For Better or Worse: Six of the Changes Mandated by Dodd-Frank

By Ed Cohen | Spring 2011

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More transparency and monitoring of derivatives trading


WHAT'S NEW: fewer transactions permitted to be done out of sight, more attention focused on system-critical institutions

Derivatives must now be traded on exchanges or through clearinghouses, which will be monitored for early signs of trouble. A derivative is a contract between two parties, each called a counterparty. The contract’s value is based on changes in interest or currency rates, or even an event such as a company’s default. After the parties have come to agreement on a trade, a clearinghouse or “central counterparty” often becomes involved through a legal process known as “novation.” The clearinghouse steps into the middle of the trade, becoming the buyer to the seller and seller to the buyer, reducing the risk of default to both parties and bringing the entire transaction into the view of regulators.

A new Financial Stability Oversight Council—an all-star team of regulators that includes the Treasury Secretary and the heads of the SEC, FDIC and Fed—is charged with identifying banks and nonbank financial institutions, including clearinghouses, that are most likely to cause systemic problems if they fail. The board is supposed to subject them to stricter regulation. In an emergency, the Fed can tap its credit lines to provide liquidity and credit to certain clearinghouses.

WHY IT MIGHT BE GOOD: It provides regulators a clearer, timelier picture of potential meltdowns.

Professor Paul Schultz:
When investment banks such as Lehman Brothers and Bear Stearns became
insolvent as a result of their derivatives trading, it put regulators in a tough spot. The companies had so many interlocking contracts that it was hard to tell what would happen to the markets if one of the firms went bankrupt.

“This is what causes regulators to really panic … The centralized clearinghouse makes it much easier to see exactly who owes what on what.”

WHY IT MIGHT BE BAD: An emergency backstop could lead to riskier behavior.

Professor Colleen Baker:
The Fed’s emergency-rescue authority could potentially create the type of moral hazard that arises in the presence of insurance.

“Some people might not drive as carefully as they should because they know that if they get in a wreck, they’ll have their $250 deductible and the insurance company will pick up the rest. So the fact that I have insurance introduces a certain moral hazard. I won’t necessarily be less careful, but I might be because I’m not going to be fully responsible for its downside risk.”

Also, the government could find itself in the same position with certain clearinghouses that it was in with some financial institutions during the crisis. “Any large, highly connected clearinghouse would be the ultimate ‘too big to fail’ entity.”
 

Exposing excessive executive compensation

WHAT'S NEW: extremely high-paid executives face potential embarrassment

The law requires companies to give shareholders a nonbinding vote on the compensation packages of the company’s directors and top executives. Companies also will have to report the ratio of the CEO’s pay to the median pay for all other employees.

WHY IT MIGHT BE GOOD: 

Senate Committee on Banking, Housing and Urban Affairs (2010):
[It] gives shareholders a powerful opportunity to hold accountable executives of the companies they own, and a chance to disapprove where they see the kind of misguided incentive schemes that threatened individual companies and, in turn, the broader economy.

WHY IT MIGHT BE BAD: The potential unintended consequences abound.

Professor Jeremy Griffin (MSA ’00):
Griffin has conducted controlled experiments in which volunteers play the roles of investors and management, and the shareholders are given a say on executive pay. He found that when management voluntarily asked shareholders for their opinion on the compensation package—as was the case before Dodd-Frank required it—the consultation built goodwill with the shareholders.

“Some of that advantage goes away when you put a gun to [the board’s] head and you have to ask the investor. Once everyone is required to [poll shareholders] by regulation, you lose the signal. Investors can’t tell the good guys from the bad guys.”

Professor Matthew Cain:
“There will be some isolated cases where shareholders are frustrated that they have had difficulty effecting change within those companies and this is going to give them a little bit of extra publicity … But shareholders already get to vote on the board of directors every year, and if they don’t like the way the company’s being run, they can vote in new directors. The new directors can come in and replace the executive team, and they can set compensation according to shareholder preferences.

Professor Paul Schultz:
“The point of [publishing the ratio] is clearly to put pressure on companies to have a lower ratio of CEO pay to median employee pay. And I think the people who included this in the bill thought this kind of reporting would embarrass people into either paying their CEOs less—which is not all that good of a goal—or paying their other employees more, which is perhaps a better goal. But the other way you can lower that ratio is to not hire as many unskilled employees. We could see companies hire independent contractors or ship jobs overseas.”

 

Higher equity requirements for banks

WHAT'S NEW: banks required to have more shareholder equity in reserve to offset risky ventures

One of the sources of the financial crisis was banks securitizing their portfolios of mortgages. They securitized because leaving the loans on their books was costing them an opportunity to make more money. Regulations required certain risk-weighted investments, such as mortgages, to be backed by stockholder’s equity in order for the bank to be considered “well capitalized.” Investors typically demand about a 10 percent return on a stock, compared with 2 percent or less interest paid on checking or savings accounts. Banks naturally wanted to minimize the expensive equity obligations their mortgages entailed. To do that, they had to move the home loans off their balance sheet, which they did by creating separate legal entities. Unfortunately, when the housing market collapsed, the banks found out they were still liable for the losses. Some banks were leveraged 50-1, leaving only 2 percent in equity. If they lost that 2 percent, they were bankrupt. Dodd-Frank and an international financial treaty close the securitization loophole and allow regulators to impose much higher equity requirements, especially on the largest financial institutions deemed systemically important. The requirements can be raised ever further if the banks get into trouble or a credit bubble develops.

WHY IT MIGHT BE GOOD: It could put the brakes on out-of-control lending.

Professor Thomas Cosimano:
An economist, Cosimano has been a visiting scholar with the International Monetary Fund since 2000. In a report he delivered to the group in Washington earlier this year, he concluded that a potential first round of higher-equity requirements would depress the growth of lending by the world’s 100 largest banks by about 1.25 percent. That would result from the banks having to charge 0.17 percent higher interest to cover the new equity requirements.

“But that’s what you would want. One of the problems was that we had this excessive boom in credit. Now, if [regulators] see that occurring, they’re supposed to essentially step in and try to do something to slow that credit down.”

Why it might be bad: Businesses inevitably find ways to sidestep rules.

Cosimano:
“All the economic incentives are there for people to figure out ways around the new requirements. Will the regulators have the guts when they find institutions [breaking the rules] to force them to abide by them? In the past, they didn’t.

“This is the bureaucratic way for solving the problem of risky behavior. What an economist would do is measure the riskiness of particular financial positions, identify who the risky people are, and then impose a tax based on how much risk they’re adding to the system. It’s what you do with a private-sector insurance company. If somebody is riskier, if they’ve had more car accidents, you raise their insurance premium to penalize them for undertaking that activity. You also put in clauses that say, ‘OK, if your house is closer to a fire hydrant, making you less of a risk, you get a better insurance premium.’”
 

Skin in the game

WHAT'S NEW: a new rule to make mortgage originators think twice about risky loans.

Lenders that convert pools of mortgages into mortgage-backed securities will have to retain at least 5 percent of the loans’ credit risk unless the underlying loans meet standards designed to reduce risk. Loan originators will thus have more “skin in the game,” or a direct stake in making sure their loans are good.

WHY IT MIGHT BE GOOD: It reduces opportunities to foist off bad loans on the securities market.

Professor Zhi Da:
The problem before was information asymmetry. The loan originators knew more about the borrowers than the eventual investors in a mortgage-backed security.

“So if I’m a bank, the loan originator, and I have about a hundred mortgages sitting on my books and I can choose to sell off 50 of them in the form of a mortgage-backed security, I’m going to sell the 50 worst.”

WHY IT MIGHT BE BAD: It could choke off credit to all but the strongest mortgage applicants.

Zhi Da:
“If I’m a bank and I can either issue a high-quality residential mortgage, which I don’t have to tie up any of my capital, or I can choose to originate a slightly lower-quality mortgage loan where I need to put up 5 percent of my own money, I might end up just focusing on the better credit sector. So people with slightly lower quality like your first-time home owner ... might be excluded. That would definitely hinder some of the recovery of the housing market and might also slow down the recovery of the economy.”
 

Bureau of Consumer Financial Protection

WHAT'S NEW: a financial-industry-specific watchdog with teeth

Predatory lending and consumer ignorance were blamed by many for the housing market bubble and subsequent collapse. Housed in the Fed, the Bureau of Consumer Financial Protection will be able to write rules for consumer protection governing all institutions that offer consumer financial services and products. It will also have authority to enforce regulations on banks and credit unions with assets over $1 billion and all mortgage-related businesses. There will be an Office of Financial Literacy and a national consumer complaint hotline.

WHY IT MIGHT BE GOOD: More responsible lending should mean fewer defaults.

Professor Zhi Da:
Investments in mortgage-backed securities collapsed because homeowners often took out loans they couldn’t afford and that were sold by loan originators being paid according to the number of loans they closed.

“Both parties are partially to blame … but I would hold the lenders more responsible. They kept coming up with creative ways to make the loan work. The borrowers overstretched themselves, but they did that precisely because they got advice from lenders [saying] housing prices are going to go up so you should be able to refinance at a much lower rate and this price appreciation will become your profit.”

WHY IT MIGHT BE BAD: means more government interference in the market.

Professor Paul Schultz:
“Some consumers certainly did stupid things, but others took a chance and thought, ‘Oh, I’ll be able to sell this house at a higher price in a couple years. By the time the low interest rate goes up, the house price will have increased enough for me to refinance.’ And for many people, the opportunity to live in a house you couldn’t afford for five years is not the worst thing. This is not to say that some people weren’t misled or ripped off, but I just don’t see that as a major factor. [I]t seems to me [this bureau] has the possibility of just over-regulating and interfering in a lot of things that are just best left to the market.”
 

The Volcker Rule

WHAT'S NEW: banks won’t be allowed to speculate as much

Named for former Fed Chairman Paul Volcker, the Volcker Rule prohibits commercial banks from proprietary or “prop” trading, which is making investments not on behalf of customers but using the bank’s own accounts. Volcker has argued that such activities played a key role in the financial crisis. The law also limits bank investments in hedge funds and private-equity funds. This is a throwback to New Deal legislation that erected a wall between investment banks and retail banks. The distinctions have blurred in recent years with deregulation.

WHY IT MIGHT BE GOOD: lt limits taxpayer exposure with bank failures.

Professor Paul Schultz:
“[I]f you’re going to have the government insuring deposits, it’s fair to have limits on the capital and the risk that a financial institution can take.”

WHY IT MIGHT BE BAD: It could drive investment and customers out of the country.

Citigroup Inc. CFO John C. Gerspach (’75):
“[Y]ou don’t want to end up with a banking system that is safer but completely non-competitive with the rest of the world. We exist in a global environment and a global market … and capital will find its way to where it can be most efficiently put to work.”

Professor Robert Battalio:
“If you make it more and more costly to become a public company, people are going to stop doing business here. The best evidence I’ve ever seen on this is what happened in 1999 with bulletin-board stocks. You’ve got the New York Stock Exchange and Nasdaq … and then you’ve got the over-the-counter market and bulletin-board stocks, which are kind of smaller stocks. The government imposed a bunch of reporting requirements on these bulletin-board stocks in 1999, and three out of every four just said, ‘Forget it, we’re leaving.’ Now, are we better off?”