Cato Institute – After Dodd-Frank: The Future of Financial Markets
Cato Institute
After Dodd-Frank: The Future of Financial Markets
Wednesday July 16 – Thursday, July 17, 2014
Key Topics & Takeaways
- Market Migration: CFTC Commissioner O’Malia said he was surprised by the “speed and totality” with which markets moved to Europe in response to the CFTC’s trading mandates
- FSOC: SEC’s Gallagher said it is “repugnant” that FSOC decisions are “made in the darkness” and that the structure of the Council presented a “clean slate” for the President’s “hand-picked individuals” to drive policy
- Systemic Risk: Olmem warned that Dodd-Frank has imposed very rigid regulation that could force banks to behave like utilities, with little innovation and identical financial products, which could also leave all banks vulnerable to the same shocks,
- Consumer Finance: Zywicki said the CFPB has demonstrated a lack of regard for “costs to consumers” and “privacy concerns.”
- McHenry Keynote Address: Rep. Patrick McHenry (R-N.C.) criticizes the Dodd-Frank Act for imposing unnecessary rules and higher costs on American consumers and companies. He said he would support a reform or repeal, but that this would require at least “52-53” Republican senators.
- Housing Finance Reform: The panelists doubted the prospects of legislative housing finance reform, with Goodman saying it would not happen until 2017 at the earliest.
Day 1
Speakers:
- Daniel M. Rothschild, Senior Vice President & Chief Operating Officer, Mercatus Center at George Mason University
- John H. Cochrane, AQR Capital Management Distinguished Service Professor of Finance, Booth School of Business, University of Chicago
- Rep. Jeb Hensarling (R-TX), Chairman, House Financial Services Committee
PANEL 1:
- Sharon Brown-Hruska, Vice President, National Economic Research Associates and Visiting Professor of Finance, Tulane University
- John Coates, Professor of Law and Economics, Harvard Law School
- Jerry Ellig, Senior Research Fellow, Mercatus Center
- Hester Peirce, Senior Research Fellow, Mercatus Center
- Moderator: Stephen Miller, Senior Research Fellow, Mercatus Center
PANEL 2:
- Daniel M. Gallagher, Commissioner, U.S. Securities and Exchange Commission
- Jeremiah O. Norton, Member, Board of Directors, Federal Deposit Insurance Corporation
- Scott D. O’Malia, Commissioner, U.S. Commodity Futures Trading Commission
Day 2
Speakers
- John Allison, President and CEO, Cato Institute
- Richard Kovacevich, Chairman Emeritus, Wells Fargo & Company
- Rep. Patrick McHenry (R-N.C.), Member, House Financial Services Committee
PANEL 1
- Stuart Plesser, Senior Director, Standard & Poor’s
- Martin Hutchinson, Author, Alchemists of Loss
- Andrew Olmem, Partner, Venable LLP and former Chief Counsel (Minority) and Deputy Staff Director at the U.S. Senate Committee on Banking, Housing, and Urban Affairs
- Moderator: Louise Bennetts, Associate Director of Financial Regulation Studies, Cato Institute
PANEL 2
- Raj Date, Managing Partner, Fenway Summer LLC
- Kevin Villani, Executive Scholar, University of San Diego and Principal, University Financial Associates
- Todd Zywicki, Professor of Law, George Mason University, and Senior Scholar, Mercatus Center
- Moderator: Mark Calabria, Director of Financial Regulation Studies, Cato Institute
PANEL 3
- Mark Calabria, Director of Financial Regulation Studies, Cato Institute
- Laurie Goodman, Center Director, Housing Policy Finance Center, Urban Institute
- Joshua Rosner, Author, Reckless Endangerment, Graham Fisher & Co.
- Moderator: Hester Peirce, Senior Research Fellow, Mercatus Center
Daniel M. Rothschild, Senior Vice President & Chief Operating Officer, Mercatus Center at George Mason University, noted that as the fourth anniversary of Dodd-Frank approaches, we should “look forward” instead of at past failures. He called for an increase in resiliency and reduction in systemic risk.
Dino Falaschetti, Director of Operations, Mercatus Center at George Mason University, asserted that finance is not a “play thing” for the elite, but the fuel for America. He stated that economies work better when we work to “do good,” and highlighted the importance of freedom of press and free markets. He noted that economies grow because of innovations and called for financial institutions to channel money to bright entrepreneurs not well-connected “cronies.”
Opening Keynote – John H. Cochrane
John H. Cochrane, AQR Capital Management Distinguished Service Professor of Finance, Booth School of Business, University of Chicago, asserted that we need to rethink regulation. He stated that Dodd-Frank and its “mountain of legislation” will not help the causes of the crisis, but noted that radical reform is on the agenda “left, right and center.”
Cochrane noted that the key problem of the crisis of 2008, was the systemic run that set off contagion in the financial markets. He dispelled the notion that mortgage backed securities are bad, asserting that the a 30 to 1 overnight leverage ratio is where the problem lay. He stated that getting rid of short term lending would lead to a system with booms and busts but not crises. He also noted that if banks issue more equity and less debt, the bank will have the same amount of risk but without the “poison” that leads to runs.
Cochrane noted that what has happened to financial regulation in the past is analogous to the song of “the old lady who swallowed a fly.” He asserted the cycle has been same with all regulation: the banks work around the regulation, government issues debts, and ultimately more regulation is added. He warned that we are headed towards “detailed microregulation,” and urged for rule-based or discretionary regulation. He concluded by noting that Dodd-Frank does not need to be repealed but rather it should be reformed.
Q&A
A member of the audience asked if Cochrane would want to allow financial institutions to issue fixed value, run-prone assets.
Cochrane said yes, but that they need to be backed by the Treasury.
A member of the audience asked about Cochrane’s perspective on long term lending.
He noted that long term loans are fine, while short term run-prone debt is the “poison in the water.” He proposed taxing short term loans.
Panel 1: Economic Analysis: Improving Transparency, Accountability and Expertise in the Regulatory Process
The moderator, Stephen Miller, Financial Markets Scholar, Mercatus Center, asked how to distinguish between regulatory analysis vs. cost-benefit analysis.
Jerry Ellig, Senior Research Fellow, Mercatus Center, stated that the caricature of cost-benefit analysis looks at the benefits and costs of regulation, but not at alternate courses of actions. He distinguished that regulatory impact analysis is the type of analysis agency executive branches are supposed to conduct when looking at regulation that is “significant.” Ellig asserted that regulatory impact analysis (or economic analysis) is a better term because the caricature of cost benefit analysis makes it seem less extensive.
Miller asked how economic analysis is used when formulating rules and regulating.
Hester Peirce, Senior Research Fellow, Mercatus Center, stated that the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) have an obligation to conduct economic analysis and look at costs and benefits. She noted that quasi-governmental agencies such as the Financial Industry Regulatory Authority (FINRA) or the Municipal Securities Rulemaking Board (MSRB), have had pressure on them to conduct economic analysis. She expressed her hope that this pressure sets a broader trend of conducting economic analysis.
Miller asked former CFTC Chair, Sharon Brown-Hruska, Vice President, National Economic Research Associates, and Visiting Professor of Finance, Tulane, how economic analysis was used at the CFTC and if it was beneficial.
Brown-Hruska stated that the CFTC has to “consider” economic analysis. She noted that during her time at the CFTC, regulation had to be signed off by the chief economist and that this was an institutional hurdle. She explained that the CFTC has since taken away the requirement for sign off and instead the chief economist has become a consultant to the commission.
Miller asked if economic analysis improves rulemaking.
John Coates, John F. Cogan Jr. Professor of Law and Economics, Harvard University, stated that there are two dimensions of beneficial economic analysis: that it is qualitative and functions as policy. He noted that economic analysis is beneficial to rulemaking when you look at the theoretical impacts regulation will have. He also explained that economic analysis as policy, not as a mandate is beneficial.
He asserted that it is difficult to do a qualitative cost benefit analysis because one cannot draw inferences about future costs or benefits. He recognized that the SEC is conducting some beneficial pilot studies but also gave the example of the impossible task of trying to run an experiment on the Volcker rule.
Miller asked if economic analysis helps in executive branch agencies.
Ellig stated that research shows economic analysis has better impacts on decision making but noted that it is not always used. He noted that the failure to conduct economic analysis can make the decision questionable.
Brown-Hruska stated that she disagrees “fundamentally” with the notion that quantitative analyses of regulations are impossible. She said that one needs to look at the broad picture and take a predictive approach coupled with standard tools of economics. She agreed, however, with Coates statement on Volcker, saying the rule is trying to “cut off an arm because it has a scratch on it.”
Miller asked about reform of economic analysis.
Peirce asserted that if economic analysis is not put into statute, regulators don’t take it seriously and noted that it took the court to push the SEC to implement a process of economic analysis. She stated that before economic analysis was the used by executive branch agencies, they worked half as well. She called for the requirement of economic analysis and a potential review by court. She urged the need for retrospective review which would provide a metric for success.
Coates agreed with the retrospective approach. However, he disagreed with requiring economic analysis and review by the court. He noted that it is problematic to give the power of statuatory obligation to people who are not economists but merely political appointees.
Miller asked if economic analysis increases transparency and accountability.
Peirce stated that economic analysis does increase transparency and accountability. However, she noted it is not the only solution. She compared economic analysis to a flashlight in a dark room-regulators are trying to walk through the dark room and while the flashlight helps, it does not illuminate everything.
Coates noted that economic analysis can achieve transparency and accountability with adequate funding and political appointees that also have knowledge of economics.
Ellig stated that economic analysis makes it easier to understand what a regulation is about and if it adequately addresses the problem. He noted that with these metrics economic analysis provides, transparency and accountability are improved.
Q&A
A member of the audience asked whether or not it would be beneficial to have one prudential regulator and have all the agencies work together.
Peirce noted that the competition between the SEC and CFTC is not helpful. She stated that the Financial Stability Oversight Council (FSOC) is supposed to streamline all agencies but instead it focuses on”too big to fail” and systemically important financial institution (SIFI) designation.
Brown-Hruska noted that there have always been challenges between the SEC and CFTC.
Coates asserted that it would be more complicated because “the larger the jurisdiction, the larger the political clout.”
Ellig expressed he would be suspicious of a monopoly of regulators.
A member of the audience asked if agencies would have to make any adjustments with an economic analysis mandate.
Coates noted that all agencies have always had economists on staff so there would be no massive change.
A member of the audience asked about the problem with regulation in the crisis of 2008.
Brown-Hruska noted that the risks taken by AIG were not caught by supervisors, hence why the U.S. strengthened regulatory power. However she stated that Dodd-Frank was a massive attempt to solve problems but ended up being an overshot.
Peirce agreed stating that the problems with AIG show that we don’t need more regulation but that companies need to regulate themselves.
A member of the audience asked what the right structure for retrospective economic analysis is.
Coates stated that there is no magic bullet but that better communication between commissioners and economic staff, and more deliberate information sharing between agencies, would be beneficial.
Peirce suggested that agencies conduct reviews themselves and then be reviewed by their peers at other agencies.
Ellig asserted that retrospective reviews should be done by an entity outside the agency as to avoid a situation in which an agency is compelled to defend past decisions.
Brown-Hruska stated that she believed review was still a role for the courts.
A member of the audience asked if Congress conducts their own economic analysis, and what academics can do to promote economic analysis.
Ellig noted that the European Union requires impact analysis of each piece of regulation but the U.S. does not.
Brown-Hruska stated that some analysis in Congress would be beneficial but asserted that the EU’s clearing requirement delays implementation.
Coates stated that academics should “train honest economists who will do honest analysis.”
The Future of Financial Markets: A Conversation with the Regulators
Role of Regulation
Peter Schroeder, Moderator and Reporter for The Hill, asked the panel what purpose the financial markets serve and what role regulation plays in that purpose.
Dan Gallagher, Commissioner at the Securities and Exchange Commission (SEC), stated that the financial markets should provide opportunities for capital formation and that the role of regulators is to ensure there is proper transparency, disclosure, and understanding of risk in the markets.
Scott O’Malia, Commissioner at the Commodity Futures Trading Commission (CFTC), said that the primary mission of his agency is to detect fraud and manipulation in the markets, to allow participants to have proper price discovery, and ensure the ability to engage in hedging.
Jeremiah O. Norton, Member of the Board of Directors at the Federal Deposit Insurance Corporation (FDIC), said the goal of the financial markets is to match investors and savers to allocate capital effectively. He added that the FDIC helps to provide financial stability and seeks to ensure that the federal “safety net” is not used in an inappropriate way.
Confidence in the Markets
Schroeder asked what steps can be taken to restore confidence in the financial markets.
Gallagher said that there is “amnesia” in Washington, DC on what caused the financial crisis and said that he has been “chasing false narratives” in rulemakings at the SEC rather than addressing the root causes of the crisis. He said the fact that Fannie Mae and Freddie Mac were not included in the Dodd-Frank Act shows that the main causes of the crisis were not addressed and added that until these core issues are addressed he is “not sure how much confidence investors will have.”
O’Malia said that regulators should make rules transparent, easy to use, and efficient as well as seek to fix old problems rather than creating new ones. He then gave the example of the CFTC’s swap dealer rule, which he called vague and broadly applied, and said it resulted in energy companies fleeing the swaps markets to conduct business in the futures markets, where there is more regulatory certainty.
Norton noted that bank regulators have not changed capital requirements for mortgages even though they are widely viewed as being a cause of the crisis. He said that the government is reforming areas that may not have caused the crisis while leaving other areas that need reforms “untouched.” He concluded that “until we take the safety net back to somewhere more recognizable there will be continued distrust.”
TBTF
Schroeder noted there is still contentious debate around the issue of “too big to fail” and asked what regulators can do in the debate when the situation will be hypothetical until a large failure tests the system in place.
Gallagher said that there is a “stunning lack of clarity about whether or not institutions can fail” and that there is “lingering confusion” about the lender of last resort function of the Federal Reserve which is “driving bad policy” across the regulatory agencies.
O’Malia said that regulations have “put in place mitigating factors, but at the end of the day, I don’t think we’ve solved too big to fail.”
Norton said it is “debatable how far we have moved” and that he is “less sanguine” about the progress being made in the resolvability of large firms. He also expressed concern that agencies are “skipping” the Title I process and focusing too much on the Title II process of orderly liquidation.
Surprises from Dodd-Frank
Schroeder asked what the biggest surprises were for the panelists as they began to work through their rulemaking mandates under Dodd-Frank.
Gallagher said the biggest surprises for him were: 1) that the SEC does not have access to the “living will” process; and 2) the amount of time that was consumed on things “entirely unrelated to the core mission” of the SEC and the goals of the Dodd-Frank Act, citing the rulemaking on conflict minerals as an example.
O’Malia said he was surprised by the “speed and totality” with which markets moved to Europe in response to the CFTC’s trading mandates. He also noted that the CFTC has not yet done a complete analysis of whether swap dealers are complying with the “massive requirements” imposed on them, and that the ability to aggregate market surveillance data from swap data repositories (SDRs) into something that is useful and accurate is “not working.”
Norton said what is concerning him “more and more” is the amount of influence that the Financial Stability Board (FSB), an international group of regulators, has on the regulatory policy of U.S. agencies. He noted that the FSB comprises 20 European bodies and only three from the U.S. and that their meetings are “not very public or transparent.” He added that these other countries in the FSB will look out for their own self-interests and that the U.S. should as well.
FSOC
Schroeder noted that the Financial Stability Oversight Council (FSOC) has come under criticism for its lack of transparency and how it functions as an entity. He asked the panel how they thought the FSOC was functioning and what can be done to improve it.
Gallagher said it is “repugnant” that FSOC decisions are “made in the darkness” and that the structure of the Council presented a “clean slate” for the President’s “hand-picked individuals” to drive policy. Gallagher also expressed disappointment that even though the SEC is a member agency, Chair Mary Jo White is the only one who can attend meetings. He supported legislation from Rep. Scott Garrett (R-N.J.) and said that the FSOC should focus more on information and data sharing.
O’Malia agreed and said the FSOC “could use a tune up to be more inclusive” and “respect the independent agency structure.” He also said that the Office of Financial Research (OFR), an arm of the FSOC, should have a protocol on how agencies can work and share information with each other because “a coordinated surveillance system would be more effective.”
CFTC Rulemaking
O’Malia noted that the CFTC has issued 206 no-action letters related to their rulemakings, often because the CFTC “didn’t get it right in the first place” and explained that these actions do not go through a notice and comment period. He stressed that the CFTC needs to focus on “fixing rules where they are broken” and said the agency should be subject to the same cost-benefit analysis requirements as the SEC.
Funding
Schroeder asked if the regulators have enough resources to meet their obligations.
Gallagher said that while the government “can always use” and “always wants more” resources the agencies should focus on being more efficient with the money they are given.
O’Malia agreed and stressed the need for the CFTC to create a strategic plan outlining how they will allocate their resources. He said this plan should be technology driven and that surveillance should be more automated to keep up with the markets.
Keynote – Rep. Jeb Hensarling (R-Texas)
Rep. Jeb Hensarling (R-Texas), Chairman of the House Financial Services Committee, stated that he is not sure what the “post Dodd-Frank world” will arrive, as the rulemaking process is still in ongoing, but said that “principled leadership” will be required to navigate the new landscape.
He stated that one of the root causes of the financial crisis was the Community Reinvestment Act which put a “government seal of approval” on bad loans and encouraged Fannie Mae and Freddie Mac to make bad loans. Hensarling said that financial reforms are seeking to remove risk from the system but said “to take away risk is to take away the opportunity for success.”
He asserted that the goals of the left side of the political spectrum are to “turn financial institutions into utilities” and “control the distribution of credit” to “politically favored classes.”
Hensarling then called the FSOC a “shadow regulator” that has the ability to “render great damage to the economy.”
He concluded that it is time to “start repealing laws like Dodd-Frank” and noted that the House Financial Services Committee will take up legislation on the “too big to fail” issue in this Congress.
Day 2
Keynote Address – Richard Kovacevich
Richard Kovacevich, Chairman Emeritus of Wells Fargo & Company, said federal regulation is affecting all industries, and that the response to the financial crisis especially was “irresponsibly implemented.” He said that because of the Dodd-Frank Act, 25 percent of Americans have restricted access to credit, inhibiting economic growth and widening the inequality in the country.
Kovacevich sharply criticized the fact that all banks, even those who did not need the support, were forced to accept funds from the Troubled Asset Relief Program (TARP), and continued to say that it gave the federal government an excuse to put out hundreds of new regulations for the financial industry. The Dodd-Frank Act, he said, was made in “anger and as a punishment” for TARP bailouts.
Explaining that effective regulation is about consistency and good oversight, Kovacevich argued that the U.S. has not achieved this balance and that regulators have not been held back by a lack of authority, but rather by an inability to apply their authority effectively. He questioned what additional regulatory authority was needed to avert the financial crisis, and claimed that if the rating agencies had been doing their jobs the crisis could have been avoided.
Kovacevich argued that the crisis was caused by about 20 institutions, but lamented the fact that thousands of small community banks are now facing regulatory burdens in response to “devastating regulatory deficiencies” in the lead-up to the crisis that Dodd-Frank did nothing to correct. He said regulators with the “political will and financial skill to take strong action” are needed.
Moderator Louise Bennetts, Associate Director of Financial Regulation Studies at the Cato Institute, opened the discussion by noting that the phrases “too big to fail” and “systemic risk” are often used as “smokescreens” to distract from regulatory failures. She said the discussion would focus on the question of whether too big to fail really exists, and if so, whether it is a “state of nature” or the result of “regulatory policy.”
Bennetts said that Title I and Title II of the Dodd-Frank Act are based on the idea that there is an “omniscient super-regulator” with the ability to see all systemic risks. She said that regulators have not been successful in this task, and asked the panelists to suggest alternatives to the current regime.
Andrew Olmem, Partner at Venable LLP, stressed the importance of thinking about systemic risk in a political context as well as from an economic and legal perspective. The “legal superstructure,” he said, keeps up with market developments, and markets in turn depend on a sound legal structure and property rights. While Dodd-Frank presents one approach to resolution authority, he said, it is important to continue dialogue and thought to “ensure we have a superstructure that can deal with” troubled large financial institutions.
Olmem cautioned, however, against focusing too much on resolution, as this draws attention from a more important aspect of crisis avoidance, namely the development of a competitive and dynamic financial sector. The best way to handle a failing financial firm, he explained, is to let it be absorbed by a more robust financial institution. This lessens the likelihood of the need for government and taxpayer assistance, he said.
Dodd-Frank, continued Olmem, imposes a “very rigid regulatory structure” on large financial institutions and said the burden could eventually cause banks to behave more like utilities. Highly regulated banks, he explained, could start to offer similar products, avoid innovation, and employ similar risk management strategies. This uniformity would leave banks vulnerable to the same types of shocks, he said. He endorsed a system that encourages a diversity of risk strategies, so that when one strategy fails, others do not. He said Congress had an important role to play in financial regulation, both in its oversight role and in keeping the public informed about the financial system.
Martin Hutchinson, author of Alchemists of Loss, said that too big to fail is “not the central problem.” Instead, he outlined several sources of systemic risk that have become more significant as the financial markets have evolved. Complicated financial products such as derivatives, he said, have “vastly increased interconnectedness,” creating the potential for one institution’s losses to be felt throughout the system. He said most banks use the same or similar “total rubbish” risk management models, which undervalue “pathological products” such as credit default swaps and collateralized debt obligations. Banks, he claimed, are highly leveraged with illiquid assets, and the Basel rules that attempt to address leverage concerns are an “invitation to play games” because they encourage high investment in government debt. It is very difficult, he explained, to “get out” of “arcane derivatives positions.”
Stuart Plesser, Senior Director, Standard and Poor’s, said the proliferation of “linkages in the system” is the main reason why big banks cannot be wound down through the Federal Deposit Insurance Corporation (FDIC) like smaller banks. Prior to Dodd-Frank, he said, there were no resolution rules for systemically important financial institutions (SIFIs). Dodd-Frank, he explained, presents ordinary bankruptcy as the preferred means of SIFI resolution, and then outlines the “orderly liquidation authority” process for cases in which bankruptcy is not feasible.
Plesser outlined the process by which Standard and Poor’s rates banks. The agency, he explained determines whether the bank is “highly,” “moderately,” or not systemically important, and then determines whether the government is “highly supportive,” “moderately supportive,” or not supportive of the bank. The firm has determined eight banks to be highly systemically important and has deemed the U.S. government to be “supportive” of these banks.
Bennetts asked about the impact of risk modeling, and whether the recent focus on concentrating safe assets rather than diversifying assets constituted a threat to stability. Plesser said that diversification is important, but “certain pockets of risk” can cause instability and losses even in a highly diversified institution. He asserted that a “uniform risk system” is important because it allows all banks to employ the best risk management technology. Concentration in government debt, he said, is only a problem if the government is likely to default. His agency considers U.S. debt to be “almost triple-A,” he said.
Hutchinson repeated his claim that the risk models employed by banks are flawed, and said that regulator mandated risk weightings “drive banks into the same securities.” When these securities are government bonds, he said, governments are allowed to “borrow like mad.”
Olmem said the “level of prescriptiveness” regulators interject into bank management practice is too high, and presents the danger that the judgment of the banker will be overridden by that of the regulator. This intrusive level of regulation “incentivizes uniformity,” which creates systemic risk, he said.
An audience member asked for the panelists’ views on the use of Chapter 14 of the bankruptcy code in addressing too big to fail. Olmem said that any idea on how to improve resolution deserves consideration. Olmem identified “dip financing” as a “key issue,” as an institution that loses access to dip financing loses a lot of value.
Another audience member asked how to balance the concerns of stress test transparency and preventing banks from “gaming” the system. Plesser asserted that stress tests have improved since 2008, and that there was “no doubt” that banks would be returning too much capital to shareholders had stress testing not been applied.
Panel 2: Consumer Finance: Risk, Protection and Moral Hazard
Todd Zywicki, Professor of Law, George Mason University, and Senior Scholar, Mercatus Center, said that while he agreed “in principle” that there should be a single agency for consumer financial protection and that state and federal law must be harmonized, the Consumer Financial Protection Bureau (CFPB) turned out to be a “missed opportunity” and a “terrible step in the wrong direction.” He called the CFPB a classic example of “bureaucratic pathology,” saying it is “unaccountable,” “insulated from feedback,” “extraordinarily political,” and guilty of “tunnel vision.” The CFPB, he claimed, lacks the “internal checks and balances found at other independent agencies.
Zywicki cited the agency’s qualified mortgage (QM) rule, which limits negative amortization mortgages, as an example of the agency’s incompetence. He claimed the rule was based on a faulty interpretation of the data. He claimed the agency had exhibited “agency imperialism” by ignoring a Dodd-Frank provision preventing it from regulating auto dealers, and asserted the agency had demonstrated a lack of regard for “costs to consumers” and “privacy concerns.”
Raj Date, Managing Partner, Fenway Summer LLC, said the “central problem” in the United States consumer financial system before the crisis was that it was “for a time very difficult to get paid for making good decisions” regarding risk. Mortgage issuers who had to compete against either government sponsored enterprises (GSEs) or firms making bad loans without holding onto the risk, he explained, could not get by issuing sound loans. Correcting this backward incentive structure, he said, is the “great promise” of the CFPB and financial reform generally. He identified expanding access to data as a means of improving decision-making throughout the consumer finance industry.
Kevin Villani, Executive Scholar at the University of San Diego and Principal at University Financial Associates, said that the U.S. economic system is one of “crony capitalism” controlled by the rent-seeking of elites. In contrast to the unregulated savings and loan banking structures of the past, he said, the vast financial regulatory structure creates dangerous “moral hazards.” He asserted that protections of savers and lenders incent “excessive leverage” and “mal-investment.” The “subprime lending debacle,” he said, was a direct consequence of these moral hazards. He advocated for a “huge” “structural adjustment” to encourage competition in the United States system.
An audience member asked for the panelists’ views on the link between behavioral economics and the CFPB. Zywicki said that behavioral economics is a young discipline and that it is “laughable” to try to generalize it into “actual policy.”
An audience member asked how the CFPB might approach payday lending. Zywicki said that the CFPB could “destroy” payday lending without resorting to rate caps, perhaps by “limiting rollovers.” Such action, he said, would continue the “regulatory onslaught” that is “driving more and more people out of the mainstream financial system.”
Keynote Address – Rep. Patrick McHenry (R-N.C.)
Rep. Patrick McHenry (R-N.C.) offered a deep criticism of the Dodd-Frank Act, saying that it does not work and only imposed unnecessary costs on financial markets and the American people. He saw it as a project in which Democrats “did not let a good crisis go to waste” and implemented many new rules that limited consumer choice.
McHenry said the Financial Stability Oversight Council (FSOC) was created to be a regulatory “super-council,” but instead has become a new venue to expose incompetence of regulators. He also mentioned the Office of Financial Research, whose first report was criticized by “everyone from Cato to the left.”
Hoping a new Senate leadership would allow for serious reform of the Dodd-Frank Act, McHenry said he supports a full repeal of the law, but admitted that the probability of that is very low. He said having 52-53 Republicans in the Senate would lead to significant reform, but that 60 would be needed for repeal. If the law were repealed, he said, “That sound everyone would hear would be the flow of capital to small business.”Back to Top
Panel 3: Housing Finance Reform: Which Way Forward?
Hester Peirce, Senior Research Fellow at the Mercatus Center, said that when the Dodd-Frank Act came out, she thought it was a major flaw that the law did not address housing finance reform. However, she said, she now sees this as fortunate because it is one area the law could not do any harm.
Mark Calabria insisted that the GSEs Fannie Mae and Freddie Mac can be wound down and should be. He argued that if banks are willing to hold $1 trillion in mortgage-backed securities, then it should not be an issue to hold $1 trillion in mortgages directly. The capacity to fund the mortgage market, he said, is still available without the GSEs.
Calabria insisted that while realistic models of the economy are already used, realistic models and discussions of the government are also needed. He said insurance premiums will always be underpriced, any new system will still be pro-cyclical, and standards and safeguards will always erode over time.
Competition, Calabria said, cannot be mixed with government guarantee, and the crisis was made worse by the pairing of guarantees with increasing competition. He advocated for losing guarantees in favor of competition. He doubted, however, that any reform of substance would come before the next Congress.
Laurie Goodman, of the Housing Finance Policy Center at the Urban Institute, agreed that legislative GSE reform is highly unlikely any time soon. While many of the principles of reform, such as the need for private capital to take the first loss, to maintain the 30-year fixed rate mortgage, and to preserve the to-be-announced (TBA) market, she said, the biggest disagreement surrounds the question of how to handle access and affordability.
Goodman said that with the GSEs being profitable and functioning at the moment, and with much high legislative priorities, any legislative would likely come in 2017 at the earliest.
Joshua Rosner of Graham Fisher & Co. said meaningful reform is possible without Congressional action, but the structure of the GSEs and the rights of creditors needs to be addressed. He blamed the failures of Fannie Mae and Freddie Mac on three main issues: 1) improper use of portfolios; 2) weak capital requirements; and 3) improperly-priced guarantee fees. He also argued that the GSEs must be separated from political influences.
Rosner criticized the Johnson-Crapo housing finance reform bill for unnecessarily trying to build an entirely new system, like fixing a car that was in an accident by building a new plant and car. He said the bill would not protect the public, reduce systemic risk, improve market discipline, or increase mortgage lending. He argued that replacing the GSEs now would disrupt the market.
Better options, Rosner contended, would include simply fixing the GSEs through conservatorship or a receivership with the new entities coming out with a cleaner charter.
For more information on this hearing, please click here.
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Cato Institute
After Dodd-Frank: The Future of Financial Markets
Wednesday July 16 – Thursday, July 17, 2014
Key Topics & Takeaways
- Market Migration: CFTC Commissioner O’Malia said he was surprised by the “speed and totality” with which markets moved to Europe in response to the CFTC’s trading mandates
- FSOC: SEC’s Gallagher said it is “repugnant” that FSOC decisions are “made in the darkness” and that the structure of the Council presented a “clean slate” for the President’s “hand-picked individuals” to drive policy
- Systemic Risk: Olmem warned that Dodd-Frank has imposed very rigid regulation that could force banks to behave like utilities, with little innovation and identical financial products, which could also leave all banks vulnerable to the same shocks,
- Consumer Finance: Zywicki said the CFPB has demonstrated a lack of regard for “costs to consumers” and “privacy concerns.”
- McHenry Keynote Address: Rep. Patrick McHenry (R-N.C.) criticizes the Dodd-Frank Act for imposing unnecessary rules and higher costs on American consumers and companies. He said he would support a reform or repeal, but that this would require at least “52-53” Republican senators.
- Housing Finance Reform: The panelists doubted the prospects of legislative housing finance reform, with Goodman saying it would not happen until 2017 at the earliest.
Day 1
Speakers:
- Daniel M. Rothschild, Senior Vice President & Chief Operating Officer, Mercatus Center at George Mason University
- John H. Cochrane, AQR Capital Management Distinguished Service Professor of Finance, Booth School of Business, University of Chicago
- Rep. Jeb Hensarling (R-TX), Chairman, House Financial Services Committee
PANEL 1:
- Sharon Brown-Hruska, Vice President, National Economic Research Associates and Visiting Professor of Finance, Tulane University
- John Coates, Professor of Law and Economics, Harvard Law School
- Jerry Ellig, Senior Research Fellow, Mercatus Center
- Hester Peirce, Senior Research Fellow, Mercatus Center
- Moderator: Stephen Miller, Senior Research Fellow, Mercatus Center
PANEL 2:
- Daniel M. Gallagher, Commissioner, U.S. Securities and Exchange Commission
- Jeremiah O. Norton, Member, Board of Directors, Federal Deposit Insurance Corporation
- Scott D. O’Malia, Commissioner, U.S. Commodity Futures Trading Commission
Day 2
Speakers
- John Allison, President and CEO, Cato Institute
- Richard Kovacevich, Chairman Emeritus, Wells Fargo & Company
- Rep. Patrick McHenry (R-N.C.), Member, House Financial Services Committee
PANEL 1
- Stuart Plesser, Senior Director, Standard & Poor’s
- Martin Hutchinson, Author, Alchemists of Loss
- Andrew Olmem, Partner, Venable LLP and former Chief Counsel (Minority) and Deputy Staff Director at the U.S. Senate Committee on Banking, Housing, and Urban Affairs
- Moderator: Louise Bennetts, Associate Director of Financial Regulation Studies, Cato Institute
PANEL 2
- Raj Date, Managing Partner, Fenway Summer LLC
- Kevin Villani, Executive Scholar, University of San Diego and Principal, University Financial Associates
- Todd Zywicki, Professor of Law, George Mason University, and Senior Scholar, Mercatus Center
- Moderator: Mark Calabria, Director of Financial Regulation Studies, Cato Institute
PANEL 3
- Mark Calabria, Director of Financial Regulation Studies, Cato Institute
- Laurie Goodman, Center Director, Housing Policy Finance Center, Urban Institute
- Joshua Rosner, Author, Reckless Endangerment, Graham Fisher & Co.
- Moderator: Hester Peirce, Senior Research Fellow, Mercatus Center
Daniel M. Rothschild, Senior Vice President & Chief Operating Officer, Mercatus Center at George Mason University, noted that as the fourth anniversary of Dodd-Frank approaches, we should “look forward” instead of at past failures. He called for an increase in resiliency and reduction in systemic risk.
Dino Falaschetti, Director of Operations, Mercatus Center at George Mason University, asserted that finance is not a “play thing” for the elite, but the fuel for America. He stated that economies work better when we work to “do good,” and highlighted the importance of freedom of press and free markets. He noted that economies grow because of innovations and called for financial institutions to channel money to bright entrepreneurs not well-connected “cronies.”
Opening Keynote – John H. Cochrane
John H. Cochrane, AQR Capital Management Distinguished Service Professor of Finance, Booth School of Business, University of Chicago, asserted that we need to rethink regulation. He stated that Dodd-Frank and its “mountain of legislation” will not help the causes of the crisis, but noted that radical reform is on the agenda “left, right and center.”
Cochrane noted that the key problem of the crisis of 2008, was the systemic run that set off contagion in the financial markets. He dispelled the notion that mortgage backed securities are bad, asserting that the a 30 to 1 overnight leverage ratio is where the problem lay. He stated that getting rid of short term lending would lead to a system with booms and busts but not crises. He also noted that if banks issue more equity and less debt, the bank will have the same amount of risk but without the “poison” that leads to runs.
Cochrane noted that what has happened to financial regulation in the past is analogous to the song of “the old lady who swallowed a fly.” He asserted the cycle has been same with all regulation: the banks work around the regulation, government issues debts, and ultimately more regulation is added. He warned that we are headed towards “detailed microregulation,” and urged for rule-based or discretionary regulation. He concluded by noting that Dodd-Frank does not need to be repealed but rather it should be reformed.
Q&A
A member of the audience asked if Cochrane would want to allow financial institutions to issue fixed value, run-prone assets.
Cochrane said yes, but that they need to be backed by the Treasury.
A member of the audience asked about Cochrane’s perspective on long term lending.
He noted that long term loans are fine, while short term run-prone debt is the “poison in the water.” He proposed taxing short term loans.
Panel 1: Economic Analysis: Improving Transparency, Accountability and Expertise in the Regulatory Process
The moderator, Stephen Miller, Financial Markets Scholar, Mercatus Center, asked how to distinguish between regulatory analysis vs. cost-benefit analysis.
Jerry Ellig, Senior Research Fellow, Mercatus Center, stated that the caricature of cost-benefit analysis looks at the benefits and costs of regulation, but not at alternate courses of actions. He distinguished that regulatory impact analysis is the type of analysis agency executive branches are supposed to conduct when looking at regulation that is “significant.” Ellig asserted that regulatory impact analysis (or economic analysis) is a better term because the caricature of cost benefit analysis makes it seem less extensive.
Miller asked how economic analysis is used when formulating rules and regulating.
Hester Peirce, Senior Research Fellow, Mercatus Center, stated that the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) have an obligation to conduct economic analysis and look at costs and benefits. She noted that quasi-governmental agencies such as the Financial Industry Regulatory Authority (FINRA) or the Municipal Securities Rulemaking Board (MSRB), have had pressure on them to conduct economic analysis. She expressed her hope that this pressure sets a broader trend of conducting economic analysis.
Miller asked former CFTC Chair, Sharon Brown-Hruska, Vice President, National Economic Research Associates, and Visiting Professor of Finance, Tulane, how economic analysis was used at the CFTC and if it was beneficial.
Brown-Hruska stated that the CFTC has to “consider” economic analysis. She noted that during her time at the CFTC, regulation had to be signed off by the chief economist and that this was an institutional hurdle. She explained that the CFTC has since taken away the requirement for sign off and instead the chief economist has become a consultant to the commission.
Miller asked if economic analysis improves rulemaking.
John Coates, John F. Cogan Jr. Professor of Law and Economics, Harvard University, stated that there are two dimensions of beneficial economic analysis: that it is qualitative and functions as policy. He noted that economic analysis is beneficial to rulemaking when you look at the theoretical impacts regulation will have. He also explained that economic analysis as policy, not as a mandate is beneficial.
He asserted that it is difficult to do a qualitative cost benefit analysis because one cannot draw inferences about future costs or benefits. He recognized that the SEC is conducting some beneficial pilot studies but also gave the example of the impossible task of trying to run an experiment on the Volcker rule.
Miller asked if economic analysis helps in executive branch agencies.
Ellig stated that research shows economic analysis has better impacts on decision making but noted that it is not always used. He noted that the failure to conduct economic analysis can make the decision questionable.
Brown-Hruska stated that she disagrees “fundamentally” with the notion that quantitative analyses of regulations are impossible. She said that one needs to look at the broad picture and take a predictive approach coupled with standard tools of economics. She agreed, however, with Coates statement on Volcker, saying the rule is trying to “cut off an arm because it has a scratch on it.”
Miller asked about reform of economic analysis.
Peirce asserted that if economic analysis is not put into statute, regulators don’t take it seriously and noted that it took the court to push the SEC to implement a process of economic analysis. She stated that before economic analysis was the used by executive branch agencies, they worked half as well. She called for the requirement of economic analysis and a potential review by court. She urged the need for retrospective review which would provide a metric for success.
Coates agreed with the retrospective approach. However, he disagreed with requiring economic analysis and review by the court. He noted that it is problematic to give the power of statuatory obligation to people who are not economists but merely political appointees.
Miller asked if economic analysis increases transparency and accountability.
Peirce stated that economic analysis does increase transparency and accountability. However, she noted it is not the only solution. She compared economic analysis to a flashlight in a dark room-regulators are trying to walk through the dark room and while the flashlight helps, it does not illuminate everything.
Coates noted that economic analysis can achieve transparency and accountability with adequate funding and political appointees that also have knowledge of economics.
Ellig stated that economic analysis makes it easier to understand what a regulation is about and if it adequately addresses the problem. He noted that with these metrics economic analysis provides, transparency and accountability are improved.
Q&A
A member of the audience asked whether or not it would be beneficial to have one prudential regulator and have all the agencies work together.
Peirce noted that the competition between the SEC and CFTC is not helpful. She stated that the Financial Stability Oversight Council (FSOC) is supposed to streamline all agencies but instead it focuses on”too big to fail” and systemically important financial institution (SIFI) designation.
Brown-Hruska noted that there have always been challenges between the SEC and CFTC.
Coates asserted that it would be more complicated because “the larger the jurisdiction, the larger the political clout.”
Ellig expressed he would be suspicious of a monopoly of regulators.
A member of the audience asked if agencies would have to make any adjustments with an economic analysis mandate.
Coates noted that all agencies have always had economists on staff so there would be no massive change.
A member of the audience asked about the problem with regulation in the crisis of 2008.
Brown-Hruska noted that the risks taken by AIG were not caught by supervisors, hence why the U.S. strengthened regulatory power. However she stated that Dodd-Frank was a massive attempt to solve problems but ended up being an overshot.
Peirce agreed stating that the problems with AIG show that we don’t need more regulation but that companies need to regulate themselves.
A member of the audience asked what the right structure for retrospective economic analysis is.
Coates stated that there is no magic bullet but that better communication between commissioners and economic staff, and more deliberate information sharing between agencies, would be beneficial.
Peirce suggested that agencies conduct reviews themselves and then be reviewed by their peers at other agencies.
Ellig asserted that retrospective reviews should be done by an entity outside the agency as to avoid a situation in which an agency is compelled to defend past decisions.
Brown-Hruska stated that she believed review was still a role for the courts.
A member of the audience asked if Congress conducts their own economic analysis, and what academics can do to promote economic analysis.
Ellig noted that the European Union requires impact analysis of each piece of regulation but the U.S. does not.
Brown-Hruska stated that some analysis in Congress would be beneficial but asserted that the EU’s clearing requirement delays implementation.
Coates stated that academics should “train honest economists who will do honest analysis.”
The Future of Financial Markets: A Conversation with the Regulators
Role of Regulation
Peter Schroeder, Moderator and Reporter for The Hill, asked the panel what purpose the financial markets serve and what role regulation plays in that purpose.
Dan Gallagher, Commissioner at the Securities and Exchange Commission (SEC), stated that the financial markets should provide opportunities for capital formation and that the role of regulators is to ensure there is proper transparency, disclosure, and understanding of risk in the markets.
Scott O’Malia, Commissioner at the Commodity Futures Trading Commission (CFTC), said that the primary mission of his agency is to detect fraud and manipulation in the markets, to allow participants to have proper price discovery, and ensure the ability to engage in hedging.
Jeremiah O. Norton, Member of the Board of Directors at the Federal Deposit Insurance Corporation (FDIC), said the goal of the financial markets is to match investors and savers to allocate capital effectively. He added that the FDIC helps to provide financial stability and seeks to ensure that the federal “safety net” is not used in an inappropriate way.
Confidence in the Markets
Schroeder asked what steps can be taken to restore confidence in the financial markets.
Gallagher said that there is “amnesia” in Washington, DC on what caused the financial crisis and said that he has been “chasing false narratives” in rulemakings at the SEC rather than addressing the root causes of the crisis. He said the fact that Fannie Mae and Freddie Mac were not included in the Dodd-Frank Act shows that the main causes of the crisis were not addressed and added that until these core issues are addressed he is “not sure how much confidence investors will have.”
O’Malia said that regulators should make rules transparent, easy to use, and efficient as well as seek to fix old problems rather than creating new ones. He then gave the example of the CFTC’s swap dealer rule, which he called vague and broadly applied, and said it resulted in energy companies fleeing the swaps markets to conduct business in the futures markets, where there is more regulatory certainty.
Norton noted that bank regulators have not changed capital requirements for mortgages even though they are widely viewed as being a cause of the crisis. He said that the government is reforming areas that may not have caused the crisis while leaving other areas that need reforms “untouched.” He concluded that “until we take the safety net back to somewhere more recognizable there will be continued distrust.”
TBTF
Schroeder noted there is still contentious debate around the issue of “too big to fail” and asked what regulators can do in the debate when the situation will be hypothetical until a large failure tests the system in place.
Gallagher said that there is a “stunning lack of clarity about whether or not institutions can fail” and that there is “lingering confusion” about the lender of last resort function of the Federal Reserve which is “driving bad policy” across the regulatory agencies.
O’Malia said that regulations have “put in place mitigating factors, but at the end of the day, I don’t think we’ve solved too big to fail.”
Norton said it is “debatable how far we have moved” and that he is “less sanguine” about the progress being made in the resolvability of large firms. He also expressed concern that agencies are “skipping” the Title I process and focusing too much on the Title II process of orderly liquidation.
Surprises from Dodd-Frank
Schroeder asked what the biggest surprises were for the panelists as they began to work through their rulemaking mandates under Dodd-Frank.
Gallagher said the biggest surprises for him were: 1) that the SEC does not have access to the “living will” process; and 2) the amount of time that was consumed on things “entirely unrelated to the core mission” of the SEC and the goals of the Dodd-Frank Act, citing the rulemaking on conflict minerals as an example.
O’Malia said he was surprised by the “speed and totality” with which markets moved to Europe in response to the CFTC’s trading mandates. He also noted that the CFTC has not yet done a complete analysis of whether swap dealers are complying with the “massive requirements” imposed on them, and that the ability to aggregate market surveillance data from swap data repositories (SDRs) into something that is useful and accurate is “not working.”
Norton said what is concerning him “more and more” is the amount of influence that the Financial Stability Board (FSB), an international group of regulators, has on the regulatory policy of U.S. agencies. He noted that the FSB comprises 20 European bodies and only three from the U.S. and that their meetings are “not very public or transparent.” He added that these other countries in the FSB will look out for their own self-interests and that the U.S. should as well.
FSOC
Schroeder noted that the Financial Stability Oversight Council (FSOC) has come under criticism for its lack of transparency and how it functions as an entity. He asked the panel how they thought the FSOC was functioning and what can be done to improve it.
Gallagher said it is “repugnant” that FSOC decisions are “made in the darkness” and that the structure of the Council presented a “clean slate” for the President’s “hand-picked individuals” to drive policy. Gallagher also expressed disappointment that even though the SEC is a member agency, Chair Mary Jo White is the only one who can attend meetings. He supported legislation from Rep. Scott Garrett (R-N.J.) and said that the FSOC should focus more on information and data sharing.
O’Malia agreed and said the FSOC “could use a tune up to be more inclusive” and “respect the independent agency structure.” He also said that the Office of Financial Research (OFR), an arm of the FSOC, should have a protocol on how agencies can work and share information with each other because “a coordinated surveillance system would be more effective.”
CFTC Rulemaking
O’Malia noted that the CFTC has issued 206 no-action letters related to their rulemakings, often because the CFTC “didn’t get it right in the first place” and explained that these actions do not go through a notice and comment period. He stressed that the CFTC needs to focus on “fixing rules where they are broken” and said the agency should be subject to the same cost-benefit analysis requirements as the SEC.
Funding
Schroeder asked if the regulators have enough resources to meet their obligations.
Gallagher said that while the government “can always use” and “always wants more” resources the agencies should focus on being more efficient with the money they are given.
O’Malia agreed and stressed the need for the CFTC to create a strategic plan outlining how they will allocate their resources. He said this plan should be technology driven and that surveillance should be more automated to keep up with the markets.
Keynote – Rep. Jeb Hensarling (R-Texas)
Rep. Jeb Hensarling (R-Texas), Chairman of the House Financial Services Committee, stated that he is not sure what the “post Dodd-Frank world” will arrive, as the rulemaking process is still in ongoing, but said that “principled leadership” will be required to navigate the new landscape.
He stated that one of the root causes of the financial crisis was the Community Reinvestment Act which put a “government seal of approval” on bad loans and encouraged Fannie Mae and Freddie Mac to make bad loans. Hensarling said that financial reforms are seeking to remove risk from the system but said “to take away risk is to take away the opportunity for success.”
He asserted that the goals of the left side of the political spectrum are to “turn financial institutions into utilities” and “control the distribution of credit” to “politically favored classes.”
Hensarling then called the FSOC a “shadow regulator” that has the ability to “render great damage to the economy.”
He concluded that it is time to “start repealing laws like Dodd-Frank” and noted that the House Financial Services Committee will take up legislation on the “too big to fail” issue in this Congress.
Day 2
Keynote Address – Richard Kovacevich
Richard Kovacevich, Chairman Emeritus of Wells Fargo & Company, said federal regulation is affecting all industries, and that the response to the financial crisis especially was “irresponsibly implemented.” He said that because of the Dodd-Frank Act, 25 percent of Americans have restricted access to credit, inhibiting economic growth and widening the inequality in the country.
Kovacevich sharply criticized the fact that all banks, even those who did not need the support, were forced to accept funds from the Troubled Asset Relief Program (TARP), and continued to say that it gave the federal government an excuse to put out hundreds of new regulations for the financial industry. The Dodd-Frank Act, he said, was made in “anger and as a punishment” for TARP bailouts.
Explaining that effective regulation is about consistency and good oversight, Kovacevich argued that the U.S. has not achieved this balance and that regulators have not been held back by a lack of authority, but rather by an inability to apply their authority effectively. He questioned what additional regulatory authority was needed to avert the financial crisis, and claimed that if the rating agencies had been doing their jobs the crisis could have been avoided.
Kovacevich argued that the crisis was caused by about 20 institutions, but lamented the fact that thousands of small community banks are now facing regulatory burdens in response to “devastating regulatory deficiencies” in the lead-up to the crisis that Dodd-Frank did nothing to correct. He said regulators with the “political will and financial skill to take strong action” are needed.
Moderator Louise Bennetts, Associate Director of Financial Regulation Studies at the Cato Institute, opened the discussion by noting that the phrases “too big to fail” and “systemic risk” are often used as “smokescreens” to distract from regulatory failures. She said the discussion would focus on the question of whether too big to fail really exists, and if so, whether it is a “state of nature” or the result of “regulatory policy.”
Bennetts said that Title I and Title II of the Dodd-Frank Act are based on the idea that there is an “omniscient super-regulator” with the ability to see all systemic risks. She said that regulators have not been successful in this task, and asked the panelists to suggest alternatives to the current regime.
Andrew Olmem, Partner at Venable LLP, stressed the importance of thinking about systemic risk in a political context as well as from an economic and legal perspective. The “legal superstructure,” he said, keeps up with market developments, and markets in turn depend on a sound legal structure and property rights. While Dodd-Frank presents one approach to resolution authority, he said, it is important to continue dialogue and thought to “ensure we have a superstructure that can deal with” troubled large financial institutions.
Olmem cautioned, however, against focusing too much on resolution, as this draws attention from a more important aspect of crisis avoidance, namely the development of a competitive and dynamic financial sector. The best way to handle a failing financial firm, he explained, is to let it be absorbed by a more robust financial institution. This lessens the likelihood of the need for government and taxpayer assistance, he said.
Dodd-Frank, continued Olmem, imposes a “very rigid regulatory structure” on large financial institutions and said the burden could eventually cause banks to behave more like utilities. Highly regulated banks, he explained, could start to offer similar products, avoid innovation, and employ similar risk management strategies. This uniformity would leave banks vulnerable to the same types of shocks, he said. He endorsed a system that encourages a diversity of risk strategies, so that when one strategy fails, others do not. He said Congress had an important role to play in financial regulation, both in its oversight role and in keeping the public informed about the financial system.
Martin Hutchinson, author of Alchemists of Loss, said that too big to fail is “not the central problem.” Instead, he outlined several sources of systemic risk that have become more significant as the financial markets have evolved. Complicated financial products such as derivatives, he said, have “vastly increased interconnectedness,” creating the potential for one institution’s losses to be felt throughout the system. He said most banks use the same or similar “total rubbish” risk management models, which undervalue “pathological products” such as credit default swaps and collateralized debt obligations. Banks, he claimed, are highly leveraged with illiquid assets, and the Basel rules that attempt to address leverage concerns are an “invitation to play games” because they encourage high investment in government debt. It is very difficult, he explained, to “get out” of “arcane derivatives positions.”
Stuart Plesser, Senior Director, Standard and Poor’s, said the proliferation of “linkages in the system” is the main reason why big banks cannot be wound down through the Federal Deposit Insurance Corporation (FDIC) like smaller banks. Prior to Dodd-Frank, he said, there were no resolution rules for systemically important financial institutions (SIFIs). Dodd-Frank, he explained, presents ordinary bankruptcy as the preferred means of SIFI resolution, and then outlines the “orderly liquidation authority” process for cases in which bankruptcy is not feasible.
Plesser outlined the process by which Standard and Poor’s rates banks. The agency, he explained determines whether the bank is “highly,” “moderately,” or not systemically important, and then determines whether the government is “highly supportive,” “moderately supportive,” or not supportive of the bank. The firm has determined eight banks to be highly systemically important and has deemed the U.S. government to be “supportive” of these banks.
Bennetts asked about the impact of risk modeling, and whether the recent focus on concentrating safe assets rather than diversifying assets constituted a threat to stability. Plesser said that diversification is important, but “certain pockets of risk” can cause instability and losses even in a highly diversified institution. He asserted that a “uniform risk system” is important because it allows all banks to employ the best risk management technology. Concentration in government debt, he said, is only a problem if the government is likely to default. His agency considers U.S. debt to be “almost triple-A,” he said.
Hutchinson repeated his claim that the risk models employed by banks are flawed, and said that regulator mandated risk weightings “drive banks into the same securities.” When these securities are government bonds, he said, governments are allowed to “borrow like mad.”
Olmem said the “level of prescriptiveness” regulators interject into bank management practice is too high, and presents the danger that the judgment of the banker will be overridden by that of the regulator. This intrusive level of regulation “incentivizes uniformity,” which creates systemic risk, he said.
An audience member asked for the panelists’ views on the use of Chapter 14 of the bankruptcy code in addressing too big to fail. Olmem said that any idea on how to improve resolution deserves consideration. Olmem identified “dip financing” as a “key issue,” as an institution that loses access to dip financing loses a lot of value.
Another audience member asked how to balance the concerns of stress test transparency and preventing banks from “gaming” the system. Plesser asserted that stress tests have improved since 2008, and that there was “no doubt” that banks would be returning too much capital to shareholders had stress testing not been applied.
Panel 2: Consumer Finance: Risk, Protection and Moral Hazard
Todd Zywicki, Professor of Law, George Mason University, and Senior Scholar, Mercatus Center, said that while he agreed “in principle” that there should be a single agency for consumer financial protection and that state and federal law must be harmonized, the Consumer Financial Protection Bureau (CFPB) turned out to be a “missed opportunity” and a “terrible step in the wrong direction.” He called the CFPB a classic example of “bureaucratic pathology,” saying it is “unaccountable,” “insulated from feedback,” “extraordinarily political,” and guilty of “tunnel vision.” The CFPB, he claimed, lacks the “internal checks and balances found at other independent agencies.
Zywicki cited the agency’s qualified mortgage (QM) rule, which limits negative amortization mortgages, as an example of the agency’s incompetence. He claimed the rule was based on a faulty interpretation of the data. He claimed the agency had exhibited “agency imperialism” by ignoring a Dodd-Frank provision preventing it from regulating auto dealers, and asserted the agency had demonstrated a lack of regard for “costs to consumers” and “privacy concerns.”
Raj Date, Managing Partner, Fenway Summer LLC, said the “central problem” in the United States consumer financial system before the crisis was that it was “for a time very difficult to get paid for making good decisions” regarding risk. Mortgage issuers who had to compete against either government sponsored enterprises (GSEs) or firms making bad loans without holding onto the risk, he explained, could not get by issuing sound loans. Correcting this backward incentive structure, he said, is the “great promise” of the CFPB and financial reform generally. He identified expanding access to data as a means of improving decision-making throughout the consumer finance industry.
Kevin Villani, Executive Scholar at the University of San Diego and Principal at University Financial Associates, said that the U.S. economic system is one of “crony capitalism” controlled by the rent-seeking of elites. In contrast to the unregulated savings and loan banking structures of the past, he said, the vast financial regulatory structure creates dangerous “moral hazards.” He asserted that protections of savers and lenders incent “excessive leverage” and “mal-investment.” The “subprime lending debacle,” he said, was a direct consequence of these moral hazards. He advocated for a “huge” “structural adjustment” to encourage competition in the United States system.
An audience member asked for the panelists’ views on the link between behavioral economics and the CFPB. Zywicki said that behavioral economics is a young discipline and that it is “laughable” to try to generalize it into “actual policy.”
An audience member asked how the CFPB might approach payday lending. Zywicki said that the CFPB could “destroy” payday lending without resorting to rate caps, perhaps by “limiting rollovers.” Such action, he said, would continue the “regulatory onslaught” that is “driving more and more people out of the mainstream financial system.”
Keynote Address – Rep. Patrick McHenry (R-N.C.)
Rep. Patrick McHenry (R-N.C.) offered a deep criticism of the Dodd-Frank Act, saying that it does not work and only imposed unnecessary costs on financial markets and the American people. He saw it as a project in which Democrats “did not let a good crisis go to waste” and implemented many new rules that limited consumer choice.
McHenry said the Financial Stability Oversight Council (FSOC) was created to be a regulatory “super-council,” but instead has become a new venue to expose incompetence of regulators. He also mentioned the Office of Financial Research, whose first report was criticized by “everyone from Cato to the left.”
Hoping a new Senate leadership would allow for serious reform of the Dodd-Frank Act, McHenry said he supports a full repeal of the law, but admitted that the probability of that is very low. He said having 52-53 Republicans in the Senate would lead to significant reform, but that 60 would be needed for repeal. If the law were repealed, he said, “That sound everyone would hear would be the flow of capital to small business.”Back to Top
Panel 3: Housing Finance Reform: Which Way Forward?
Hester Peirce, Senior Research Fellow at the Mercatus Center, said that when the Dodd-Frank Act came out, she thought it was a major flaw that the law did not address housing finance reform. However, she said, she now sees this as fortunate because it is one area the law could not do any harm.
Mark Calabria insisted that the GSEs Fannie Mae and Freddie Mac can be wound down and should be. He argued that if banks are willing to hold $1 trillion in mortgage-backed securities, then it should not be an issue to hold $1 trillion in mortgages directly. The capacity to fund the mortgage market, he said, is still available without the GSEs.
Calabria insisted that while realistic models of the economy are already used, realistic models and discussions of the government are also needed. He said insurance premiums will always be underpriced, any new system will still be pro-cyclical, and standards and safeguards will always erode over time.
Competition, Calabria said, cannot be mixed with government guarantee, and the crisis was made worse by the pairing of guarantees with increasing competition. He advocated for losing guarantees in favor of competition. He doubted, however, that any reform of substance would come before the next Congress.
Laurie Goodman, of the Housing Finance Policy Center at the Urban Institute, agreed that legislative GSE reform is highly unlikely any time soon. While many of the principles of reform, such as the need for private capital to take the first loss, to maintain the 30-year fixed rate mortgage, and to preserve the to-be-announced (TBA) market, she said, the biggest disagreement surrounds the question of how to handle access and affordability.
Goodman said that with the GSEs being profitable and functioning at the moment, and with much high legislative priorities, any legislative would likely come in 2017 at the earliest.
Joshua Rosner of Graham Fisher & Co. said meaningful reform is possible without Congressional action, but the structure of the GSEs and the rights of creditors needs to be addressed. He blamed the failures of Fannie Mae and Freddie Mac on three main issues: 1) improper use of portfolios; 2) weak capital requirements; and 3) improperly-priced guarantee fees. He also argued that the GSEs must be separated from political influences.
Rosner criticized the Johnson-Crapo housing finance reform bill for unnecessarily trying to build an entirely new system, like fixing a car that was in an accident by building a new plant and car. He said the bill would not protect the public, reduce systemic risk, improve market discipline, or increase mortgage lending. He argued that replacing the GSEs now would disrupt the market.
Better options, Rosner contended, would include simply fixing the GSEs through conservatorship or a receivership with the new entities coming out with a cleaner charter.
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