Sen. Ted Kaufman (D., Del.) supported the Dodd-Frank financial-reform legislation, but he also expressed “significant reservations” just before casting his vote. “This was a time for Congress to draw hard lines that get directly at the structural problems that afflict Wall Street and our largest banks,” Kaufman said. “Congress largely has decided instead to punt decisions to the regulators, saddling them with a mountain of rulemakings and studies.”
Whether one favors or opposes the 2,300-page bill — which President Obama signed into law on Wednesday — it’s hard to disagree with that assessment. Rather than adopt clear, concise new guidelines on leverage, systemic risk, derivatives, proprietary trading, and other hot-button issues, Congress embraced ambiguous language and outsourced the relevant rulemaking to Washington bureaucrats. Indeed, federal regulatory agencies have been given broad discretion over how to implement Dodd-Frank, which explains why its long-term impact is so uncertain. According to analysts at the Davis Polk & Wardwell law firm, the legislation will require at least 243 rulemakings, and probably many more. (The 243 figure refers only “to explicit rulemakings in the bill, and thus likely represents a significant underestimate.”) As Sen. Chris Dodd (D., Conn.) himself told reporters after finalizing the measure, “No one will know until this is actually in place how it works.”
Take leverage and capital standards. Excessive leveraging at certain financial institutions was unquestionably a major cause of the 2008 Wall Street meltdown. According to a McKinsey Global Institute study
, gross leverage (assets/equity) at the former “Big Five” broker-dealer investment banks — Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley — increased by 42 percent between 2002 and 2007. During that same period, government-sponsored mortgage giants Fannie Mae and Freddie Mac also became dangerously overleveraged.
Congress could have addressed the leverage problem in several ways. For example, writes financial adviser Ron Resnick, it could simply have mandated that “leverage may not exceed X-to-1.” Or it could have enacted something like the Hart-Zingales plan, which would combine new capital requirements with a market-based trigger mechanism for regulatory intervention. Or it could have forced big firms to carry a minimum amount of “contingent capital” (such as convertible debt). Or it could have revamped corporate tax incentives. (A 2005 Congressional Budget Office report found that the effective tax rate on equity-financed corporate capital income is 42.5 percentage points higher than that on debt-financed corporate capital income.)
In the end, Congress chose to avoid tackling the specifics of leverage and capital standards. Dodd-Frank does call for new standards, but it authorizes federal regulators to devise them. The requirements may turn out to be muscular, or they may prove weak and ineffectual. Either way, regulators will be making the key decisions.
They will also be making the key decisions about systemic risk and derivatives. The Financial Stability Oversight Council, headed by the Treasury secretary, will be charged with monitoring risk and identifying non-bank financial companies that are systemically important. If a firm receives that designation, it will be subject to regulation by the Federal Reserve. Will such firms essentially be considered “too big to fail”? Most likely, yes, which will exacerbate the moral-hazard problem.
On derivatives, Dodd-Frank demands more transparency and stronger oversight. Yet, as Manhattan Institute scholar Nicole Gelinas notes, the relevant provisions are riddled with loopholes. “How much the final position will burden companies depends largely on the implementation of the law by regulators,” conclude the experts at Gibson, Dunn & Crutcher. In other words, those who have pushed for much greater openness in derivative trading will have to pin their hopes on the Commodity Futures Trading Commission and the Securities and Exchange Commission (SEC).
Likewise, advocates of the so-called Volcker rule — which will curb “proprietary trading” (trading for profit) by federally insured depository institutions and their holding companies — have to cross their fingers that regulators come up with an adequate operational definition of the trading practices in question. Dodd-Frank contains a version of the Volcker rule, but regulatory authorities will have wide latitude to determine how it is implemented, and which investment activities are exempted. Nobody knows how tight or loose the final Volcker restrictions will be.
Nor does anyone know precisely how the Consumer Financial Protection Bureau (CFPB) will affect credit access, market stability, and economic growth. Located in the Fed, the CFPB will have an independent director, an independent budget, independent rule-writing ability, and enforcement authority (though other regulators will have the chance to appeal its proposed rules). The agency will wield substantial influence over credit cards, mortgages, and other financial products.
That’s the common theme of Dodd-Frank: Regulatory power has been put on steroids. As a result, the full consequences of the legislation will depend heavily on the future decisions of federal bureaucrats. Says former SEC commissioner Paul Atkins, “It’s going to be literally decades before we figure out exactly what this means.”
– Duncan Currie is deputy managing editor of National Review Online.