Your book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance
, provides a detailed analysis of the Act by you and your economic colleagues. What is your overall assessment of the Bill?
The Dodd-Frank Act is clearly the largest regulatory overhaul of the financial sector in the United States since the Great Depression. What it does for the first time, at least as far as financial regulation in the US is concerned, is to take on the issue of systemic risk, the risk that a large number of financial sectors may collapse at the same time, freezing intermediation to households and the corporate sector. The Act requires that the regulators - in particular, a “Council” of regulators - designate a set of institutions as systemically important financial institutions (SIFIs) and then regulate these institutions with better capital and liquidity requirements. The Act also gives the Council the legislative authority to break them up as last resort. In this sense, given that it shifts the focus away from supervising and managing the risk of an individual institution to thinking about the risk of a system as a whole, I would say the Act is a very important step forward. On this it certainly has its heart in the right place.
But if I could pick one big issue with the Act, it’s with its lack of addressing government guarantees. Dodd-Frank believes the primary problem with systemic risk and its creation is the existence of systemically important financial institutions, and their propensity to become too big to fail institutions; but it doesn’t pay as much attention to the fact that in many cases this kind of behavior, of institutions to become excessively large or that they are herding, arises in the first place because there are government guarantees in place.
Let’s take some examples. We had Fannie Mae and Freddie Mac, which were clearly a major part of the housing boom in the United States and they were, for most purposes, implicitly and now explicitly guaranteed by the United States government. We’ve had depository institutions in the United States that have really not paid in good times the cost of the deposit insurance because of certain poorly designed policies for charging them premiums.
I think this aspect is completely getting missed in the Act. First and foremost, you need to ensure that the financial sector’s cost of capital is not artificially low because government guarantees are being offered to them. Once you’ve corrected for the cost of capital, even if there are guarantees in place, one then needs to take on the issue that if the financial sector collapses as a whole, it imposes systemic costs on the rest of the economy and we have to get them to internalize those costs in some fashion.
So I would say while there are two steps that are needed to be taken to really deal with systemic risk, the Act takes one step forward – dealing with too big to fail problem, but it’s entirely silent on the other step – dealing with distortion of government guarantees.
Can it prevent another crisis or, at least, significantly deter negative effects?
Again, I would say the answer is mixed. On the one hand, the Act does identify systemically important institutions and subjects them to more stringent regulation. It actually does something quite interesting, which is to require the regulators to conduct at least an annual stress test where they subject a number of institutions to a common set of macroeconomic scenarios and see whether the system can withstand such a shock. But I think where it probably falters a little bit is in addressing the government guarantees head on.
The second issue where it’s less clear it can handle a crisis well is in that the resolution authority that has been proposed under the Dodd-Frank Act is one of orderly liquidation
. It’s something that the FDIC in the United States is going to design. We think that some parts of what the Act requires the FDIC to do are perhaps somewhat at odds with what one can do with a systemically important financial institution. To elaborate, the Act requires that the FDIC’s liquidation authority wind down an institution by passing losses to equity holders and creditors. But, by definition, a systemically important financial institution is one whose winding down will impose costs on other creditors in the system where other creditors themselves might be systemically important financial institutions. So you can imagine a scenario where in the process of liquidating the first distressed institution, the FDIC is actually simultaneously putting several others into distress and having to deal with them.
Now the Act does allow for the FDIC to deal with the situation, which is that the FDIC can dip into an orderly liquidation fund, which is a reserve that the FDIC has to keep. But it says if you run out of this reserve, FDIC should collect levies ex post from those institutions that survive. Now this is problematic for several reasons. One, it says you’re imposing the cost on the financial sector precisely at the time when you’re trying to manage the risks of distress on some parts of the financial sector. So it’s the wrong time to be taxing them. Second, if you only impose levies ex post you can only impose them on those institutions that survive. This means that you are actually imposing the cost of the crisis on those who ride through the crisis well rather than charging it upfront to those who seem systemically more important.
So in terms of having a policy that’s countercyclical and also that deters incentives of individual firms to load up on systematic risk, the resolution authority aspects of Dodd-Frank leave something to be desired. Our worry is that the first time the next crisis arises, the liquidation
nature of the liquidation authority, given that it won’t have a fund that’s large enough to deal with systemic risk, may create so much uncertainty that it might just lead to another round of panic of the type we had with the Lehman Brothers.
The details are supposed to be fleshed out and the FDIC can anticipate all these problems and try to work around them. But that’s something that remains to be seen. It’s not clear that the Act by itself give a very clear path to an orderly resolution of a too big to fail institution.
The book touches on a comparison of the proposed reforms to those that were undertaken in the 1930s following the Great Depression. Do you see any parallels?
Yes, I would say that there are quite a few parallels. In many ways the 1930s reforms are a good benchmark because they were right around the time of a significant financial crisis in the States, the Great Depression. Many of the regulatory institutions that were put in place dealt with a very special failure of the market that had been witnessed until the Great Depression, and including the Great Depression. In particular, the deposit insurance system was put in place to deal with panic runs of retail depositors. However, it was recognized that you do need to charge premiums for this up front. Second, it was recognized that if you gave deposit insurance to commercial banks but they continued to undertake risky speculator investment activities, it would be the wrong intended purpose of deposit insurance, so the Glass-Seagall Act, separating commercial and investment banking was put in place. Third, it was recognized that there had been a fair amount of opacity about many of the products that had been peddled around prior to the Great Depression, especially in the commercial mortgage bond market. There were also perhaps some conflicts of interest within the banks and the SEC was put in place in order to deal with provision of better information to the markets. And fourth, the FDIC, over time, developed a resolution authority and recognized that you do need to wind down institutions before they lose all their capital, given the systemic nature of bank failures, rather than wait till most capital is wiped out as we did with Lehman Brothers.
Now the Dodd-Frank Act faces the same problems because the real issue was that the 1930s reforms were not flawed, but in fact they were right for the set of institutions that existed in the 1930s. One aspect on the financial sector that the regulation has to grapple with is that institutional forms evolve over time, partly because of technological progress in finance, but partly also because newer forms are designed in many cases precisely to get around the existing regulation.
“Shadow banking” developed in the United States, starting from the ‘70s, primarily to get around the various regulations that were put in place. Money market funds came about to get around the regulation that banks had ceiling rates on the rates they could pay on deposits. A large number of shadow banking institutions started developing over the counter derivatives and wholesale deposits, which looked in many ways to be demandable just like retail deposits but were outside of depository insurance regulation. And then of course we had the gradual steady repeal of investment banking and commercial banking, emergence of hedge funds, and the like. So, in a sense, the regulation set in 1930s was primarily focused on depository institutions but by late 1990s that was probably less than half or just around half of the total financial sector undertaking risks or providing intermediation to rest of the market.
In some sense, Dodd-Frank’s attempt is to design the net of the regulation in a broader way so as to better deal with many of these institutions. It allows the Council of regulators to designate as systemically important institutions, even those financial institutions which are not the traditional banks. It also improves the regulation of over the counter derivatives by requiring many of them to be centrally cleared. It improves their transparency as well as gives regulators the authority to require better capital and collateral on the remaining over the counter products. A limited form of Glass-Steagall in the form of the so called “Volcker rule”, which restricts how much bank holding companies can invest in hedge funds, private equity funds, etcetera, has also been put in place.
However, there are many aspects of the Dodd-Frank Act which don’t go as far as we would like. For example, the Federal Reserve’s lender of last resort of the discount window is allowed for banks or depository institutions, but the Act restricts the Fed from doing any lender of last resort to an individual non- bank institution. Now this kind of regulation by form rather than function is not a great idea because it creates distortions in terms of a level playing field in the financial sector. Once again, it means that the focus of regulators will be much greater on depository institutions because they are the ones who are ultimately eligible for lender of last resort. Whereas the other institutions, right when they are about to get distressed, or just before, could simply merge with depository institutions and still have access to the Federal Reserve of lender of last resort.
Another example, as I’ve said, is that derivatives have to be centrally cleared, but then we will have centralized counter-parties. It seems that you clearly don’t want to wind down a central counter-party in terms of being liquidated in an orderly manner by the FDIC when it fails. The whole idea of a centralized counter-party is at least partly to improve the guarantees that can be provided on derivative contracts being honored. So it would seem that if a centralized counter-party was to get into trouble in the midst of a crisis, then its dealers might also be capital constrained and may be unable to meet additional capital costs. You might want to let the Fed be a lender of last resort to such an institution. Perhaps centralized counterparties will be considered “utilities” of importance to the financial sector and accorded such a privilege.
Overall, I would say Dodd-Frank is a step in the right direction. It tries to expand the scope of the 1930s reform and is very much in a similar spirit as the ‘30s reforms were, but in some cases it doesn’t go all the way there.
A main cause of the financial crisis — Fannie Mae, Freddie Mac, and the housing agencies – are omitted from the Bill and are an ongoing issue for the government. This is the focus of your next book, Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance
. What you tell us about the book’s genesis and main issues it discusses?
This book was really a spinoff of other efforts in the book on Regulating Wall Street. We thought that the Dodd-Frank Act would tackle the issue of government guarantees head on, in particular talk about what role Fannie and Freddie are playing in the financial sector, why the government guarantees to the mortgage market are highly distortionary, and how to deal with that problem going forward. Now to the extent that the Dodd-Frank Act did not do that, and because we thought it was such an important topic, we decided that it needed to be discussed somewhere. Hence, the second book.
The book really makes two big points. First is that what happened in the mortgage market was really a race to the bottom as far as risk-taking and leverage-seeking was concerned. It was a race to the bottom between Fannie and Freddie on the one hand and the private financial sector that also entered the mortgage securitization business on the other hand. The private financial sector tried to achieve similar returns from sub-prime mortgage securitization that Fannie and Freddie had traditionally been achieving through prime-quality mortgage securitization. Now why the race to the bottom? Because Fannie and Freddie were effectively guaranteed on the down side. Their cost of capital was cheaper than that of the private financial sector. Even if by thirty or forty basis points, that’s a lot of reduction in the cost of capital in the financial sector.
Second, the moment you have such a huge unbounded government foray into the private financial market, we say in the book that Fannie and Freddie could be called the largest hedge fund on the planet but with effectively an explicit government guarantee. Now when you have something like this it just distorts the level playing field and produces a least common denominator as far as risk taking is concerned.
Hence our proposal in the book is to unwind from Fannie and Freddie in an orderly manner over the next 7 to 10 years, deploy a fully fleshed out transition plan to do this, the intention being to restore the private financial sector’s role in the mortgage market, and not push the extent of securitization at all costs beyond what is the right natural level that the market gravitates to. In transition, some government role will be necessary given the huge presence of Fannie and Freddie in the market. We lay out in the book how to bring it down to de minimis levels over time. Also, it is important to ensure that any role the government has to play in the long run, e.g., to continue to provide for some affordable housing, it should only be for very tightly controlled mortgages, just like what the FHA (Federal Housing Administration) does right now. It’s fully on the government balance sheet. It’s recognized within the debt ceiling of the government. We are worried that if you don’t do this, like Fannie and Freddie, any future government guarantees will again be just a Ponzi scheme that’s running off balance sheet, away from the government balance sheet, but reappears on the balance-sheet when underlying risks go sour.
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Viral V. Acharya is Professor of Finance at New York University Stern School of Business (NYU-Stern), Research Associate of the National Bureau of Economic Research (NBER) in Corporate Finance, Research Affiliate of the Center for Economic Policy Research (CEPR) in Financial Economics, Research Associate of the European Corporate Governance Institute (ECGI), and an Academic Advisor to the Federal Reserve Banks of Cleveland, New York and Philadelphia, and the Board of Governors.
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