Interview: “Dodd–Frank is not designed to prevent failure in all occasions”

On January 5, 2010, the United States Congress passed a landmark legislation that ended the era of government bailouts. The Dodd–Frank Wall Street Reform and Consumer Protection Act aims “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American taxpayer by ending bailouts, and to protect consumers from abusive financial services practices.”

The Dodd–Frank bill addressed two things: bank capitalisation and regulation especially of derivatives. Institutions were required to be much better capitalised. Capital requirements and strict regulation were imposed on the larger banks. Banks under $10 billion in assets were regulated much less.

Where derivatives are concerned, a provision known as the Volcker rule prohibited banking entities from (i) engaging in short-term proprietary trading of securities, derivatives, commodity futures, and options on these instruments for their own account; and (ii) owning, sponsoring, or having certain relationships with hedge funds or private equity funds, referred to as “covered funds.” Only certain activities were exempted, including market making, underwriting, hedging, trading in certain government obligations, and organising and offering a hedge fund or private equity fund. These exemptions, however, would be limited if they involve a material conflict of interest; a material exposure to high-risk assets or trading strategies; or a threat to the safety and soundness of the banking entity, or to US financial stability.

Loss of trust
“We no longer trust banks to make their own choices about how to control their indebtedness,” declared Barney Frank, one of the law’s two principal authors. “What happened in the financial crisis of 2008 was financial institutions and banks got indebted far beyond what they could keep track of, beyond what they could pay off.”

Government’s retribution was swift, with the law coming into effect barely a year after Lehman Brothers collapsed, followed by AIG, then the mortgage lenders. The US economy had been on a hot streak of growth for almost a decade leading up to 2008 on the back of an overheated housing market. So lucrative was the market that the mortgage loans were not only dished out almost capriciously to those who may not be able to repay, but resold among financial institutions in an exotic form of derivatives trading.

“Financial derivatives are what went out of control eight years ago,” Frank stated. “There should be margins on individual trades considering many trades go through exchanges.”

To exacerbate the problem, excess liquidity outside the banking system and advances in information technology concocted an even more volatile mix. This was compounded by excessive levels of debt among the lenders themselves.

“Much of what caused the problem couldn’t have happened 20 years earlier because you did not have the information technology then to package all of these loans into various complex derivatives and sell them,” Frank explained. “The biggest lesson we have learned is that financial regulation has to keep up with financial activity.”

Misconceptions
The Dodd–Frank legislation aimed to close the gaps in financial oversight by, among others, creating a financial stability council, finding ways to liquidate systemically important firms, and strengthening the financial system against further shocks.

However, six years after the law was passed, there still exists misconceptions on what the law aims to do. For one, it is not just the level of debt per se that is material, but the saturation of debt relative to the size of the financial institution.

“What we decided to do was acquire safeguards against large financial institutions incurring huge debts,” explains Frank. And here is where the “too big to fail” concept has been misread. “The question is not about breaking up big banks, but breaking them up to a certain level to substantially restrict the extent to which they can be indebted beyond their ability to pay their debts,” he stressed.

Corollarily, not all the big American banks will be cut down to size.

“We don’t break up all banks arbitrarily or impose ‘one size fits all.’ But there are powers in the Act that can be invoked to order particular institutions most likely to get into trouble to reduce in size, either by becoming less complex or just becoming smaller. I believe that over the next 10 years, those powers will be invoked for one or two institutions.”

A second misconception is that the Act is designed to prevent failure in all occasions.

“We did want to make failure much less likely by limiting indebtedness. But no matter how much you try, there may still be failures,” Frank admitted.

“What we said, what we ensured, was that if they are too big, they do fail. The bill says that if a large institution gets so indebted that it cannot pay its debts, it goes out of business. The federal government steps in and takes over and it pays off some of the debts. Nobody is too big to fail.”

Extraterritorial impact
As the financial world gets smaller and more tightly bound at the hip due to digitisation, the ramifications of the Dodd–Frank can be expected to extend beyond US shores. “The world is one system. The basic principle that we try to say is this: we will monitor activity that affects America. As long as the American taxpayers and the American economy are affected by a bank wherever it is operating, we will insist on regulating it to a great extent. For foreign banks in the US, we are going to regulate.”

“The government does not make business decisions; we let the financial industry make the business decisions,” he clarified. “Our ways are not terribly prescriptive except for one area—we tell banks that they cannot extend mortgage loans to people who cannot pay them back. Other than that, we are very much market-oriented in our bill.” Neither does the US consider imposing its regulations in countries with already sufficient regulation. “If the American regulators find that the host country has added regulation, we will allow that to be the governing principle, not ours,” he remarked. Nevertheless, he is heartened by the decision of HSBC to stay headquartered in London rather than in Hong Kong. 

“Institutions go to where there is less regulation, what is called regulatory arbitrage,” he explained. “I thought the decision by HSBC to stay headquartered in London rather that in Hong Kong was important because it was a rejection of the notion that they should make that decision based on where they could be less regulated. So I would hope that would be the rule.” 

To banks in Asia, Frank hopes to impart the lesson of the US experience, which is to allow financial institutions to play their financial intermediary role without endangering the rest of the economy; as well as the issue of indebtedness.

“Our hope is that there will be common applications of these regulatory principles,” he declared, “because we do not want to intrude or dictate on other countries.”

This includes China
“As far as banks in China are concerned, there is not much we can do—nor have an urge to do anything about. I would hope the Chinese model would evolve more in a market-oriented direction. Chinese banks have been lending mainly to promote growth in many ways rather than what we would think would be more prudent. [But] that is up to the Chinese.”

The new banking order
Today, there is much better regulation, which is a very important feat, declares Frank. And though the Act may be substantially dismantled if a Republican wins in November, Frank thinks this is not likely, although the Act could be “put away to a point where it would be much less attractive.”
Frank believes the new banking order will not see the death of the global mega banks. There will continue to be banks with the capacity to work internationally, he said, or provide global banking services as demanded by the enterprises they are servicing. However, regional banks will be on the rise.

“There are smaller companies whose activity do not transcend regions that will be perfectly well served by regional banks. So that very well seems the way to go.”