that package loans into securities would have to retain 5% of the value of each loan on their own books as a way to guarantee that the lender has a stake in the loan’s performance.
Protect consumers from predatory lenders: The change that is likely to have the most visible effect on the lives of ordinary Americans is the creation of a new Consumer Financial Protection Bureau (CFPB). CFPB is designed to introduce the same kind of safety oversight brought to bear on, say, cars or toys to a broad range of banking products—ranging from consumer loans, to credit cards to mortgages. (Auto loans, however, are exempt from the bureau’s oversight, for no reason other than the lobbying power of car lenders.)
Some consumer advocates, such as veteran financial writer Jane Bryant Quinn, were disappointed that Dodd-Frank did not force all advisers to put consumers’ interests before their own in recommending investments. (At the moment, only certain advisers are held to that standard, while stock brokers and insurance agents can sell any junk as long as they can claim that it’s “suitable”.) But by and large, consumers are the big winners in this legislation: CFPB has enormous power to outlaw shady practices, enforce disclosure and encourage financial firms to sell only model products.
For financial institutions, the law is more of a mixed bag: collectively, they have had their hands slapped, yet most can claim some victories. Meanwhile, the credit rating agencies face new liabilities. For example, they were able to postpone (and maybe kill) the creation of a new agency to monitor their conflicts of interests. Big banks will have to spin off some of their derivative trading operations, but they managed to hold on to the highest volume contracts, such as currency and interest rate swaps. Most important for the big banks, the law does nothing to end the “too big to fail” status enjoyed by some banks. Since it’s clear that the government would have to step in if a bank as large and complex as Citigroup or Goldman Sachs got into financial trouble, such banks are able to get funding in the public market at lower rates than smaller banks. After all, investors know that if they fail, the US treasury will bail them out. That’s a major competitive advantage for big banks.
But there’s more to “too big to fail”. It also creates what economists call a moral hazard: since bank executives know that they’ll be bailed out if they get into trouble, they are more likely to take bigger risks in pursuit of the kind of profits that win them million-dollar bonuses. The philosophy is: “Heads I win. Tails, the taxpayer loses.” If one of the results of Dodd-Frank is that it preserves the psychology that played a role in bringing the global economy to its knees, that is an unintended consequence indeed.
Eric Schurenberg is editor-in-chief, CBS Interactive Business Network, and former editor of Money.
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