The Dodd-Frank Act: A Flawed and Inadequate Response to the Too-Big-To-Fail Problem

The Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank ) was enacted in July 2010. Dodd-Frank\u27s preamble proclaims that one of the statute\u27s primary purposes is to end \u27too big to fail\u27 [and] to protect the American taxpayer by ending bailouts. Dodd-Frank does contain useful reforms, including potentially favorable alterations to the supervisory and resolution regimes for systemically important financial institutions ( SIFIs ). However, Dodd-Frank falls far short of the fundamental reforms that would be needed to eliminate (or at least greatly reduce) the public subsidies that are currently exploited by too big to fail ( TBTF ) financial institutions. After briefly describing the financial crisis that led to the enactment of Dodd-Frank, this article evaluates whether the new statute is likely to solve the TBTF problem. Dodd-Frank establishes a new umbrella oversight body – the Financial Stability Oversight Council – that will designate SIFIs and make recommendations for their regulation. The statute also authorizes the Federal Reserve Board ( FRB ) to apply enhanced supervisory requirements to SIFIs. Most importantly, Dodd-Frank establishes a new systemic resolution regime – the Orderly Liquidation Authority ( OLA ) – that should provide a superior alternative to the bailout or bankruptcy choice that federal regulators confronted when they dealt with failing SIFIs during the financial crisis. Nevertheless, Dodd-Frank does not solve the TBTF problem. Congress did not adequately strengthen statutory limits on the ability of large complex financial institutions ( LCFIs ) to grow through mergers and acquisitions. The enhanced prudential standards to be imposed on SIFIs under Dodd-Frank rely heavily on capital-based regulation, which has repeatedly failed to prevent financial crises in the past. Moreover, the success of Dodd-Frank\u27s supervisory reforms will depend heavily on many of the same federal agencies that failed to stop excessive risk-taking by LCFIs in the past and, in the process, showed their vulnerability to political influence wielded by LCFIs and their trade associations. Dodd-Frank\u27s most promising reform – the OLA – does not completely close the door to future transactions that protect creditors of failing LCFIs. The FRB and the Federal Home Loan Banks retain authority to provide emergency liquidity assistance to troubled LCFIs. The FDIC can borrow from the Treasury and can also use the systemic risk exception to the Federal Deposit Insurance Act in order to generate funding to protect creditors of failed SIFIs and their subsidiary banks. While Dodd-Frank has made bailouts more difficult, the continued existence of these additional sources of financial assistance indicates that Dodd-Frank probably will not prevent TBTF rescues during future episodes of systemic financial distress. Contrary to my earlier recommendation, Dodd-Frank does not require SIFIs to pay risk-based assessments to pre-fund the Orderly Liquidation Fund ( OLF ), which will cover the costs of resolving failed SIFIs. Instead, the OLF will be forced to borrow the necessary funds in the first instance from the Treasury (i.e., the taxpayers). Dodd-Frank also does not include my previous proposal for a strict regime of structural separation between SIFI-owned banks and their nonbank affiliates. Thus, unlike Dodd-Frank, my earlier proposals would (i) require SIFIs to internalize the potential costs of their activities by paying risk-based premiums to pre-fund the OLF, and (ii) prevent SIFI-owned banks from transferring their safety net subsidies to their nonbank affiliates. In combination, my proposals would strip away many of the public subsidies currently exploited by financial conglomerates and would subject them to the same type of market discipline that investors have applied over the past three decades in breaking up inefficient commercial and industrial conglomerates. Financial conglomerates have never demonstrated their ability to provide beneficial services to customers and attractive returns to investors without relying on federal safety net subsidies during good times and taxpayer-financed bailouts during crises. Congress must remove those subsidies and create a true “market test” for LCFIs, in which case market forces would probably compel many LCFIs to break up voluntarily

Comment Letter to the U.S. Treasury Department Concerning the Regulatory Structure for Financial Institutions

This comment letter was submitted to the U.S. Treasury Department in connection with that Department\u27s review of proposals for changes in the regulatory structure for financial institutions. The comment letter presents the following policy recommendations: (1) the thrift charter should be eliminated, existing thrifts should be required to convert into banks, and the Office of Thrift Supervision should be merged with the Office of the Comptroller of the Currency (OCC); (2) the dual banking system should be preserved and strengthened in order to promote innovation in banking regulation and to support the community bank sector; (3) at least one federal agency that is separate and independent from the OCC should be designated as the primary federal regulator for state-chartered banks; (4) the existing statutory limits on bank mergers and acquisitions should be maintained, including the 10% nationwide deposit cap and the 30% statewide deposit cap; (5) greater scrutiny and special conditions should be required for large bank mergers; (6) Congress should establish federal consumer protection standards for all home mortgage lenders, credit card lenders, and other providers of consumer credit; (7) Congress should prohibit the OCC from issuing regulations that preempt state law, except in specific areas where Congress has given the OCC explicit authority to adopt preemptive rules; (8) Congress should establish a separate and independent federal authority to enforce federal consumer protection laws against all providers of financial services, including national banks; (9) Congress should recognize the authority of state attorneys general to enforce applicable state laws against all financial service providers, including national banks, (10) Congress should provide the Federal Reserve Board (FRB) with direct oversight over all significant financial conglomerates that control FDIC-insured banks; (11) Congress should prohibit the FDIC\u27s deposit insurance fund from making any payments to uninsured depositors or other uninsured claimants; and (12) all responsibility for protecting uninsured creditors of too big to fail (TBTF) financial institutions should be assigned to the FRB, and the FRB should impose assessments on significant financial conglomerates to recover the FRB\u27s cost of providing financial assistance to TBTF institutions

Narrow Banking: An Overdue Reform that Could Solve the Too-Big-To-Fail Problem and Align U.S. And U.K. Regulation of Financial Conglomerates

This article is based on testimony presented on December 7, 2011, before the Subcommittee on Financial Institutions and Consumer Protection of the Senate Committee on Banking, Housing, and Urban Affairs. The article provides an update and extension of my previous work showing that: (1) the U.S., U.K. and other developed nations provided enormous subsidies for “too-big-to-fail” (“TBTF”) financial institutions during the financial crisis, thereby creating dangerous distortions in our financial markets and economies; (2) large financial conglomerates follow a hazardous business model that is riddled with conflicts of interest and prone to speculative risk-taking; (3) the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) creates helpful new tools for regulating systemically important financial institutions (“SIFIs”) and dealing with their potential failure, but Dodd-Frank does not completely close the door to government bailouts of creditors of SIFIs; (4) Dodd-Frank relies on the same regulatory techniques – including capital-based regulation and prudential supervision – that failed to prevent the banking and thrift crises of the 1980s and the current financial crisis; and (5) Dodd-Frank also depends on many of the same federal agencies that failed to stop excessive risk-taking by financial institutions during the credit boom that preceded both crises.In view of Dodd-Frank’s shortcomings, the article reiterates my proposals for more extensive structural reforms and activity limitations that would (i) prevent SIFIs from using federal safety net subsidies to support their capital markets activities, and (ii) make it easier for regulators to separate banks from their nonbank affiliates when financial conglomerates fail. Congress should mandate a pre-funded Orderly Liquidation Fund (“OLF”) and should require all bank and nonbank SIFIs to pay risk-based assessments to the OLF to provide for the future costs of resolving failed SIFIs. Congress should also mandate a “narrow bank” structure for financial conglomerates that would (a) protect the Deposit Insurance Fund from the risks created by nonbank affiliates of SIFI-owned banks, and (b) prevent narrow banks from transferring their FDIC-insured, low-cost funding advantages to their nonbank affiliates. My recommended reforms are similar to the “ring-fencing” proposal issued by the U.K. Independent Commission on Banking and endorsed by the Cameron coalition government. The narrow bank concept provides a promising way for the U.S. and the U.K. to adopt a common approach for regulating financial conglomerates. If the U.S. and the U.K. adopted consistent regimes for controlling the risks posed by SIFIs, they would place great pressure on other developed nations to follow suit

Turning a Blind Eye: Why Washington Keeps Giving In to Wall Street

As the Dodd–Frank Act approached its third anniversary in mid-2013, federal regulators failed to meet statutory deadlines for more than 60% of the required implementing rules. The financial industry has undermined Dodd–Frank by lobbying regulators to delay or weaken rules, by suing to overturn completed rules, and by pushing for legislation to freeze agency budgets and to repeal Dodd–Frank’s key mandates. The financial industry did not succeed in its efforts to prevent President Obama’s re-election in 2012. Even so, the Obama Administration has continued to court Wall Street’s leaders and has not placed a high priority on implementing Dodd–Frank. At first glance, Wall Street’s ability to block Dodd–Frank’s implementation seems surprising. After all, public outrage over Wall Street’s responsibility for the global financial crisis impelled Congress to pass Dodd–Frank in 2010 despite the financial industry’s intense opposition. Moreover, scandals at systemically important financial institutions (SIFIs) have continued to tarnish Wall Street’s reputation since Dodd–Frank’s enactment. However, as the general public’s focus on the financial crisis has waned—due in large part to massive governmental support that saved Wall Street—the momentum for meaningful financial reform has faded. Wall Street’s political and regulatory victories since 2010 shed new light on the financial industry’s remarkable success in gaining broader powers and more lenient regulation during the 1990s and 2000s. Four principal factors account for Wall Street’s continuing dominance in the corridors of Washington. First, the financial industry has spent massive sums on lobbying and campaign contributions, and its political influence has expanded along with the growing significance of the financial sector in the U.S. economy. Second, financial regulators have aggressively competed within and across national boundaries to attract the allegiance of large financial institutions. Wall Street has skillfully exploited the resulting opportunities for regulatory arbitrage. Third, Wall Street’s political clout discourages regulators from imposing restraints on the financial industry. Politicians and regulators encounter significant “pushback” whenever they oppose Wall Street’s agenda, and they also lose opportunities for lucrative “revolving door” employment from the industry and its service providers. Fourth, the financial industry has achieved “cognitive capture” through the “revolving door” and other close connections between Wall Street and Washington. A widely-shared “conventional wisdom” persists in Washington—notwithstanding abundant evidence to the contrary—that (i) giant SIFIs are safer than smaller, more specialized institutions, (ii) SIFIs are essential to meet the demands of large multinational corporations in a globalized economy, and (iii) requiring U.S. SIFIs to comply with stronger rules will impair their ability to compete with foreign financial conglomerates and reduce the availability of credit to U.S. firms and consumers. Despite Wall Street’s continued mastery over Washington, two recent events could lead to a renewed public focus on the need for stronger restraints on SIFIs. In March 2013, Attorney General Eric Holder admitted that global SIFIs are “too big to jail,” and a Senate subcommittee issued a stunning report on pervasive managerial failures and regulatory shortcomings surrounding JPMorgan Chase’s “London Whale” trading scandal. In response to those events, Senators Sherrod Brown and David Vitter introduced a bill that would require SIFIs to satisfy much higher capital requirements and would also limit their access to federal safety net subsidies. The Brown-Vitter bill could prove to be a milestone because it demonstrates Dodd–Frank’s inadequacy and because it also focuses the “too big to fail” debate on issues where Wall Street is most vulnerable – including dangerously low levels of capital at the largest banks and extensive public subsidies exploited by those banks

Was Glass-Steagall\u27s Demise Inevitable and Unimportant?

The demise of the Glass-Steagall Act was the result of affirmative policy decisions by federal regulators and Congress, and it was not the inevitable byproduct of market forces. Economic disruptions and financial innovations posed serious challenges to the viability of Glass-Steagall, beginning in the 1970s. However, federal regulators and Congress could have defended Glass-Steagall and made necessary adjustments to preserve its effectiveness. Instead, they supported efforts by large financial institutions to break down Glass-Steagall’s structural barriers, which separated commercial banks from securities firms and insurance companies. Federal agencies opened a number of loopholes in Glass-Steagall’s barriers during the 1980s and 1990s. However, those loopholes were subject to many restrictions and did not allow banks to establish full-scale affiliations with securities firms and insurance companies. The largest banks needed two major pieces of legislation to achieve their longstanding goal of becoming full-service universal banks. First, big banks and their trade associations persuaded Congress to pass the Gramm-Leach-Bliley Act of 1999 (GLBA). GLBA authorized the creation of financial holding companies that could own banking, securities, and insurance subsidiaries. Second, the financial industry convinced Congress to adopt the Commodity Futures Modernization Act of 2000 (CFMA). CFMA insulated over-the-counter (OTC) derivatives from substantive regulation under both federal and state laws. The campaigns that led to the enactment of GLBA and CFMA lasted two decades and cost hundreds of millions of dollars. The largest financial institutions and their trade associations would not have pursued those campaigns unless they believed that both statutes would have great importance. GLBA and CFMA proved to be highly consequential laws. They enabled banking organizations to become much larger and more complex and to offer a far broader range of financial products. They transformed the U.S. financial system from a decentralized system of independent financial sectors into a highly consolidated industry dominated by a small group of giant financial conglomerates. GLBA and CFMA promoted explosive growth in shadow banking, securitization, and OTC derivatives between 2000 and 2007. All three of those markets played key roles in fueling the toxic credit boom and unstable financial conditions that led to the financial crisis of 2007-09

Narrow Banking as a Structural Remedy for the Problem of Systemic Risk: A Comment on Professor Schwarcz\u27s Ring-Fencing

In a recent article, Professor Steven Schwarcz describes the concept of ring-fencing as a potential regulatory solution to problems in banking, finance, public utilities, and insurance. Ring-fencing has gained particular prominence in recent years as a strategy for limiting the systemic risk of large financial conglomerates (also known as universal banks ). Professor Schwarcz’s article describes several ring-fencing plans that have been adopted or proposed in the United States, the United Kingdom, and the European Union.This Comment argues that narrow banking is a highly promising ring-fencing remedy for the risks created by universal banks. As the Comment explains, narrow banking would strictly separate the deposit-taking function of universal banks from their capital markets activities. If properly implemented, narrow banking could significantly reduce the safety net subsidies currently exploited by large financial conglomerates and thereby diminish their incentives for excessive risk-taking

The Financial Services Industry\u27s Misguided Quest to Undermine the Consumer Financial Protection Bureau

Congress decided to establish the Consumer Financial Protection Bureau (“CFPB”) after concluding that federal bank regulators had utterly failed to protect consumers during the credit boom leading up to the financial crisis. Because of the prudential regulators’ systemic failures, Congress vested CFPB with sole responsibility and clear accountability for protecting consumers of financial services. Title X of the Dodd-Frank Wall Street Reform and Consumer Protection Act delegates broad rulemaking and enforcement powers to CFPB. To insulate CFPB from political influence, Title X grants CFPB substantial autonomy as well as an assured source of funding from the Federal Reserve System.The financial services industry and most Republican members of Congress vehemently opposed CFPB’s creation, and they have sought to prevent CFPB from implementing its mandate under Title X. In July 2011, the Republican-controlled House of Representatives passed legislation that would seriously undermine CFPB’s autonomy and effectiveness by (i) changing CFPB’s leadership structure from a single Director to a five-member commission, (ii) giving federal prudential regulators a greatly enhanced veto power over CFPB’s rules, and (iii) giving Congress complete control over CFPB’s funding. Republican Senators declared that they would block confirmation of any CFPB Director until Congress approves legislation making the same three changes. Without a Director, CFPB cannot effectively regulate nondepository providers of financial services or exercise many of the powers delegated to the bureau by Title X.The financial services industry and Republican leaders have justified their campaign against CFPB by claiming that the bureau has unprecedented authority as well as a unique structure that is unaccountable to the political branches. In fact, CFPB’s structure and powers closely resemble those of other federal financial regulators, including the Federal Housing Finance Agency (“FHFA”) and the Office of the Comptroller of the Currency (“OCC”). Major banks and their legislative supporters strongly supported the creation of FHFA as a means of controlling Fannie Mae and Freddie Mac, and they emphasized FHFA’s need for sweeping powers and independent funding that could not be undermined by Fannie’s and Freddie’s political allies. Similarly, large banks and Republican leaders have vigorously defended OCC’s independent authority to act on behalf of its regulated constituents (i.e., national banks). Thus, it seems clear that the financial services industry and its political supporters oppose CFPB because of its statutory mission, not its structure.Large financial firms evidently fear that they cannot exercise the same degree of political influence over CFPB as they have successfully deployed in the past with regard to prudential regulators. In the financial industry’s view, CFPB is likely to act independently and conscientiously in carrying out its mandate to protect consumers from predatory financial practices. Congress should want that result. The financial crisis has shown convincingly that a systematic failure to protect consumers will eventually threaten the stability of our financial system as well as our general economy. Congress should therefore preserve CFPB’s existing authority and autonomy despite the determined attacks of the financial services industry and its Republican allies

The FDIC Should Not Allow Commercial Firms to Acquire Industrial Banks

On March 17, 2020, the Federal Deposit Insurance Corporation (“FDIC”) published a proposed rule (the “Proposed ILC Rule”), which would govern applications for deposit insurance, changes in control, and mergers involving FDIC-insured industrial banks and industrial loan companies (“ILCs”). If adopted, the Proposed ILC Rule would open the door to widespread acquisitions of ILCs by commercial firms engaged in industrial, retail, information technology, and other types of nonfinancial activities. In addition, on March 18, 2020, the FDIC approved deposit insurance applications filed by ILCs owned by two commercial firms – Square and Nelnet. The FDIC’s issuance of the Proposed ILC Rule and the FDIC’s approvals of Square’s and Nelnet’s applications represent a fundamental change in policy. Those actions effectively reverse the FDIC’s previous policy of barring acquisitions of ILCs by commercial firms. The FDIC imposed an 18-month moratorium on acquisitions of ILCs by commercial firms between July 2006 and January 2008. The Dodd-Frank Act placed a three-year moratorium on such acquisitions between July 2010 and July 2013. The FDIC did not allow any firms engaged in commercial activities to acquire ILCs from July 2006 (when the FDIC imposed its moratorium) until March 2020 (when the agency approved Square’s and Nelnet’s applications). The Proposed ILC Rule does not explain why the FDIC decided to initiate such a major change in policy with potentially transformative effects on our financial system, economy, and society. If adopted, the Proposed ILC Rule would be contrary to the public interest and unlawful for the following reasons: (1) Further acquisitions of ILCs by commercial firms would (a) undermine Congress’s longstanding policy of separating banking and commerce, (b) threaten to inflict large losses on the federal “safety net” for financial institutions during future systemic crises, and (c) pose grave dangers to the stability of our financial system and the health of our economy. (2) Further acquisitions of ILCs by commercial firms – including “Big Tech” firms like Alphabet (Google), Amazon, Apple, Facebook, and Microsoft – would create toxic conflicts of interest and would also pose serious threats to competition and consumer welfare. (3) The FDIC’s limited supervisory powers over parent companies and other affiliates of ILCs are plainly inadequate to prevent the systemic risks, conflicts of interest, and threats to competition and consumer welfare generated by commercially-owned ILCs. (4) Adoption of the Proposed ILC Rule would be contrary to the public interest factors specified in the Federal Deposit Insurance Act and would also violate the Administrative Procedure Act (“APA”). This article explains why adopting the Proposed ILC Rule would be contrary to the public interest and unlawful. In addition, the FDIC should not adopt the Proposed ILC Rule while our nation is preoccupied with the challenges of responding to the global COVID-19 pandemic. The FDIC should withdraw the Proposed ILC Rule, or postpone any further action on the Rule, until (1) the enormous problems caused by the pandemic have been successfully resolved, and (2) as required by the APA, the FDIC has completed the following actions: (a) explaining the factual, legal, and policy basis for its change in policy on acquisitions of ILCs by commercial firms, and (b) providing public notice of that explanation and affording the public a reasonable opportunity to submit comments on the FDIC’s change in policy and the agency’s stated reasons for making that change. The FDIC should not approve any additional acquisitions of ILCs by commercial firms until all of the foregoing actions have been completed