HBS Faculty Debate Financial Reform Legislation
Harvard Business School professors Robert Steven Kaplan, David A. Moss, Robert C. Pozen, Clayton S. Rose and Luis M. Viceira share their perspectives on the Dodd-Frank Wall Street Reform and Consumer Protection Act, slated to be signed this week by U.S. President Barack Obama. Key concepts include:
- Overall, faculty see reasons for optimism as well as concern and caution.
- We need appropriate risk-taking and credit extension to fuel economic growth, says Robert Steven Kaplan. While the Dodd-Frank bill creates safeguards, will it discourage and impede these activities?
- According to David A. Moss, an open question is how the regulators will use the new authority granted to them.
- The Dodd-Frank bill fails to reform large mortgage finance institutions such as Fannie Mae, Freddie Mac, and the housing agencies, says Robert C. Pozen.
- While the bill does tackle some causes of the crisis, says Clayton S. Rose, it may increase risk to the U.S. financial system by skirting the issues of firms "too big to fail" and the excessive use of market-based short-term funding by financial firms.
- At first sight, Dodd-Frank has elements that indicate we are moving in the right direction, while other parts of the bill leave us uncertain about its future success, says Luis M. Viceira.
The Dodd-Frank Wall Street Reform and Consumer Protection Act slated to be signed this week by U.S. President Barack Obama has been called the most sweeping set of rules for banks and Wall Street since the Great Depression.
But what do several Harvard Business School faculty experts who conduct research on financial markets and regulation and who, in many cases, have held leadership positions in the financial sector, think about the bill and its intended (and unintended) consequences?
Below, HBS faculty members Robert Steven Kaplan, David A. Moss, Robert C. Pozen, and Clayton S. Rose share their perspectives on the bill and its key provisions. Their opinions range from calling it a major step forward to concern that it will actually raise the risk to the system.
Robert Steven Kaplan, Professor of Management Practice:
Overall, I am cautiously optimistic about Dodd-Frank. It's not everything I might have wanted, but the legislative process seldom produces that.
Certain elements of this reform are positive and helpful, including the creation of a formal resolution authority and a systemic risk regulator; provisions requiring derivatives to be put on clearinghouses/exchanges, thereby reducing counter-party risk between financial institutions; and the strengthening of regulators' abilities to require more capital (and less overall leverage) at our financial institutions. They clearly will have this explicit power pursuant to this reform (if they wish to use it).
On the cautionary side of the ledger, much of this reform is yet to be determined. Many parts of the legislation are subject to study and the discretion of the regulators. For example, many elements of the so-called Volcker rule will be left to regulators to study and then implement. It will take some time, therefore, to see how this law will be implemented in practice.
In addition, there are likely to be some unintended negative consequences. Will the new derivatives rules pull in various industrial companies that will now have to use additional capital to hedge their various exposures, thus diverting capital from other productive uses? Will the consumer "protections" and other limitations on bank fees ultimately reduce the availability of credit? Will capital requirements go too far? Will the Volcker rule be implemented in such a way that reduces profitable businesses at financial institutions that did not contribute to the recent crisis?
Whatever the impact, regulators also have to be careful not to be "fighting the last war." Today, we face a new battle. The household and government sectors are overleveraged. The middle class continues to erode as unemployment stays stubbornly high. To fight these forces, we need appropriate risk-taking and credit extension to fuel economic growth. This regulation creates safeguards, but it may in fact discourage and impede these activities. Regulators need to think about this carefully as they implement this new reform.
David A. Moss, John G. McLean Professor of Business Administration:
The financial reform bill represents a major step forward for our financial system and our country. Like virtually every product of American democracy, it is a creature of compromise, and therefore fully satisfies no one, including me. But the legislation deserves to be recognized as a large and impressive accomplishment nonetheless.
The most important part of the statute, Title I, authorizes regulators to tighten regulatory standards for the largest and most systemically dangerous financial institutions. In the run-up to the crisis, a number of massive—and massively leveraged—firms, ranging from Bear Stearns to Citigroup to AIG, played a central role in driving both the bubble and the eventual collapse. And because they were so large and strategically positioned in the marketplace, they threatened to trigger an avalanche of losses across the financial system if they failed (think Lehman). Financial institutions that pose such a threat are the financial equivalent of nuclear power plants, providing an important service in many cases but also posing a profound danger to society. As a result, these systemically dangerous firms must face tough regulation going forward, including strict limits on overall leverage and short-term debt. Under the new reform legislation, regulators will be empowered to rein in the largest financial institutions in precisely these ways.
The legislation also promises to create a resolution mechanism (Title II), allowing regulators to liquidate systemically dangerous firms in an orderly way if one or more of these firms get into serious trouble. Had such a mechanism existed in 2008, we likely could have avoided not only the $29 billion bailout of Bear Stearns in March, but also the systemic catastrophe that followed the bankruptcy of Lehman Brothers in September.
In fact, had the reform legislation been in place starting in the 1990s or early 2000s, we might well have avoided the worst aspects of the financial crisis altogether. While there are many vital features of the bill (from the regulation of derivatives to consumer protection), I believe the focus on systemically dangerous firms in Titles I and II is of particular importance.
The big question now is how regulators will use the new authority that has been granted to them: Will they be tough where toughness is required? Or will they initially tighten standards only to loosen them again as memories of the crisis fade and pressure from industry mounts? Continued vigilance—both now and over the long term—is absolutely essential to prevent another crisis. The financial reform legislation gives regulators the necessary tools, but it will be up to the regulators themselves to use these tools wisely.
Ideally, I would like to have seen more in the way of hard limits, including a tougher cap on leverage, written into the legislation to prevent backsliding by regulators in the future. Although the bill doesn't include everything that I believe is needed (and includes a number of things I might have left out), it is nevertheless a good compromise that promises to make our country stronger as a result.
Robert C. Pozen, Senior Lecturer of Business Administration:
The financial reform legislation takes three steps forward, two steps to the side, and jumps over a large pothole.
Congress took a giant step forward by establishing a framework for monitoring and addressing systemically risky institutions (SRI). The Federal Deposit Insurance Corporation is authorized to seize an SRI and preserve its essential operations. At the same time, shareholders and some debt holders will suffer losses, since their securities will no longer have value.
Second, Congress dramatically reduced the risk of trading financial derivatives by requiring most of them to go through a clearing corporation. The "clearing corp" will force the short side of any financial derivative (i.e., those with the obligation to make delivery) to make a large deposit at the beginning of each deal to assure performance even if the market goes south.
Third, the legislation requires managers of hedge funds (but not the funds themselves) with more than $150 million in assets to register with the Securities and Exchange Commission (SEC). Such registration will subject these managers to regular reporting and inspections by the SEC, although these managers can continue to pursue any investment strategy they choose.
On the other hand, Congress tried to turn back the clock by prohibiting banks from engaging in proprietary trading for their own accounts, subject to complex exemptions. Trouble is, proprietary trading was not a cause of the financial crisis and may reduce risk in certain situations. Moreover, this prohibition is likely to be ineffective, since nothing in this legislation or prior law prevents banks from proprietary trading outside the United States.
Another instance of poor regulatory design is the new Consumer Financial Products Commission (CFPC). The CFPC will make rules for most retail products offered by banks such as certificates of deposit and consumer loans, but it will not be allowed to inspect most banks, since they are already examined by the banking agencies. At the same time, the CFPC's jurisdiction was narrowed to exclude many financial products not well regulated by any federal agency (e.g., loans from auto dealers, retail stores, and real estate brokers).
Finally, Congress missed the main cause of the financial crisis—Fannie Mae, Freddie Mac, and the housing agencies. Given the fragility of the U.S. housing markets, Congress was unwilling to reform these mortgage finance institutions, although they seem to be incurring potential losses of over one billion dollars a day. This glaring omission will clearly have to be addressed sooner rather than later.
Clayton S. Rose, Professor of Management Practice:
If the goal of Dodd-Frank is to prevent another crisis or substantially blunt its effects, then it is a disappointment.
To be sure, the bill does address some causes of the crisis in meaningful ways. There is significantly enhanced transparency in the derivatives markets—a problem at the center of the "interconnectedness issue." The bill seems to have balanced pretty well the needs of legitimate users of derivates with systemic protections. In addition, it provides greater clarity as to how troubled non-bank financial institutions can fail. We should, however, be wary of the claim that the government will no longer bail out distressed firms. If a large, systemically important firm is failing, the political, financial, and economic pressures will be intense for the government to do what it has always done (directly or through surrogates)—intervene. (Rhetoric notwithstanding, the government will do what it wants to do in this regard.)
Perhaps because of its effectiveness as political theater, there is too much focus on proprietary trading and hedge funds, both of which had limited culpability for the crisis. Little has been done to eliminate or mitigate the threat to the system from firms that are "too big to fail." Rather than deal with the real size and structural issues, the bill relies largely upon the judgment and willingness of regulators and politicians to deal with firms that threaten the "system" and make difficult decisions before a crisis strikes. In light of the power of political influences, this is a suspect mechanism in the best of situations. Now, with some rearrangement of the "deck chairs," most of the same regulatory agencies that were responsible for oversight going into the crisis are responsible going forward.
The bill also fails to deal in an effective way with the excessive use of market-based short-term funding by financial firms. There has been much discussion about increasing capital requirements, especially among the largest firms—something that is happening with or without the bill. After all, while leverage and capital were issues in the crisis, access to liquidity was a central problem.
Bottom line: By not dealing effectively with "too big to fail" and the funding issue, Dodd-Frank may actually raise the risk to the system.
Luis M. Viceira, George E. Bates Professor:
The key to preventing future banking panics probably lies in smarter, not more, regulation. At first sight, Dodd-Frank has elements that indicate we are moving in the right direction, while other parts of the bill leave us uncertain about its future success.
A key element in avoiding a banking panic is transparency. In the 21st century, banking has expanded well beyond the boundaries of the narrow, institutionally, and legally focused definition familiar to most people outside the business. The so-called "shadow banking system" (i.e., non-bank financial institutions involved in an array of financial transactions) is shadowy only in that it is not transparent to those who are supposed to supervise and regulate the banking function.
However, it is not shadowy in the sense of lacking substance or being faint. On the contrary, a large fraction of the banking function—transforming the holdings that savers large and small want to have in liquid, immediately available form into the long-term lending most borrowers need—is now performed outside the channels most visible to the Federal Reserve or the Federal Deposit Insurance Corp.
We should not blame anyone but ourselves for this. Almost 40 years ago, savers invented ways to bypass traditional banks and get paid for their cash holdings by moving them into institutions that invest directly in money markets. But cash is not king if there are no people to rule. Cash still needs to be lent if it is going to yield anything, and most borrowers require resources to finance long-term projects. So someone needs to transform our demand for liquidity and immediacy into long-term lending of the kind that promotes growth and prosperity. And banks are the institutions with the expertise to do this.
Thus banks had to find new ways to recapture these now more expensive resources—and do it in a way that it covered their costs and the return required by their capital providers. This led to an extraordinary institutional change that was not accompanied by a corresponding mandate to the Fed and other regulatory agencies to expand their "housekeeping" responsibilities. By doing nothing, we forced the Fed and other regulatory agencies to stay in the old footprint of the house as we expanded its size several times over. This left several areas uncared for. Dodd-Frank allows the Fed to expand its reach.
A stronger Fed with fuller access to financial institutions more widely defined is a welcome change. That said, I would have also favored a functional definition of the Fed's supervisory outreach: If it smells like banking, then it is the Fed's business. And I would have probably entrusted it with the role of new systemic regulator. The Fed has its shortcomings, but on the whole it has been far more competent and proactive than we admit.
Dodd-Frank also provides for the creation of new organized markets to deal with and standardize the flurry of new derivatives products that have appeared in recent years. This is a smart move, since the last thing we need now is to hamper the growth of credit. Modern banking is done through the likes of the repo market and securitization. The behavior of the equity and futures markets during the financial crisis has been living proof of the endurance of well-organized markets. Although we saw dizzying volatility in the markets during the crisis, they were always open and never failed to clear trades.
By providing the means to make these markets transparent and secure, we might be able to bring them back to life and thereby reactivate the flow of credit that entrepreneurs need so badly. But the devil is in the details: What markets will be standardized? Will the repo market be one of them? How can we set these markets so we don't have recurring panics?
Finally, there's no question that there is one glaring omission in the legislation. Freddie Mac and Fannie Mae don't show up. There are several cures available for what ails these organizations, but it will be difficult for the powers that be in Washington to arrive at a consensus about which one to apply. We'll all have to wait and see what happens next.