In passing the Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress has taken the first step in reforming the financial system.
However, it is unfortunate that many of the basic issues that led to the 2008 credit crisis were not directly addressed — especially the level of capital and limitation on leverage for the largest and riskiest firms. The legislation also is so vague as to leave most decision-making to the regulators, creating uncertainty in the financial markets for months to come.
One of the most important results of the Dodd-Frank act is the explicit acknowledgement that there are two groups of financial institutions in the U.S. — Wall Street and Main Street — and that a closer watch needs to be paid to Wall Street.
Many of the law’s provisions will apply only to the largest banks and nonbank financial companies, which dominated the financial system and in some cases had to be bailed out by taxpayers. For example, large institutions will now be under the watchful eye of the Financial Stability Oversight Council, which is being created to oversee such firms.
Alongside the large institutions, however, is another group of financial companies that are not “too big to fail” and do not pose a systemic risk. As financial reform moved forward, these firms pushed for stronger, more effective regulation of the largest firms and a system that does not give those firms a competitive advantage.
One area in which it remains to be seen whether the distinction will hold is proprietary trading, a very difficult area to define, so it is not surprising that the Congress chose to let the regulatory agencies have the final say. The bill would allow the regulatory agencies to ban most proprietary trading by banks or any firm affiliated with a bank, regardless of the size of the firm or whether the firm posed any risk to the financial system. This includes many of the Main Street broker-dealers affiliated with commercial banks.
But proprietary trading may not be as easy to recognize as some might think, and in an effort to clamp down on the largest and riskiest firms, regulators will need to ensure that the definition is broad. Unless regulators acknowledge there are differences between the firms that can cause systemic damage — those that have the resources to find ways around the rules — and the Main Street firms, the result could well be that the Main Streeters are disadvantaged.
One clear victory for the Main Street firms in the new law was the elimination of the Orderly Liquidation Fund. There was an obvious attraction to having such a fund because one could say that Wall Street was going to pay for its own messes in the future.
But the practical effect of having such a fund would be no different than having a government guarantee, similar to the implicit guarantee provided for years by the U.S. government to Fannie Mae and Freddie Mac. Anyone doing business with the largest institutions would know that behind them were not only the assets of the firms themselves, but also a large pot of money to pay creditors. Perversely, having such a pot of money would have benefited the largest firms because people would have been more willing to do business with them and give them favorable terms, to the detriment of Main Street firms.
The system that was finally adopted, while not perfect, is far preferable to the current one. It more closely resembles a bankruptcy system where shareholders, executives and creditors are at risk for their bad judgments.
But few of the provisions in the new law are as clear-cut as having or not having an Orderly Liquidation Fund. By necessity, much of the ultimate effect of the law will depend on what the regulators will do, and nothing will be more fundamental than capital and leverage requirements. Firms should be required to have more capital and lower leverage as they get larger and more capable of inflicting damage system-wide. Firms should also be required to have more capital if they engage in riskier lines of business.
It is true that the new rules will make those firms less profitable than they otherwise would be, but we have seen the result of profits garnered through excessive risk — taxpayer bailouts, millions of people unemployed, and millions of foreclosed homes.
We recognize that in this global economy, the United States cannot act alone and capital requirements will need to be negotiated with other countries. The Regional Bond Dealers Association pressed for explicit, minimum capital and leverage requirements in the bill. We believed that a strong statement in law by the U.S. government would improve the likelihood of getting a strong international agreement. Congress chose not to include such requirements. Now it’s up to our regulators and negotiators to make it happen.
Michael Nicholas is chief executive officer of the Regional Bond Dealers Association, which exclusively represents securities dealers primarily focused on the U.S. fixed-income markets.