THERE were amendments to this, amendments to that, even amendments to amendments. Negotiators and aides seemed to be drowning in paper. But a marathon session of bleary-eyed horse-trading between Democrats and Republicans yielded, at 5.39am on June 25th, an agreed text of what supporters portray as America’s most important package of financial law since the Depression—and opponents decry as a 2,319-page cop-out.
Before becoming law as the Wall Street Reform and Consumer Protection Act (known as Dodd-Frank after its architects, Chris Dodd and Barney Frank—pictured above, showing the strain), the bill must be approved by both houses of Congress. On June 30th the House of Representatives obliged by passing it by 237 votes to 192. The Senate is proving less easy. Democratic leaders were scrambling to secure the 60 votes needed to avoid a filibuster after Robert Byrd, the longest-serving of the 57 Democrats, died (see article), and a Republican whose support was crucial, Scott Brown, refused to vote for a bill that raised taxes. He objected to a $19 billion levy on large banks, insurers and hedge funds to cover the costs of implementing the law—setting up new regulators, paying for studies and so forth—which had been slipped in at the last minute.
Messrs Dodd and Frank took the unusual step of reopening the conference that had thrashed out the bill, and stripped out the bank levy. They proposed instead that only $6 billion come from banks (from higher deposit-insurance fees) and the rest from winding down the Troubled Asset Relief Programme (TARP) early. Mr Brown said he would mull it over. The Senate’s vote has now been postponed until after the week-long July 4th recess.
If there are no more hiccups, Dodd-Frank will give Barack Obama his second domestic triumph of the year, after health care. The president has wasted no time in touting it: indeed, he had pushed for a deal before the meeting of the Group of Twenty (G20) countries in Toronto on June 26th and 27th so that officials could parade it there as a model for others to follow. Some European countries are keen on tighter financial regulation, and various proposals from the European Commission are in the works. On June 30th the European Union’s member states and parliament proposed limits to the share of bonuses paid at once and in cash. But the pace in Europe is likely to be slower, and deep international disagreements remain.
It takes thick rose-tinted glasses to accept Mr Obama’s assertion that the new law will ensure an end to bank bail-outs. Moreover, there are some glaring omissions. The bill’s authors ducked big decisions on the future status of Fannie Mae and Freddie Mac, to the chagrin of Republicans, who rightly view the mortgage agencies as having been instrumental in causing the financial crisis. Nor is there a meaningful tidying-up of the tangle of federal regulatory agencies. On both counts, an excuse for doing nothing was the concern that political opposition would have jeopardised the whole bill.
Still, the document covers a lot of ground in its effort to replace the PVC in the financial plumbing with copper pipe, as one official put it. It creates a new consumer financial-protection bureau. It empowers regulators to dismantle any failing financial firm, not just banks, and pushes more of the clean-up costs onto surviving competitors, rather than the taxpayer. Those who securitise loans will have to retain more of the risk. The so-called Volcker rule will limit banks’ proprietary trading and investment in hedge funds and private equity. Derivatives markets will no longer be left to their own devices.
The pendulum swings
The package is part of a global—though uneven—shift towards more government intrusion in finance after the meltdown of 2008. Starting in the late 1970s, America began a process of deregulation that accelerated in the 1980s and 1990s, culminating in a law that left fast-growing swaps markets largely unregulated and the repeal of Glass-Steagall, the 1933 act that had segregated commercial banking and investment banking (see table). The re-regulation of corporate America began with the Sarbanes-Oxley act of 2002, which was designed to tighten companies’ governance after the dotcom bust and Enron’s bankruptcy. But in finance the deregulatory mood carried on until the bust.
Dodd-Frank is riddled with messy compromises. The Volcker rule was watered down to let banks invest up to 3% of tier-one capital in hedge and private-equity funds—implying $3 billion-4 billion for the largest banks. JPMorgan Chase can keep its giant Highbridge hedge fund, because it invests only clients’ money. Morgan Stanley must offload its proprietary-trading operation, PDT, which accounts for less than 2% of group revenue. Goldman Sachs will be hardest hit: it derives at least 10% of its revenue from proprietary trading. The prop-trading ban is subject to approval by a new Treasury-led council of regulators, which will study its impact. And firms will get at least seven years to divest assets.
The deal on banks’ swaps desks was grubbier still: a nonsensical compromise to allow Senator Blanche Lincoln, author of a proposal to force banks to spin these off, to save face. Interest-rate, foreign exchange and high-quality credit swaps can be retained; supposedly riskier commodity, equity and non-investment-grade credit contracts must go into separate affiliates with higher capital costs.
Interest-rate swaps may be more germane to banking than commodity swaps, but the idea that they are inherently safer is laughable: poorly chosen rate contracts have caused countless losses for banks, companies and municipalities over the years. But because rate and foreign-exchange swaps make up the bulk of the market, American banks will have to move only 10% or less of their $218 trillion (notional) combined derivatives holdings. Talk of an exodus of derivatives operations to London has receded.
Though Volcker and the Lincoln amendment have attracted most of the recent headlines, the meat of the bill lies elsewhere: in the consumer bureau, which will have broad powers to write rules and ban financial products; in the resolution mechanism that extends regulators’ powers to force losses on creditors as well as shareholders and requires healthy financial firms to cover the cost of winding up collapsed rivals; in the requirement that “standardised” derivatives be routed through clearing houses and traded on exchanges, with higher capital charges for customised contracts; and in the requirement that hedge funds and private-equity firms overseeing $150m or more in capital to register with the Securities and Exchange Commission (SEC) and give information about their trades and portfolios.
These have won praise and condemnation in roughly equal measure. Some consider the resolution authority a big improvement on the current non-regime for dealing with non-bank financial firms. Others fear it does as much to enshrine bail-outs as to prevent them. Bank regulators have long neglected consumer protection. But some worry that the new agency may be a bureaucratic monster—and that in the interests of “improved access” and “fairness” it may promote rather than curb reckless lending. Putting routine derivatives on exchanges makes sense, but too many restrictions might sacrifice liquidity.
Shed no tears for bankers
Unhappy though they are with much of the bill, bankers know it could have been a lot worse. There is no return of Glass-Steagall; no forced break-ups. The biggest banks are still huge (see chart 1) and will remain so even if Congress passes Mr Obama’s proposed $90 billion tax, over ten years, on their liabilities, which is designed to discourage bigness as well as to recoup the costs of the TARP.
Dodd-Frank will, though, take a bite out of banks’ profits through fee reductions, higher compliance costs, the tying-up of more capital in trading, and so forth. Analysts expect the impact to be anywhere from 5% to 20% of the largest banks’ total profits by 2013. The hit to regional banks will be at the low end of that range, though that could still be enough to drive some of them into each other’s arms, further reducing the number of lenders (see chart 2).
Some of the biggest hits could come in derivatives, an area dominated by a cosy club of big global banks. Kinner Lakhani of Citigroup thinks their average return on equity (ROE) in this business, which brings in $100 billion of revenue a year, could fall from 25% to 15%. This leaves some wondering if the top 50 American banks can sustain anything like the 16% average ROE they enjoyed in 1997-2006.
There will, though, be offsetting factors. Banks will seek to pass costs on to customers in higher fees and spreads on loans. This is already happening: they have not passed on the full benefit of the low mortgage rates engineered by the Fed’s purchases of mortgage-backed securities, points out Richard Ramsden of Goldman Sachs. In derivatives, increased standardisation should lead to higher volumes, offsetting the reduction in dealers’ profit margins. Moreover, they will enjoy some capital relief as more contracts are cleared centrally, freeing some of the buffer needed to back over-the-counter trades. Bank of America alone could benefit to the tune of nearly $5 billion, according to Betsy Graseck of Morgan Stanley.
The precise impact is hard to gauge, not least because the new law hands a lot of discretion to regulators. Much of the text is little more than a template, which regulators are expected to flesh out. It may take them more than two years. They have been told to conduct 150 studies and write 350 detailed rules that could run to 15,000-20,000 pages, reckons Barclays Capital.
Banks will hope that, as in the past, regulators are more sympathetic than lawmakers to their claim that tough rules will harm their competitiveness and stunt economic growth. “Frankly, it’s an enormous relief to be dealing with [regulators] again rather than Congress,” says a Wall Street executive.
Take the provision that would regulate for the first time the “interchange” fees that banks charge merchants on debit-card transactions. A 50% cut in those fees would reduce big card issuers’ pre-tax income by 2-3.4%, estimates Moody’s, a ratings agency. But the actual effect will depend on what the Fed, which will do the regulating, deems “reasonable and proportional”, as the bill puts it. Watchdogs will also have the task of defining proprietary trading (as opposed to hedging or marketmaking)—which many view as impossible. In another section of the Volcker rule, lawmakers kindly left it to regulators to work out the meaning of “high-risk assets”. Another mind-bender will be to sort standardised and customised derivatives.
Of particular concern to capital-markets firms is a provision—inserted late, after the SEC had filed fraud charges against Goldman over its marketing of a collateralised-debt obligation—which bans banks that package together asset-backed securities from any related transaction that causes a “material conflict of interest”. The precise definition of this will be crucial in setting the bounds of marketmakers’ activities, says Anna Pinedo of Morrison & Foerster, a law firm.
On top of all this, Dodd-Frank gives regulators another new job, of identifying and responding to emerging threats to financial stability, particularly asset bubbles. It establishes a systemic-risk oversight council, comprising the Treasury, federal regulatory agencies and an independent member.
A multilateral mess
The bill’s authors have not only outsourced much of the definition of the new order to domestic regulators; much of the most important business, notably on bank capital, has been cast even farther afield, to international rulemakers. If reform in America is hard, managing the process across dozens of countries is akin to herding cats. At a recent meeting in Vienna of the Institute of International Finance (IIF), an industry lobbying group, a fair cross-section of the world’s top bankers agreed behind the scenes that the task of building global rules is getting harder the closer it gets to decision time. The G20’s latest meeting did yield the usual communiqués about global co-ordination, but there was open disagreement too. The idea of a global bank levy, which America and some European countries are keen on, has been dropped. Hardly surprisingly, countries that did not have a crisis, including Australia, Canada and most of the emerging world, view the idea as somewhere between unnecessary and nuts.
Disagreement is growing, too, over new global rules on capital and liquidity, which most countries are relying on to make finance safer. For a start, the widening split between accounting standard-setters is a huge difficulty. American rule-makers have signalled they would like to extend “mark-to-market” accounting to loan books as well as securities, whereas the standard-setting body that decides the rules in most other countries is moving in the other direction.
Since accounting largely defines what capital is, it is ludicrous to attempt a common capital standard without fairly homogenous book-keeping standards. Bill Rhodes, a vice-chairman of the IIF and a former vice-chairman of Citigroup, says agreement here is so important that politicians should bang standard-setters’ heads together to get progress, even if that undermines their independence. “This is a G20 issue. The G20 has to say, ‘Look, you’ve got to come to some kind of convergence.’”
This lack of progress compounds the fault-lines over the proposed “Basel 3” rules on capital and liquidity. For all the rhetoric of togetherness, most countries are lobbying for carve-outs. America talks tough but is keen to allow banks to include future mortgage-related fees as capital, for example. Almost every big European country also has some kind of quirk for which it wants special dispensation.
In isolation, many of these are reasonable. In combination, they represent death by a thousand cuts. Most countries outside America, which rely much more on banking than on capital markets to fund their economies, are also jittery about the impact of tighter rules on economic growth. Bankers have fuelled such fears: a study by the IIF concluded that the Basel 3 standards as proposed could knock 3% off cumulative GDP in America, the euro zone and Japan by 2015 (it did not attempt to capture the benefits that a more stable regime might bring by making crises rarer).
Global regulators say that they retain political support for tough action and that the rules will be phased in by the end of 2012, to minimise economic disruption. The potential seriousness of that disruption is hotly debated. In contrast to the IIF, Swiss regulators argue that the dramatic rise in capital levels at their two big banks has had little impact on the economy.
The Basel club of regulators is undertaking its own study, which is likely to conclude that its proposals are far less costly than the IIF’s estimate—perhaps 0.5% of cumulative GDP (again excluding the benefits of having fewer crises). About the only bits the club is prepared to concede are too fierce are the rules that would force banks to raise more long-term funding quickly, which look unrealistic given the degree of disruption in debt markets.
Are national regulators right to put so much faith in global bodies? International regulators remain defiant. The odds are that they will muddle through, hammering out a compromise on accounting and forcing through capital and liquidity rules that represent a modest strengthening of the already much improved buffers that banks have. But the worry is that the political capital expended on this quite basic task means other priorities get sidelined.
That is particularly so with resolution regimes for failing banks. Here most countries are doing their best to provide regulators with the legal tools to put losses onto creditors. But legal tools alone may be insufficient given the financial realities of bank balance-sheets, where the fear of potential loss causes the vast bulk of counterparties and creditors to consider running.
What is needed is a clearer line between creditors who would bear loss when a bank fails and those who would be protected. This, in turn, might require a rejigging of creditors, or the creation of a new type of debt that would convert into equity in certain circumstances. Although Basel continues to consider such measures, much of its energy has been sapped by the supposedly straightforward question of building up banks’ safety buffers. Whether the international process can deliver anything more than a lowest common denominator remains to be seen.
Back in February 2009, the U.S. Congress passed an $862 billion "economic stimulus" bill to help the struggling American economy recover from the horrible financial crisis of 2007 and 2008. Right now, federal agencies are spending this stimulus money at the rate of approximately 196 million dollars an hour, and they will continue to spend it in staggering amounts up until the September 30, 2010 deadline. Unfortunately, instead of being spent on useful projects that would revitalize U.S. industry and put American workers back to work, much of this money is being flushed directly down the toilet on some of the most wasteful projects imaginable. The truth is that nobody is better at wasting money than the U.S. government. In fact, some of the things that the U.S. government has been spending money on are absolutely mind blowing. 
