The Dodd-Frank Financial Regulatory Law: Long-Awaited Cure — or Cause for ‘Wild-Eyed Alarm’?

President Barack Obama’s policy architects say they will begin enforcement of a sweeping new set of financial regulations intended to govern risk-taking on Wall Street and offer greater protection to consumers. The goal is to help the U.S. economy return to prosperity after the worst crisis since the Great Depression.

Neal Wolin, deputy secretary of the U.S. Department of the Treasury, and Diana Farrell, deputy director of the National Economic Council, visited Wharton several weeks after the bill was signed into law as part of an effort by the Obama administration to engage the public in a discussion of the financial overhaul and to outline its timetable for implementation. Wolin spoke at Wharton’s main campus in Philadelphia and, less than a week later, Farrell gave a speech at Wharton San Francisco. (See video of audience questions during Wolin’s presentation on this page.)

Critics of the new legislation argue that it will increase the size of government, restrict credit at a time of continued economic strife and lead to costly rules for business owners, while also failing to adequately protect consumers or do enough to cut large interconnected financial entities down to size. Yet according to Farrell and Wolin, the changes are essential to future economic growth. Echoing an earlier speech by President Obama, both quoted a Time magazine article from 1933 about outrage on Wall Street over the creation of the Federal Deposit Insurance Corp. in the wake of the Great Depression. (For Wharton faculty reaction to the legislation, see: “‘A Major Transformation’: The Pros and Cons of the Dodd-Frank Act.”)

“Through the great banking houses of Manhattan last week ran wild-eyed alarm,” the Time article read. “Big bankers stared at one another in anger and astonishment.A bill just passed … would rivet upon their institutions what they considered a monstrous system…. Such a system, they felt, would not only rob them of their pride of profession but would reduce all U.S. banking to its lowest level.”

In his speech, Wolin said that while the regulatory framework put in place in the 1930s served the nation well for many decades, supporting “an enormous amount of lasting innovation and economic growth the likes of which the world has never seen,” it was clear that the system was insufficient to meet the challenges of the financial world in the 21st century. Although there is no way to ensure that big risks and challenges will not emerge down the road, the new law creates a flexible regulatory system that will better handle any stresses, he noted. “This is not meant to be a magic elixir. This is meant to be a serious, rigorous set of rules that we think has the fundamental bases covered.”

The End of ‘Too Big to Fail’?

To understand why the reform makes sense, Wolin said it was important to know what factors fed the recent crisis. And here, he added, there was plenty of blame to go around. “The failures that led to the crisis were many,” he pointed out. “Throughout the financial system, firms took on risks that they did not fully understand. In Washington, regulators did not make full use of the authority they had to protect consumers and limit excessive risk. Legislative loopholes allowed large parts of the financial industry to operate without oversight, transparency or restraint…. And there is no doubt that, across the country, Americans took on more debt than they could afford, and that many firms encouraged them to do just that.”

The Dodd-Frank law addresses this unfortunate confluence of events through five core elements. The new tools at the government’s disposal include a council to identify and manage systemic risk, more stringent capital requirements for banks, comprehensive oversight of the derivatives market, a mechanism for the government to shut down large financial institutions whose failure could trigger a broad meltdown, and a new consumer watchdog group under the Federal Reserve to prevent the deceptive marketing of financial products.

One key goal is to eliminate the danger of firms that are “too big to fail” — so interdependent on the larger economy that a bailout was the only alternative to a crash of the entire system. According to Farrell, the new rules solve that problem. “Part of what contributed to the crisis was the moral hazard of very large interconnected firms operating under the market perception, and their own perception, that there was nothing to worry about, because if they failed, the government would step in,” she stated. “Sadly, the crisis exacerbated that moral hazard, since the government did have to step in…. So a lot of thought and care was given to how you construct a system that is safe, but really puts an end to this moral hazard, this ‘too big to fail’ mentality.”

Under the new law, the government now has the power to unwind any firm that poses a risk to the entire financial system, regardless of whether the troubled firm is a bank or not. On this point, Wolin put Wall Street on notice that taxpayers would not be opening their wallets again anytime soon. He noted that stronger capital standards should reduce the risk of insolvencies. But in the event that a large financial institution were to collapse, he added, healthy financial firms would be hit with a charge to cover the failure. “This new law makes it absolutely clear that taxpayers will never be asked to bear the costs of a financial firm’s failure.”

Creating a Timeline

Farrell offered a timeline for implementing the new set of agencies that will oversee the nation’s financial well-being. By October, she said, the Financial Stability Oversight Council will be created and vested with the ability to break up firms that pose a risk to the system. The council is comprised of the heads of the U.S. Treasury, the Federal Reserve, the Securities and Exchange Commission, the FDIC, the director of the soon-to-be-formed Bureau of Consumer Financial Protection and others.

Within six months, corporate boards must offer shareholders a nonbinding say-on-pay vote, which gives these shareholders a public way to protest how much executives are paid. Within nine months, a provision kicks in affecting companies that package mortgage-backed securities, requiring them to hold at least 5% of the credit risk (except under certain conditions meeting new risk-lowering metrics). In the past, many loan originators and packagers sold off 100% of an offering, which provided little incentive for them to ensure loan quality — something viewed as allowing many toxic loan packages to go undetected. The idea is that by being forced to hold part of the risk themselves — by  having some “skin in the game” — the loan packagers will now be more careful about loan quality.

A year from now, or perhaps earlier, the Bureau of Consumer Financial Protection will be set up to focus on fraud and unfairness, and deal with issues such as the punishing credit card terms that often shifted under the feet of debt-burdened consumers.

Wolin suggested that a key driver of the economic meltdown was “people taking on liabilities and debt they didn’t understand … [and] couldn’t cope with.” Those problems, he stated, are addressed head-on in the law through the creation of the consumer protection group under the Fed. While Wolin didn’t weigh in on speculation over who will be appointed to run that entity, he added that the new group will ensure that consumers understand the pros and cons of any financing they tap, whether it is a mortgage or a student loan.

Importantly for Wall Street, the Volcker rule is scheduled to be in place within 18 months. The rule, named for former Fed chairman Paul Volcker, says that banks cannot engage in proprietary trading if it is not on behalf of a customer. Banks are also prohibited from making significant investments in hedge funds and private equity funds, noted Farrell, who was director of the McKinsey Global Institute — the firm’s economics research arm — before taking a federal post.

But economic experts note that many pieces of the reform still need to be hammered out, and that the task of writing regulations to implement the law alone is a massive undertaking. On the issue of what to do with the housing finance market — including Fannie Mae and Freddie Mac, the two troubled government-sponsored mortgage insurers — Wolin acknowledged that the path was unclear. The Obama administration hosted a summit on that topic on August 17 to help officials sort out options for reform. The administration will put forth its plan for that overhaul in early 2011, stated Wolin, who spent six years in the Clinton administration as deputy counsel and general counsel of the Treasury, and served as president and COO of the property and casualty insurance companies of the Hartford Financial Services Group before taking his current post.

A ‘Pyrrhic Victory’

Farrell said that while the broad objectives defined by the Obama team have been achieved, there were some disappointments as final changes were made to the legislation. “In general, the places where this bill didn’t get all that it should have were places where either the industry, or industry groups, lobbied Congress and got carve-outs,” she stated. One carve-out puts auto dealer lenders under the oversight of the Federal Trade Commission instead of the new bureau of consumer protection, the agency that will regulate others that issue car loans. Although that exception was the result of efforts by the dealer lenders, Farrell pointed out that it might be a Pyrrhic victory if the FTC ends up being the tougher regulator.

Another minor setback for the Obama team was on derivatives trading rules, Farrell noted. She said it had been a priority to make sure that firms that use derivatives to hedge risk should not be subject to the same capital and margin requirements that restricted dealers and major swap participants. The exemption created some maneuvering. “Everyone used it to try and get exemptions of all sorts,” she acknowledged. “By and large, I think the end result was a pretty narrow exemption.”

When the topic turned to the economy, Wolin echoed the cautiously optimistic tone taken in recent weeks by his boss, Treasury Secretary Timothy Geithner. Wolin noted that while there was evidence of “a moderate recovery that is beginning to build,” he conceded employment figures were “uneven” in recent months and that there was “substantial more work to do” on the jobs front. “There is no question there is still an enormous amount of pain being felt by individuals, families and small businesses.”

In contrast to the 2009 stimulus package, however, the Obama administration’s plans for addressing the current unemployment problem appear less ambitious. Wolin pointed to the recently passed law that provides some financial assistance to the states, as well as pending legislation that would aid small businesses through tax cuts and improved access to credit as the kinds of tools that would help improve the employment picture.

As to what might prompt corporate America to start investing and hiring again — a serious concern in light of Federal Reserve figures that show nonfinancial firms sitting on $1.8 trillion in cash — Wolin added the Administration would continue its efforts to stimulate private sector investment through prudent fiscal and tax policy. But he also counseled patience. “The economy just went through an enormous amount of stress,” he said. “It is still unwinding from that stress.”

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